Pros and Cons of Commercial Real Estate Investment

Commercial real estate investment isn’t the choice of the majority of new investors.  If you surveyed all “real estate investors,” probably the vast majority are engaged in residential single family or multi-family residential property investment.  It’s natural, as many investors have bought and sold homes before as personal residences.  They’ve also probably rented at some time in their lives.  This familiarity with the product gives them a greater comfort level, and that pushes them in the residential direction.

For those with the assets for commercial real estate investment, there is definitely some great ROI potential out there.  There are also other considerations and factors that can make commercial investment the right choice for many who have avoided it so far.  That avoidance isn’t necessarily because they have a negative attitude about it.  They simply don’t know enough, and consider the money amounts involved to be significant.  So, they feel that more knowledge is required before taking the risk.

 Pros of Commercial Real Estate Investment

Commercial real estate investment enjoys some advantages that can make it the best choice for an investment strategy:

  • Varied property types:  Commercial real estate covers a wide swath of property types.  Investors can, if they choose, specialize in office space, restaurants, malls, retail space, light industrial, warehouse, strip malls and others.  Some investors develop a comfort level with a certain type of property, or they just know more about the type of business leasing the space.
  • Multiple lease structures:  Commercial leases can be structured in a number of ways to meet the needs of landlord and tenant:
    • Gross lease – The tenant pays a single set amount in rent and the landlord handles all property related costs including janitorial, maintenance and taxes.
    • Net lease – The net lease exists in multiple formats, single, double or triple net.  In this lease structure the costs related to the property ownership and management are split between the landlord and tenant to meet their specific needs.
    • Percentage lease – This lease is popular with retail businesses, especially newer ones or those with seasonal or variable revenue.  The base lease is a smaller amount, and after a certain sales level is reached the tenant pays a percentage of sales in additional rent.
  • Different cycles and risk profile:  The commercial investor can balance a portfolio that may include residential and multi-family with commercial property investment.  This diversification can balance risk and smooth out market cycles.

 Cons of Commercial Real Estate Investment

Investors don’t get a risk free ride with commercial real estate, as it has its own unique characteristics:

  • Higher dollar investments required:  Generally commercial real estate investment will require higher dollar investment to buy into a deal or to carry one individually.  It’s just more expensive property.  This keeps many investors out of commercial real estate investment.
  • Risk is concentrated:  The same amount of money that can buy a great many single family homes may only buy a single strip center or small mall property.  The investment is concentrated in a single property, even when there are multiple tenants.  The loss of an anchor tenant can result in the flight of the smaller businesses and a high sudden vacancy rate.
  • More demanding tenants:  Business people will be tougher negotiators, or hire them.  They also will be quicker to complain about property problems or service that impact their revenue.

Commercial real estate investment can be highly profitable and enjoy great tax advantages.  It’s a great way to expand a successful residential investment business.

What is the Difference Between Net Lease & Gross Lease?

It is easy to get confused with all of the commercial real estate lingo out there.  Two such examples are Net Lease and Gross Lease.  Understanding the differences between the two can equate to a substantial savings when negotiating commercial real estate lease terms.

Gross Lease

A gross lease is an agreement whereby the Tenant pays a fixed rental rate and the Landlord pays all of the operating expenses.  This means that the Landlord pays expenses such as insurance, real estate taxes, utilities and common area maintenance (CAM).  The Tenant would then be responsible for the rent and any specific business-oriented expenses.  Due to the Landlord assuming inflation risks by allowing the Tenant to pay a fixed sum every month, many commercial real estate landlords have abandoned the gross lease – with the exception of some smaller office leases.

Net Lease

In a net lease, the Tenant pays rent, plus a portion of expenses associated with the building being rented.  The expenses may include insurance, real estate taxes, utilities and common area maintenance.  There are basically three categories of a net lease.  They are single, double and triple net.  These types of leases put the burden of increasing expenses on the Tenant and remove them from the Landlord.

Single Net Lease

A single net lease is an agreement in which the tenant pays the rent and certain expenses.  In this situation, the Tenant is usually expected to pay all or part of the property taxes in addition to the rent.  This type of lease is more common in older buildings with shared utilities.

Double Net Lease

With a double net lease, the Landlord is responsible for structural repairs to a building, while the Tenant is responsible for taxes, building insurance, utilities and maintenance costs.

Triple Net Lease

A triple net lease is an agreement in which the tenant pays for maintenance, operating expenses, taxes and insurance.  In this situation, the Tenant is responsible for repair and maintenance of any common areas.  This form of net lease is typically used with freestanding buildings and multi-unit structures where multiple Tenants share the maintenance costs of the common areas.

Conclusion

While Tenants may perceive the best deal is to go with a gross lease, this is not always the case.  The terms and price of the lease agreement can affect the overall  value of the lease arrangement.  For example:

If the average gross lease in your area is $18.00 per square foot, while a net lease is calculated at $12.00 per square foot and expenses calculated at an additional $4.00 per square foot, the next lease in this instance will save the Tenant about $2.00 per square foot over the gross lease.  This savings needs to be weighed carefully against variable expenses and any potential increases that may go along with them.

Are you looking for representation in negotiating either a gross or net lease?  If so, let Rodney McNabb w/MainStreet Realty Services assist in weighing the costs and potential risks for you.  You can contact him via email at Rodney(at)MainStreet-Realty.net or by calling (919) 322-3960 ext. 7