Evaluating Commercial Real Estate Investments

Commercial real estate can be an extremely lucrative investment opportunity if done properly. However, accurately valuating commercial properties and determining their income potential requires an understanding of unique factors you don’t encounter when investing in residential real estate. Unlike houses and apartments purchased by individual homebuyers, commercial buildings are income-generating assets bringing in money for investors through tenant rents and property appreciation over time.

Assessing Property Value and Expected Returns

The first step in evaluating a commercial real estate purchase is retaining the services of a certified commercial real estate appraiser. An appraiser considers the property’s location, condition, usable space, likely operating expenses and market conditions to determine a property’s market value. This assessment allows you to set a fair purchase price when negotiating with the seller.

You’ll also want the appraisal to contain a NOI (net operating income) capitalization rate for the property. The cap rate divides the property’s NOI by either its purchase price or market value. It represents the expected rate of return from owning the asset. The higher the cap rate, the better the investment potential. For example, a property purchased for $1 million that generates $100,000 per year in NOI would have a 10 percent cap rate.

Checking Market Fundamentals

Thoroughly research population growth, job expansion, and other commercial real estate trends in the metro area where you want to invest. Growing companies need additional office and industrial space, increasing the occupancy rates and rents landlords can charge tenants. Make sure there is healthy demand from business and consumers to fill any space you acquire so that you can keep it rented.

Visit the Area in Person

The actual location of the property on the ground reveals much more useful information than what you can glean from a property listing. Drive or walk around the neighborhood during weekday business hours to check foot traffic volume, area amenities, access to public transit and highways, and the overall viability of the investment’s specific submarket. This allows you to spot any potential drawbacks the area may have for supporting commercial tenants long-term.

Choosing the Right Property Type

Each commercial real estate category comes with its own pros, cons and valuation methods that investors must understand before purchasing.

Office Space: This sector is most heavily influenced by job and rent growth. Target metro areas creating white-collar jobs. Evaluate the property’s Class rating and rents per square foot against competing nearby buildings.

Retail: Customer traffic counts and proximity to highways/residential areas are critical. Property value is highest for grocery/necessity-anchored community centers. Avoid declining malls with high vacancies.

Multifamily: Value is based on a complex’s NOI and cap rate. Properties in neighborhoods with rising rents and low vacancies make the best investments.

Industrial: E-commerce and logistics have boosted demand significantly. Choose smaller flex/warehouse spaces near ports, railways and highways in high-growth regions.

Specialized: Hotels, self storage, medical offices, etc. each have unique valuation methods. Study their economics before investing.

Leveraging Outside Expertise

Consider partnering with an experienced commercial real estate investor or sponsoring a deal with a private equity firm for your first few investments. Tapping into their location-specific market knowledge, tenant relationships and other expertise can remove much of the guesswork from decision making. Many sponsor firms source and negotiate the best deals, handle property management, then sell fractional ownership shares in the asset to passive investors.

The Bottom Line

A profitable commercial real estate purchase requires thoroughly researching regional market conditions, physically inspecting potential assets, setting realistic valuations and cap rates, and partnering with knowledgeable sponsors if they lack direct experience. While commercial real estate investments present higher risks and large capital requirements, their income potential over the long run significantly outpaces most other alternatives.

Let me know if you would like me to clarify or expand on any part of this blog post. I aimed to give an informative overview of key factors to evaluate when assessing investment potential for different commercial property types. Please provide any feedback so I can improve my business writing skills.

Disclaimer: The information provided in this article is for educational purposes only and should not be considered financial or investment advice. It is always recommended to consult with a qualified financial advisor or investment professional before making any investment decisions.

Scott Naasz

Founder and President Broker

North Star Commercial Real Estate Advisors Keller Williams Preferred Realty