Real estate is an expensive investment with the potential to make huge profits in the long run if you research the property and market conditions properly. Commercial properties are the business aspect of real estate, while residential properties are intended for those who want to purchase a house. While Both are excellent opportunities to earn, commercial real estate is the best route to go if you’re looking for an active source of income.
In this post, we explore the pros and cons of investing in commercial properties to help you weigh the risks and benefits before you make any decisions. Let’s begin with some basics:
What are Commercial Properties?
Commercial properties are a type of real estate where the purpose of investment is to rent or lease the property to businesses. Commercial properties include constructions such as office buildings, business parks, industrial warehouses, and retail stores.
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The Pros of Investing in Commercial Properties
1. Steady Income Potential
Commercial properties are designed and built for business operations, which means they will be rented out to business firms who intend to do their business for a long time. Most business firms who rent out office spaces want a place where they can establish their businesses and continue doing so at the same place.
This means that if a firm rents out your office space, you have a long-term tenant who will pay rent for a long time, i.e., 5-15 years. It also means that you don’t have to keep looking out for new and better tenants like you would have to if you invest in residential property. This makes commercial properties a great choice to avoid the hassle of searching for new tenants every year.
2. Long-Term Appreciation
One of the biggest benefits of commercial properties over residential ones is the potential for higher value appreciation. Commercial real estate established at popular locations already provides you with higher rental yields, but with the addition of prime locations, the capital appreciation on such properties is very high.
With additional upgrades to your building or property, the value can grow even higher. With time, as the place develops, the value of your investment in rental yield and capital appreciation keeps increasing.
Commercial real estate is a long-term investment that can grow significantly over time. Places in prime locations have the potential to grow 5% annually and 5%-10% increase in rental income over a few years.
3. Diversification
Commercial properties provide balance to a risky portfolio with their long-term income potential. If you are someone who has already invested in various places such as bonds, stock, and residential properties, then commercial property provides you with a more stable option.
How does commercial real estate help you stabilize your portfolio? When the stock market is down, it does not affect the real estate market similarly; the chances are the real estate market will remain the same or better. So, investing in different sectors will reduce your risk of losses.
4. Potential Tax Benefits
Owning a commercial property also offers tax advantages that help you save some extra money generated from the property. One of them is depreciation deductions on the value of the building over time. Depreciation is a non-cash deduction, which means you can write off a portion of the property’s cost each year as if the building is losing its value with time. You can do this even if the value of your property keeps growing.
Another one of the taxation advantages is through the 1031 exchange. Under Section 1031 of the U.S. Internal Revenue Code, investors can defer capital gains taxes when they sell one property and reinvest the proceeds into a new “like-kind” property.
Another major tax benefit of investing in commercial real estate is the possibility of deducting the interest paid on loans. Since most investors utilize credit to finance commercial real estate purchases, it is possible to deduct these costs significantly, thereby decreasing the overall expense of borrowing.
5. Control Over Your Investment
Commercial properties are to be managed by the owner, which means you have complete control over how things will be. You are the one who will decide how much rent is to be charged. Even though market prices play a role here, the ultimate decision is on the owner. You can also add upgrades to your unit to hike the rental prices. These additions not only help to increase your rental value but also impact the overall valuation of your property.
Moreover, as the property owner, you are the one who decides how to fund the purchase. You can use a loan to purchase completely, bring in a partner, or even use your own money, whatever seems profitable for the long term.
The Cons of Investing in Commercial Properties
1. High Upfront Costs
One of the biggest downsides of investing in commercial properties is the huge initial investment. Commercial properties have a higher initial and maintenance cost than traditional residential properties because of their size.
Additionally, procuring finances from banks also requires a huge downpayment of around 25% or more compared to a residential property, where the down payment is around 20% of the total amount. Every institution wants a more secure investment, but that’s not the case with commercial properties, which is why they charge more. This is because of the higher market risks associated with the investment.
2. Market Volatility
Commercial real estate can be more volatile than residential property as it heavily relies on factors like supply and demand, tenant behaviour, and overall economic health.
Suppose the country’s overall economic condition is bad; businesses that rent office spaces usually back out from renting more offices to cut costs. Many companies even close down some of their offices to cut costs. Such actions have a huge impact on commercial property owners.
Sometimes, certain industries can also face downturns, leading to more vacant commercial properties. The recent case of COVID-19 comes to mind, where everyone started working from home, forcing physical offices to shut down. It even forced hotel businesses to shut down and many more cases.
3. Complex Property Management
One of the big factors to consider is property management. Commercial properties require active management and are more complex than residential property management because of their size, the nature of the tenants, and regulatory requirements.
Moreover, commercial buildings have a different and more massive design, which means the repairs and maintenance of the property require more money. Maintenance charges will increase if the building provides facilities like elevators, parking garages, fire safety systems, landscaping, and security. Of course, you will outsource these factors to the tenant, but there is also the risk of the prices going too high, which can push many tenants away.
Additionally, you will be dealing with more professional tenants, which means lease negotiations, renewal discussions, and resolving disputes will be more complicated and include legal factors.
4. Liquidity Challenges
As an investor, commercial properties are your assets, which you can convert into cash if needed. However, selling a commercial property is more challenging than selling virtual stocks or bonds. This is because it is harder to find clients who want to buy the property from you, and you profit while selling it. Satisfying both criteria takes a considerable amount of time.
Additionally, you have to consider the market condition and whether it is the right time to sell; otherwise, you are just draining your hard-earned money into water. And even if you find the ideal deal, due diligence, appraisals, legal negotiations, and financing approvals also take several months to get processed before you are completely free of the process.
5. Higher Legal and Regulatory Risks
Commercial properties have more strict legal regulations than residential properties. Commercial properties are subject to specific regulations regarding zoning that govern how the property is used. Zoning changes or violations could severely limit the ability of an investor to develop, expand or reuse an asset.
Industrial properties, particularly manufacturing facilities, must comply with environmental laws covering garbage disposal, pollution and hazardous substances. Failure to comply with environmental regulations can result in costly fines and expensive clean-up efforts, rendering the property less desirable or inaccessible.
Commercial lease agreements are generally more complicated and flexible than residential leases. They usually have provisions for maintenance obligations, rent escalations and other legal provisions that must be closely monitored. Disputes over lease terms could cause costly legal fights.
Commercial real property investors are more at risk of suing over tenant disputes, zoning issues, environmental violations, or lawsuits involving personal injuries. The legal process can be long and costly; sometimes, it could result in property value or financial loss.
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Frequently Asked Questions (FAQs)
Is it a good idea to invest in commercial real estate?
Yes, commercial properties are an excellent investment with a high potential for steady income, provided you are ready to manage the property actively.
What are the cons of commercial property?
The main downsides of investing in a commercial property are the higher initial cost, your property being subjected to market risk, complex property management, liquidity challenges, and Higher Legal and Regulatory Risks.
What type of commercial property is most profitable?
Industrial properties, especially warehouses, are the most profitable investment in 2024 due to the rise of online shopping.
Final Statement
Commercial properties are a smart investment option, but it’s important to approach it with an open mind. On the plus side, commercial real estate typically offers steady income, the potential for growth over time and attractive tax advantages.
On the negative side, commercial real estate is pricey and comes with a significant upfront cost. Aside from the higher upfront cost, they are also influenced heavily by market downturns, which make them a risky investment. Managing commercial properties requires a lot of time and active participation. Additionally, you cannot sell your property when you need quick cash due to lower liquidity.
Finally, whether you want to invest in commercial real estate depends on your goals. You can weigh the pros and cons, see what factors are crucial for you, and then decide.