Why You Should Make the Leap Up to Commercial Real Estate Investing
If you are just getting started investing in income producing real estate, congratulations! According to the IRS, less than 8% of all taxpayers own investment real estate and less than 3% own commercial investment property. So, can you just start out by investing in commercial real estate? Sure you can do this, but it’s a major learning curve and takes a lot more money compared to investing in a residential rental. It does make more sense to start out like most people do by buying one single family rental home and then moving up to a 2-plex or 4-plex. Commercial real estate has to be 5 units or more.
Commercial real estate is valued foremost based on its net operating income, where residential real estate is valued mostly on what other similar properties are selling for. Also, financing on commercial is far more complex than residential financing. Getting to know the property or what we call due diligence in the commercial real estate world is also vastly more complicated with over 40 items to evaluate compared to about a dozen for residential real estate investing.
I might be prejudice, since I have been working in commercial real estate for 25 years, but my mission is convincing more people to make the leap up to investing in commercial real estate. Why? Because of economy of scale.
Let’s say you have a small rental property business that has grown over 5 years from one home to 5 homes. Now you are driving all over town to rent and maintain these 5 properties. What if you sold some of them and moved up to a small 12-unit apartment complex? Now all the units are under one roof and this means you’re going to make much more money on your investment for two reasons. 1. The price per door is going to be a lot less to purchase. The average price per door of a residential home in 2021 according to Zillo was $340,000. The average price per door for an Apartment Complex was $168,000. 2. Expenses are going to average much less per door on the apartment complex than on a residential rental. We are talking about taxes, insurance, maintenance, repair and off-site management. Because commercial property is a much larger investment you are going to make so much more money from operations, annual rental increases and appreciation as well as much more savings on your taxes with depreciation.
Time is probably the most valuable possession we own, or don’t own if we have a job working for someone else. Just think about how much time it would take for you to find, and make accepted offers on 12 doors of residential properties, compared to making one offer on the 12-Unit apartment building. Also with a 12-unit, the property is large enough that you can afford professional management that will oversee renting vacant units and all the maintenance – again saving you time.
Commercial Real Estate has Five Sources of Income
Remember when you had just one source of income – the paycheck? Well, commercial real estate has 5 sources of income: Rental Income from operations, rental increases, appreciation, depreciation and reinvestment of equity. Residential real estate investing has these too, but with so many more units under one roof, commercial property multiplies your earnings from 5 to 10 times or more.
1. Rental Income from Operations – this is your profit or cash on cash return after paying all expense and the mortgage payment
2. Rental Increases – According to Zillow, rents increased in America by 10% in 2021, and 13.5% in December 2021. Rental increases usually average more like 6%. I expect rents to go up 8% - 10% annually for quite a while. This is because the price of the average home shot up to $340,000 in 2021 which put a lot of folks out of the housing market who are now competing in the lowest vacancy rental market in history – under 4.5% nationally according to the National Association of Realtors. To add insult to injury – because of Covid, there have been very few construction starts on new apartment complexes, and with the cost of labor and materials soaring, this is going to compound the problem for some time. So, supply just can’t keep up with demand. People seem to value a good place to live above everything else and are willing to pay a higher percentage of their income for housing than ever before.
3. Appreciation – In 2021 multifamily, self-storage and industrial properties shot up in value more than 12% with cap rates hovering between 5% and 6%. As long as you can raise rents, the value of a commercial property will go up. Commercial properties usually earn more from appreciation than any other source.
4. Depreciation – Only in America can you own an income property investment that appreciates and depreciates at the same time. Depreciation earns money for you by lowering your 1040 income tax. Here’s an example: I’m going to use an apartment complex which the IRS will allow you to depreciate over 27.5 years. It’s different for other types of commercial real estate. The value of the land cannot be depreciated. So let’s say you are purchasing a million dollar apartment complex and the value of the land is $100,000. That leaves $900,000 to be depreciated over 27.5 years: $900,000 divided by 27.5 years equals $32,727 in annual depreciation which if you are in a 25% tax bracket will put $8,181 more in your pocket each year.
$900,000/27.5 years = $32,727 Annual Depreciation
5. Reinvestment of Equity – Through a 1031 Exchange or a Cash-Out Refinance. This will make more money for you over time than anything. Doing a 1031 tax deferred exchange allows you to sell the property and reinvest your equity in a larger replacement property that has more income, more rental increases, more appreciation and more depreciation. Again only in America, do you get to leverage your equity which has grown over time into buying more income property without paying capital gains taxes. Or I should say deferring the tax. But my favorite way of leveraging equity is to do a cash-out refinance to buy another income property.
With a cash-out refinance you have all the benefits that you had in the 1031 tax deferred exchange, plus you get to keep your original property too. Now you have two properties that are going to give you income from operations, rental increases, appreciation, depreciation and future income from reinvestment of equity.
Can You Make the Leap up to Commercial Real Estate Investing?
What I want to tell you is nothing can defeat the human spirit when someone makes up their mind that they are going to succeed at something. And it takes passion to fuel our dreams. Commercial real estate is a business – and its not an easy one to grasp - it has quite a learning curve and takes a lot of cash. But the most successful first-time commercial real estate investors that I’ve worked with didn’t seem to care about that. For some reason they simply didn’t focus on how hard and complicated it is – this was their greatest asset in getting started. They discovered that what they didn’t know they could learn, and the money they didn’t have they could raise from investors and lenders – and they learned how to find great properties, and how to crunch the numbers and create a good business plan. And then they practiced their delivery on selling the deal with enthusiasm to lenders and investors.