Many indicators show the economy is strong, which in turn means small businesses are following suit.
Small business financials were at the strongest point in 2017 since data collection started in 2007, according to BizBuySell’s Q4 2017 Insights data. The median revenue of sold businesses grew more than 5 percent this year. There’s also a trend of home-based businesses moving to brick-and-mortar locations, says Danny Mulcahy, director of equity for Northstar Commercial Partners in Denver.
This bodes well for the landlords of the small office and retail commercial spaces they occupy, which have the potential to ride their success in the form of potential above-average returns.
But before investing in small commercial office, retail and industrial properties, which are fiercely different products than residential investment properties, it’s important to exercise adequate due diligence and heed the following advice, experts say.
Hire a good team of advisors. “Deciding to invest in commercial real estate is a large decision typically,” says Michael Marsh with real estate brokerage Lee & Associates in Phoenix. “There are many factors to potentially consider such as legal structures, financial evaluations, liability, loans, tax implications, and property management.”
A sales specialist in the type of commercial real estate you’re interested in will have the best available information for you to consider, he says.
“A commercial broker will be able to quickly work through a large set of properties as well as present off-market opportunities,” he says.
An investor should also have an idea of financing options from a competent commercial real estate banker. An experienced property attorney can help with setting up an adequate structure for holding the real estate and put bulletproof leases in place, Marsh adds.
Avoid empty buildings, at least to start. “The main criteria when selecting such a [commercial] property is to look for ones that have cash flow,” says Spencer Chambers, a general contractor and Realtor with The Chambers Organization in Newport Beach, California. “That is the reason you make any real estate investment. Avoid ones that don’t make money.” Properties with cash flow are more proven and it is easier to get financing to purchase them.
* * *
Do your research. Small commercial real estate is a trickier investment than residential. Before you buy, ask, “What are rents for comparable properties? How quickly are vacancies filled in the area? How much should you expect to spend on maintenance and repairs?” says David Reiss, a real estate professor at Brooklyn Law School. “You want to be able to predict the likely income and expenses the building will have.”
Evaluate any current tenants and their leases carefully as well: “There is a big difference between buying a building that is fully rented up with tenants who are paying their rent regularly and have a lot of time left on their lease and a building [that] has tenants with month-to-month leases who are behind on their rent,” he says.
That’s because the greatest costs for the landlord are vacancy and management. These aren’t often efficient with a limited economy of scale compared to larger landlords and real estate investment trusts, says Walt Batansky, chief financial officer of Avocat Group, a corporate real estate firm in Tampa, Florida.
Look at the capitalization rate. The building’s capitalization rate, based on its net operating income, is used to evaluate a commercial property. To arrive at the cap rate, the net operating income (or annual rental income minus expenses but before any mortgage payments are factored in) is divided by the average rate of return for similar properties in the area.
“You should go as big as your purchasing power allows, meaning whatever you’re able to get a loan for,” Chambers says. “As long as you’re buying a cash flow property from day one. You want to buy something with over 8 percent capitalization rate.”