Commercial property is generally defined as office, retail, or industrial property, or any large-scale development or property. The sector is a much different beast than residential property for a few reasons:
- It’s subject to economic fluctuations.
- It sometimes requires complex permitting, zoning, and land-use strategies.
- Leases and sale deals are more complex and take more time.
Because of these considerations, the decision of whether to buy commercial property at all may cross your mind. Ask yourself the following five questions if you’re thinking of buying commercial property:
1. Is the property occupied?
If your property is occupied, how much time is left on the lease? Is the tenant current on their obligations? If so, buying a commercial property with a tenant can offer stable cash flow. However, there are risks to consider down the line. If you buy a commercial property and the tenant’s lease has five years left and they don’t renew, can the property be easily adapted and marketed to a variety of new prospects? Will the property need modifications? You may want to interview the current tenant to see if they are happy and find out what might keep them in the property for the long term.
2. Do I have a tenant in mind?
If the property is vacant, you may have a chance to add a lot of value to the property. If you’ve been in the business a while, have made some contacts, and are keeping tabs on a specific neighborhood or area’s happenings, you may have learned that there are a few businesses or organizations that need more space or a new space, but aren’t interested, or can’t buy one of their own.
You can serve a need here, in this case, that allows you to negotiate a deal to buy the property with intimate knowledge of the prospective tenants’ needs. You could even negotiate the contract with a due-diligence period that allows you to advertise the space or negotiate a lease before closing.
If you don’t have a tenant in mind, you need to at least know what kind of tenant could use the prospective property, and whether the property’s current use is conforming to the zoning code.
3. What are the market lease and vacancy rates?
Before you purchase a commercial property, you need to know the market in which you’re purchasing like the back of your hand. Research the lease rates and vacancy rates for the type of commercial property and class, down to those on the same street, using a commercial database such as CoStar.
When talking about commercial property lease rates, it’s generally on a per-square-foot, annual basis. So an office space that is 1,000 square feet and rented for $10 per square foot would pay $10,000 in annual rent. When you are evaluating a commercial property to buy, even $1 or $2 per square foot can make a big difference in your net income, so you want to make sure you’re advertising the spaces appropriately and at the right price.
The commercial tenant market is very price-sensitive, so you must purchase a commercial property at the right price too in order to maximize your return on investment.
Commercial spaces also tend to be vacant longer before securing a tenant, who is usually there for a longer term. Vacancies can be anywhere from six months for smaller units to well over a year or more for larger properties.
4. Does the property need a lot of work?
A commercial property that needs a lot of work will take longer to lease. That’s because you may not want to do any work on it until you know the tenant that is going in it and what type of fit-out they need. Having a blank commercial space can make for a wider tenant pool. You may be able to attract a restaurant, boutique, accountant, or art gallery if your space has flexible uses. You wouldn’t want to do all the work to a property, only to find the perfect tenant later who wants you to undo or change it.
Tenant fit-out and renovations are a big negotiation point in getting a lease for a commercial property, because the costs are often shared between landlord and tenant. Sometimes the tenant pays for the fit-out in exchange for free rent, and other times the landlord and tenant may share the costs.
If your property is not turnkey, you need to account for this in your budget so that you have cash reserves in order to provide a tenant allowance.
5. What’s my exit strategy?
Just as it takes longer and is more difficult to secure a commercial lease with a tenant, it also can be more difficult or take longer to sell a commercial property. That’s why it’s important to purchase a commercial property with a target holding period in mind and an exit strategy.
Having a business plan in place for each individual commercial property you purchase can help guide your decisions as you own it. If your goal is to place a tenant, perform improvements, hold for a couple of years, and 1031 exchange it into a new property, then you’ll want to negotiate a solid, long-term lease with a tenant that would be attractive to a buyer. If you would like to hold the property for 20 years until it’s time to retire, then you may have some flexibility to slowly make improvements or get tenants on shorter-term leases while you let the market mature.
In any case, commercial property is illiquid. You’ll want to make sure you have plenty of cash reserves to make it through the market’s ups and downs over a lengthy period of time.
Take your time deciding
There’s no need to rush into a decision of whether to purchase a commercial property. Many elements go into financing, managing, buying, and selling that make commercial property complex.
If you’re willing to put in the work to search for and evaluate a commercial property, and to be patient, the right opportunity will present itself when and if the time is right.