Passive income, capital appreciation, portfolio diversification, and tax benefits are just some of the few benefits which make commercial real estate investing attractive.
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If you want to diversify your investment portfolio, look no further than real estate. Whether you start with commercial real estate investing or stick with residential properties, it’s a great way to make passive income outside the stock market.
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Commercial real estate is a category of income-generating real estate.
It can include but is not limited to:
Commercial property differs from residential property, such as your single-family home or small 1- to 4-unit apartment building. Residential real estate with five or more units is considered “commercial” and must use commercial financing.
While commercial real estate is still technically considered an “alternative” investment (vs. stocks, bonds, and other equities), it has become an increasingly popular way to invest over the past two decades.
Interest in commercial real estate has amplified since 2012 when changes to federal legislation made it easier for people to invest fractionally in large commercial properties through crowdfunding platforms. Commercial real estate once considered accessible only to the well-heeled, is now open to investors of all kinds.
There are many reasons to invest in commercial real estate properties.
Financial benefits—such as passive income, capital appreciation, and tax benefits—make commercial real estate investments attractive in their own right.
Other benefits, like higher revenue and longer leases, make a commercial property attractive compared to other real estate assets, like residential real estate.
Let's dig into some of the benefits in more detail 👇
Commercial real estate typically generates more absolute revenue (or profit) than residential properties.
This is especially true when you look at the operational costs associated with owning single-family rentals or other small-scale residential portfolios. The time and management of residential buildings can quickly diminish returns.
Commercial property, meanwhile, tends to be larger, and therefore, there are operational efficiencies that translate into higher revenue.
Most commercial buildings are leased for a minimum 5-year period. Depending on the nature of the property, commercial leases might be 30 years or more.
For example, a grocery store generally wants to sign a long-term lease before committing to a location. This provides stability and predictability for commercial property owners. They do not need to worry about tenants turning over year in and year out, as they would at a residential property where tenants generally sign 1-year leases.
Consider the competition for single-family homes. It’s not unusual to see dozens of people bidding on the same property. Increasingly, this competition comes from would-be homeowners and investors looking to grow their single-family rental (SFR) portfolios. High competition drives up the price and lowers the overall return.
Commercial real estate property has significantly less competition. Few people are looking to buy assets in the commercial real estate market. Moreover, many commercial buildings never hit the open market. They are traded in off-market deals where there is virtually no other competition.
Real estate investors are often drawn to commercial property because of its consistent cash flow. Long-term leases, as noted above, help to limit vacancy. Many commercial properties are leased on a triple-net (NNN) basis, which essentially passes all building and operational costs on to commercial tenants.
These factors result in reliable, passive income that is hard to find among other asset classes.
In addition to earning steady passive income, commercial real estate investors also benefit from property appreciation. While no property is ever guaranteed to appreciate, most do with time. Owners can benefit from this higher property value when refinancing or selling.
There are tremendous tax benefits associated with commercial real estate. Commercial real estate investors can utilize what’s known as “depreciation” to offset their passive income. A commercial property depreciates over a 39-year period (which the IRS has deemed its “useful life”). Multifamily buildings with 5+ units can be depreciated over 27.5 years.
Depreciation is effectively a paper loss. Most properties are actually appreciating in value, even if an owner takes depreciation. Depreciation is one of the ways the IRS incentivizes people to buy commercial property and then offset the costs associated with maintaining that property over time.
In recent years, commercial real estate investors have been able to utilize what’s known as accelerated or “bonus” depreciation. Rather than taking 1/39th of the depreciable value as a write-off each year, they can front-load the value of that depreciation in the first few years of ownership. This can make the first few years of profits essentially tax-free.
This is a huge tax benefit as it puts more money back into investors’ pockets sooner. That money can then be redeployed into other investments as owners see fit.
Watch: LLC Structures in Real Estate Syndications - what you need to know!
There are some challenges associated with commercial real estate investing. Some of these challenges can prove difficult for would-be investors to overcome.
Commercial real estate investing is very capital-intensive. In a best-case scenario, a lender will want the owner to put down 20 percent in equity before acquiring a property. The rest can be financed with debt. However, in many cases, lenders will want to see 30 or even 40 percent equity, depending on the nature of the deal and the owner’s experience.
On a $2 million investment, that’s a minimum $400,000 down payment. A 40% loan-to-value ratio would require an $800,000 up-front investment. Clearly, not all investors have that much cash on hand to invest.
There are ways to get around this, though. For example, many people will invest in a real estate syndication where each contributes $50,000 in equity. They own a pro-rata share of the investment based on their equity contribution.
HoneyBricks for example, has made real estate syndications more accessible than ever with investment minimums of only $5,000.
Commercial real estate projects also traditionally have low liquidity. Unlike stocks or bonds that can be traded with the click of a button, commercial real estate has a long lead time.
A typical purchase or sale could take six months or more between negotiations, due diligence, financing, and the actual closing. Some real estate deals will take 3-5 years or more to stabilize before the ownership team refinances or exits the deal.
Therefore, anyone who needs capital for another purpose will want to carefully consider investing in real estate. Those who need liquidity may be better off investing in real estate investment trusts (see below).
As noted earlier, commercial real estate investing was once only available to extremely high net-worth individuals. This is because of the sector’s high barriers to entry. However, new investment vehicles have made it easier for individuals to buy commercial property.
One way to invest in commercial property is via direct investment. This is when someone purchases a commercial building for their use (e.g., as their business’ office space) or to lease. Direct ownership requires active management. The owner is responsible for all decision-making and, therefore, should be well-versed in financing, improving, leasing, and stabilizing the property before going down this path.
