What is Commercial Property and How To Buy It

Savvy investors who want to build long-term growth from commercial investing must learn the vast nuances of this dynamic sector. 

Commercial properties are defined as real estate used for business activities, and the primary goal is to generate revenue through long-term capital gains or rental income. 

What Is Commercial Property?

Commercial property investments are used to generate consistent income from operations while building long-term capital gains growth.

• Office properties, the most common asset class, have become significant in the overall commercial property sector. Check property records to gain insights into ownership history, building permits, and any potential issues, helping to assess the property’s true value.
• Retail space is the interface between commercial investments and the consumer. Commercial investors in retail enjoy various benefits, such as stable income and tax breaks. 
• Industrial and warehouse properties should always be on the investor’s radar. In a growing economy, there is a vital demand for storage and distribution locations.
• Multi-family housing is single-family residential investing on steroids, considered the “Golden Child” of commercial property acquisition. This moniker is due to consistent demand for the ability to generate cash. There are different types of multi-family housing properties: 

- A duplex is a two-unit residential property that shares a wall; the duplex will have separate entrances and yards.

- Apartment buildings have five or more residential units with common areas such as pools and parking areas.

- Condominiums are generally buildings containing several owned housing units. Condo owners usually pay monthly homeowner fees for upkeep and other expenses.

Why Invest In Commercial Real Estate?

Commercial assets often have annual returns over 6% to 12%, depending on several factors, such as the economy, the property, and the immediate area. The benefits of owning commercial properties include longer rental yields and lease terms. 

Tax benefits are plentiful for investors:

• Capital gains taxes are generally lower than other personal taxes on IRAs. When accessing personal IRA funds, you will be billed at an individual tax rate. 
• There are tax savings on post-sales. If you leave a commercial property to a beneficiary and they decide to sell, their tax will only be on the property's increase in value.
• Interest expense paid on a commercial property mortgage is deductible. 
• Commercial buildings begin to depreciate the minute they are purchased. Depreciation often offsets a company’s tax liability. The IRS allows the depreciation of a residential asset over 27.5 years and commercial properties for 39 years. 
• You can calculate property tax by checking the assessed value of the property, which is typically determined by the local tax authority, and then applying the local tax rate. This can help estimate your annual property tax liability.

How To Value and Buy Commercial Property

It is important to consider the importance of accurately evaluating a commercial property for potential purchase. Accurate evaluation directly impacts the potential for profit while minimizing the risk of overpaying. 

• Capitalization rate is a ratio used to estimate income-generating properties and their potential rate of return. It is a relatively simple calculation: divide the property's net operating income (NOI) by its market value, expressed as a percentage. Values between 4% and 8% are considered acceptable. 
• One of the many real estate valuation methods is net operating income (NOI). This method measures a property’s profitability. NOI is calculated by subtracting a property's operating expenses from its revenue. 
• Location analysis gathers data on a specific commercial property to determine its suitability for a particular project. 

Investment Objectives

Define objectives by understanding personal and professional goals, whether for capital gains or income generation. Determine the areas of the city or county that align with those goals and the properties that fall within these objectives.

Market Analysis

Analyze supply and demand dynamics, rental rates, and vacancy trends of the same properties of interest. Define the properties that fall within your categories of interest. 

Financing

Speak with loan officers to determine the amount of money you can borrow and the terms and apply for a mortgage to get pre-qualified. Negotiate every detail on the loan, including interest, loan to value, and repayment terms.

Submit an Offer and Close the Deal

Make an offer to the seller, which includes the purchase price, contingencies, closing costs, and time frame. Work with the real estate agent and seller to negotiate agreeable terms. Close the deal.

Steps to Purchase a Commercial Property

You must align the investment with your long-term objectives and minimize risks through due diligence. That’s the right approach to differentiating between making a profitable investment and wasting money. 

Success in commercial property investing involves four distinct steps, and shortcutting any of these will doom the project.

Research The Market

Start by thoroughly researching the market and detailing every pertinent aspect of an investment property. 

• Identify any major competitors in the area and any developers considering your chosen location for future development.

• Analyze the regulatory environment for the chosen area, city, county, and state.

Evaluate Properties

Analyzing a commercial property for purchase involves evaluating the financing, price-to-rent, and price-to-income ratios, cash flow, and yields, to name just a few. 

• The income capitalization approach considers the property’s potential resale value at different times in the future, along with the market rent it can generate.

• The cost approach evaluates the cost of new construction plus the value of the land. This approach is often the simplest, and most investors use it for renovated properties.
• Gross Rent Multiplier (GRM) values a property by multiplying the gross rental income by the property's price or similar projects in the area. 

Secure Financing

Investors should always consider financing in many forms. Commercial property financing is a complex maze that involves finding creative capital solutions, longer terms, large down payments, regulatory concerns, and massive amounts of paperwork. 

Consider a variety of lenders when looking for funds. Never have one lender as the go-to source for all your money needs. 

• SBA 7 loans for small businesses
• Commercial mortgage loans are the most common types
• Balloon loans are shorter terms, but the balloon looms at the end

Conduct Due Diligence

Nothing is more important than performing a thorough investigation and assessment of every property up for acquisition. Due diligence includes analyzing loan documentation, market analysis, and a complete site inspection. 

Tax Considerations: How To Calculate Tax on The Sale Of Commercial Property

The formulas for computing tax on the sale of commercial properties are simple in nature but have broad implications throughout the property's ownership. The basic formula for calculating capital gains is (Selling Price—Purchase Price) X Capital Gains Tax Rate. Capital gains tax rates have several variables that make the calculations much more complex, such as length of ownership and income rates. 

Strategies to Avoid Capital Gains Tax:

• 1031 Exchange – owners can defer tax gains by reinvesting profits into another property of equal or greater value.
• Opportunity Zone Investments – distressed areas where investments are encouraged with tax incentives.
• Installment sales – the seller of a commercial property allows for payments over time, and thus, the tax is deferred. 
• Tax-loss Harvesting – this strategy involves selling other properties at a loss to offset the gains of a specific property. 
• Charitable donations – donating the property or a part of the property can offset capital gains taxes.
• Depreciation recapture – if a business sells a piece of property for a gain, the IRS requires the company to report part of the gain as ordinary income to recapture some of the benefits from deductions. 

Common Challenges When Buying Commercial Property

Investing in commercial assets can be extremely challenging, but it can also be highly rewarding for both new investors and seasoned pros. It should always be remembered that no investor always gets it right. 

Here Are Two Common Challenges:

• Commercial lease and purchase documentation can involve intricate and highly complex legal agreements. Pitfalls such as inadequate due diligence, ignoring market conditions, and regulatory requirements must be avoided at all costs. 
• One of the most frustrating aspects of securing and managing commercial properties is establishing the correct valuations for them. Overestimating a property leads to higher mortgage payments and taxes and sets the tone for all future valuations. Underestimating a property leads to the loss of profits, both in capital gains and rental income. 

Tips For First-Time Commercial Property Buyers

There are many number-one rules when it comes to commercial asset investing. However, every investor must come to terms with their tolerance for risk. Commercial property investing takes a lot of work, even before any documents are signed. 

• Consider every aspect of your personal tolerance for risk; being flippant and dishonest will only detriment your goals. Set a checklist and read volumes on setting goals and risk management. Start small and build your wealth one dollar at a time.
• Market research is foundational to success in real estate investing at any level. However, considering the challenges of commercial property investing can be daunting for newcomers. 
• Build a team of trustworthy advisors for every transaction. Never try to manage the complexities of commercial property investing alone.
• Finding the owner of a property is important to verify all available information, allowing you to make informed decisions before making any investment.