Many people look to commercial real estate as an outlet for passive income. Commercial real estate is a broad term that covers everything from factories, retail locations, offices, and much more. If you’re new to commercial real estate investing, how do you know what’s best for you and what goes into it? Factors like the classification of the property and the type of lease your tenants have will impact your investment and risk. In understanding the potential risk/reward, you can make better decisions in your investments.
Classifications of Commercial Real Estate
In general, commercial real estate is split into three categories for classification. These classifications can help an investor get valuable information to assess risk/reward for potential properties. The most important information you’ll get out of these classifications is how much income from the rent you can expect and how much you can expect to pay for specific properties.
Class A Buildings
These are newly built high-quality properties in good locations. Usually, these buildings bring in higher rental income than the others due to the amenities they provide to tenants. These amenities include everything from parking garages, attended lobbies, on-site security, and great neighborhoods.
Class B Buildings
Class B buildings are sometimes found in the same neighborhoods as Class A buildings but don’t have the same amenities as Class A. They’re usually older buildings but aren’t as expensive to rent as Class A buildings. In most cases, these are considered to be a very sensible option.
Class C Buildings
These offer the lowest rental options because they are considered mostly functional spaces that aren’t that attractive. In addition to being the most affordable option, they are sometimes in undesirable locations.
There are usually a few ways to set up a lease structure for incoming tenants. Knowing which structure your property uses will help determine how much net income you can expect to see. The two most common lease structures are a Gross Lease and a Triple Net Lease.
A gross lease is generally the most simple structure for your tenants. This is usually a higher base rent that is usually set up to accommodate some property expenses. However, with this model, management of the property and responsibility for the varying expenses falls upon the landlord.
Triple Net Lease
In a triple net lease, a tenant’s rent includes a percentage of the total expenses of the property. This usually consists of a percentage of insurance, maintenance, and taxes. A structure like this can be favorable because there is less stress upon the landlord to oversee the property and incur other expenses.
How can you value a commercial real estate property?
Commercial real estate cap rate is a formula investors use to determine the rate of return they can expect from an investment property. This is done by analyzing the property’s Net Operating Income and dividing it by its purchase price. Investors use this to gauge the risk of the flow of income from the property. If the formula produces a high cap rate, that signifies higher risk, and a lower cap rate generally means less risk.
As an investor, what does all of this mean for you? Put simply, many factors go into real estate investing and sometimes aren’t as passive as some people would want. By putting in the research, you can find how commercial real estate investing can work for you. Take the time to see how much risk you can inherit from the property and how much you stand to gain from it. If you take the time, commercial real estate investing can be very lucrative.
About the Author
Veronica Baxter is a writer, blogger, and legal assistant operating out of the greater Philadelphia area. She frequently works with legal and financial professionals, including First Nation Realty Partners, a rapidly growing commercial real estate private equity firm.