Real estate investment trusts, or REITs, are companies formed to acquire and operate property. Publicly-traded REITs offer shares of their business to individuals—just as people would buy shares in companies like Apple or Tesla. However, when someone invests in a REIT, they invest in that business. They do not own any direct real estate shares that the REIT controls.
REITs are often highly-specialized. For example, a REIT may only invest in commercial real estate office buildings. Another may only buy hotels or shopping centers. REITs tend to be very narrowly focused.
REITs are attractive to those who want exposure to real estate and to preserve their liquidity. This is because REIT shares can be purchased and sold just as easily as other stocks and bonds.
Real estate funds and syndications are similar in many ways. Both are usually structured to allow individuals to invest a nominal amount—say $25,000 or $100,000.
A real estate fund will aggregate capital from individual investors pooled to make various investments. A fund will usually have certain parameters outlined up front: for example, the sponsor will only invest in multifamily apartment buildings in Sunbelt cities. The fund may have pre-identified properties, but people often invest in the fund without knowing exactly which properties will be purchased.
With a real estate syndication, the sponsor has identified a property and is now lining up the capital needed to acquire or improve the asset.
Both funds and real estate syndications are a great way for those with limited capital to invest in commercial real estate.
Learn more: Investing in Multifamily Real Estate
The federal JOBS Act of 2012 changed how real estate sponsors could solicit investments from prospective investors. Previously, a sponsor needed to have a pre-existing relationship with each investor. This gave commercial real estate the reputation of being only for those with “country club” money.
Now, sponsors can solicit investments from people all over the world. This sparked the advent of online real estate crowdfunding platforms like CrowdStreet and RealtyMogul. These are merely platforms that make it easier to raise money for funds and syndications. Essentially, the wining and dining that sponsors used to do has now been replaced with virtual meetings, webinars, and other technologies that can be used to pitch to investors worldwide.
Some real estate platforms require individuals to be accredited, investors. Others offer deals for non-accredited investors (see below).
HoneyBricks is a platform that takes the crowdfunding model one step further. It allows investors to own tokenized shares of real estate that can be purchased and sold using cryptocurrencies.
The commercial real estate sector, like other industries, tends to use a lot of jargon. Here are some of the most important CRE terms to know.
Properties are typically referred to as Class A, B, or C. Class A properties are newer, in more desirable locations, and tend to be owned by institutional investors. Class B and C properties are usually older, in secondary or tertiary markets, and may need substantial building improvements before they can be fully stabilized.
Net operating income, or NOI, refers to a property’s total cash flow after operational expenses have been deducted from the gross operating income. NOI does not include capital expenditures (CapEx) or debt payments.
The “capitalization rate” is a metric used to value properties. The cap rate formula is NOI / purchase price. Cap rates are represented as a percentage that usually ranges from 3 to 12% depending on the property type, location, condition, and more.
Commercial properties are generally leased on a triple-net (NNN) basis. With a NNN lease, the tenant is responsible for paying all property taxes, insurance, and other expenses (e.g., repairs and maintenance associated with their leased space). This differs from single-net leases in which the tenant pays just their base rent, and the owner incurs all other expenses.
Some commercial real estate deals are only open to accredited investors. To be an accredited investor, someone must earn at least $200,000 per year (or $300,000 in joint income with their spouse) or have a net worth exceeding $1 million (excluding their primary residence).
Learn more: How to become an accredited investor
Here are some of the most commonly asked questions associated with investing in commercial real estate.
There is no time like the present! Regardless of where we are in the real estate market cycle, there are always good opportunities to invest in commercial property. In a high-interest rate or high-inflation environment like today, properties tend to sell for less. This creates an opportunity for those looking to buy at a lower price, especially as competition dwindles.
There is arguably no “best” way to invest in commercial real estate. Instead, people should look at their personal goals and objectives.
For example, someone who wants to preserve their liquidity may want to invest in a REIT. Someone who prefers greater control over the direction of the investment may want to buy their buildings with no partners. Those looking to invest passively should consider funds or syndications, a great way to expand one’s investment portfolio without bearing the day-to-day responsibility of direct ownership.
A property’s ROI can be calculated by dividing the annual return by the total investment. The ROI is different than the cap rate in that it factors in debt payments. It also looks at the amount of equity invested rather than the purchase price.
Most people will look for an ROI of at least 8 to 12% on commercial property investments. What makes a “good ROI” is primarily a factor of what other investment opportunities exist at that time. A commercial real estate investor will also want to look at the spread between US Treasury rates (considered the risk-free rate of return) and an asset’s proposed ROI. The higher the US Treasury rate, the higher ROI an investor will want to earn by risking their capital in a commercial real estate deal.
The most profitable CRE investments are those that provide stable, consistent cash flow, and capital appreciation. No one property type is inherently more profitable than others. The owner’s approach to leverage drives profitability (e.g., higher leverage can increase returns but are, in turn, riskier) as well as the owner’s business plan and time horizon. Investors should partner with a sponsor whose investment approach aligns with their own.
Learn more: How to Evaluate an Online Real Estate Investment
People often default to investing in traditional stocks and bonds through their employer-sponsored retirement plan or Roth IRA. While this is encouraged, it is equally important to diversify your investment portfolio beyond stocks and bonds. Commercial real estate has a low correlation with the stock market. This protects investors whose portfolios would otherwise be at the whim of a notoriously unstable stock market.
Given the variety of ways people invest in commercial real estate, there is no reason not to get started today. There are ways to invest in CRE with as little as $500 using a platform like HoneyBricks. Consider starting small and growing your portfolio as you gain more confidence in the sector.
Are you considering investing in commercial real estate but unsure if now is the best time to invest? Consider diversifying your investment portfolio with commercial real estate through HoneyBricks.