Real estate offers reliable value over time. While markets may struggle and returns on investment (ROI) may fluctuate, real estate can be a solid investment strategy. For potential buyers, there's a key question to consider: Should they purchase residential real estate or commercial properties?
While residential properties often come with a lower bar to entry, they can't always compete when it comes to ROI. Here's what you need to know about potential profit opportunities, the pros and cons of commercial real estate1 purchases and how to get your investment strategy off the ground.
What Is Commercial Real Estate?
There are two broad types of investment properties: commercial and residential. Perhaps the most iconic example of residential property is the single-family home. These homes are on the high-end of popularity and price. They're also typically easier to rent out and can offer steady returns over time. Other residential options — such as condos, townhomes and duplexes — offer varying ROI based on current market conditions, neighborhood amenities and population shifts. Commercial real estate properties, meanwhile, offer more diversity. As noted by Nolo, commercial offerings include:
- Retail buildings
- Office buildings
- Industrial buildings
- Apartment buildings
- Mixed-use buildings
While residential real estate often garners the most attention — especially when markets undergo significant shifts due to local or global events — there's less general knowledge around the types of commercial property and their potential returns for investors. As a result, it's worth doing your research.
Pros and Cons of Investing in Commercial Real Estate
If you're considering a commercial property investment, start by considering both sides of the coin. Let's break down some of the biggest pros and cons of investing in commercial real estate.
Some of the biggest pros of commercial investment may include:
- Potential ROI — The ROI of commercial investment is typically higher than comparable residential properties. On average, commercial real estate offers an ROI between 6% and 12% while residential ROI lands between 1% and 4%.
- Price per square foot — The rental price per square foot of commercial space significantly outpaces the price of residential properties. In Phoenix, for example, not only are commercial builds on the rise but low vacancy rates are driving up the cost of rent with prices topping $25.48/sf per month. While residential rates are also on the uptick, they come in far under their commercial counterparts at around $1.00/sf per month.
- Professional relationships — Since tenants often rely on their location to ensure consistent foot traffic, property owners can develop long-term professional relationships for consistent income.
- Limited operational hours — Unlike a residential property, where tenants are always living in the space and could encounter serious issues 24/7/365, businesses typically have much more limited hours of operation, meaning there's less chance of encountering issues in the middle of the night. The caveat? You'll need reliable alarm and alert monitoring systems to ensure businesses are protected after hours and the proper authorities are notified for potential insurance claims.
There are also potential drawbacks to commercial real estate investing, such as:
- Multiple tenant management — Many large-scale commercial properties have more than one tenant, which means you're managing multiple client relationships at once. This can become problematic if tenants can't agree on the use of common spaces or parking is at a premium. Your potential ROI is higher, but so is your potential time commitment.
- Maintenance at scale — Commercial properties come with substantial maintenance requirements, both for common spaces and individual units. As a result, you must be prepared to pay for both property management and maintenance services which generally charge between 5% and 10% of total rent revenues to provide service.
- Upfront costs — While the average residential home price in Arizona is just over $275,000, commercial properties can easily cost between $1,000,000 and $3,000,000 (or more). This makes investor buy-in a more daunting task, especially if you lack available capital.
- Increased overall risk — With more people — both tenants and visitors — commercial properties carry more risk. From damage to the property itself or the chance of injury to customers, be prepared to pay more for insurance and ready to handle potential claims or lawsuits.
While it's one thing to talk about the potential ROI of commercial properties, it's another to do the math and see what you're actually getting back once you invest in office buildings, medical spaces or mixed-use structures. Thankfully, there's a simple formula:
ROI = annual gain of investment - the annual cost of investment ÷ total cost of investment
Let's break down this formula in more detail with a practical example.To find your total cost of investment, start with what you paid for the property itself plus any closing costs or extra expenses. This means a property purchased with cash for $900,000 plus $90,000 in maintenance work and $10,000 in closing costs yields a total investment cost of $1,000,000.
To calculate your annual investment gain, simply multiply your monthly rent by 12 — so if you're bringing in $10,000 per month in total from multiple tenants, your total gain is $120,000. Finally, calculate your annual investment cost by totaling up your property taxes, insurance, maintenance and any utilities you pay for. For example, if you're paying $2,000 per month for these costs, your total cost of investment per year is $24,000.
Now we have everything we need to calculate ROI. First, take your annual gain ($120,000) and subtract your annual cost ($24,000). This gives you $96,000. Now, divide that by the total purchase price ($1,000,000), which gives 0.096. Multiply by 100 to covert this number to a percentage and your total ROI is 9.6%.
Worth noting, this calculation is for cash transactions. If you've purchased commercial property with a mortgage or other financing options, the math gets slightly more complicated. To calculate your total cost, add the amount of your down payment, closing costs and remodeling expenses. Let's say you paid 20% down in the example above — or $200,000. Add in closing costs of 2.5% (or 25,000) plus the $90,000 you spent in maintenance work and your total cost of investment is $315,000.
While your annual investment gain remains the same at $120,000, your annual costs are also different. Start with your mortgage payment. Let's say you chose a 25-year fixed mortgage with an interest rate of 4.5% — this yields a monthly payment of approximately $4,400. Add in the $2,000 per month to cover property taxes, insurance and maintenance and you're paying $6,400 per month or $76,800 per year.
To calculate your ROI, subtract your annual costs from your annual gains ($120,000 - $76,800), which gives $43,200, then divide by your total cost of investment ($315,000), which gives 0.13 or 13% ROI.
The Investment Process
Most commercial property investors don't have enough cash on hand to purchase properties outright, meaning a mortgage or other financing option is often the quickest way to get started with commercial property purchasing. We offer several options
- Conventional financing: We offer a variety of conventional loan options for both new investors and owner occupied commercial real estate ventures (buyers who already occupy some or all the space they're going to purchase). With flexible terms, rates and prepayment options, we've got you covered.
- SBA Financing: Our bankers can also help you secure SBA financing to help grow your business. This option includes up to 90% financing for up to 5 years plus full amortization with no balloon payments and reduced equity requirements to keep more capital in your business.
- Small Real-Estate Program: Ideal for those just starting out their commercial real estate investment journey, our Small Commercial Real Estate program offers quick and streamlined financing for loans up to $3 million.
Commercial property purchasing comes with the potential for substantial ROI and the ability to develop profitable business relationships with long-term tenants. Put simply? While this investment strategy requires planning and research to ensure you find the ideal property, once you do the math on ROI and secure solid financing, buying a commercial property can be a good idea that can deliver solid gains.
If you’re new to commercial real estate investment or if you’re simply looking to refinance a property, our Small Commercial Real Estate Program offers a simple way to secure financing1 for your investor or owner-occupied commercial real estate.
(1) Loans subject to credit approval. Terms and conditions apply. See banker for details. NMLS#467014