Commercial real estate refers to properties used specifically for business or income-generating purposes. The four main classes of commercial real estate are office, industrial, retail, and multi-family rental. Commercial real estate also includes hotels, farms, land, and healthcare facilities.
While a small percentage of commercial real estate buyers purchase properties for their own business usage, majority of commercial real estate buyers are investors. Investors can make money through property appreciation when they sell, but most returns come from tenant rents.
Investing in commercial real estate can be lucrative and serve as a hedge against the volatility of the stock market. There are two ways to invest in the commercial real estate: indirect investing and direct investing.
Under the indirect investing method, investors may invest in the commercial market indirectly through the ownership of various market securities, such as real estate investment trusts (REITs) or exchange traded funds (ETFs) that invest in commercial property-related stocks, or by holding the stocks of commercial property-related companies.
Under the direct investing method, investors become landlords through the ownership of the physical property. In comparison to the indirect method, direct method is much riskier, but the potential reward is also much higher. The investment threshold under the direct method is much higher as it requires a considerable amount of capital.
It is critical to know the fair value of the commercial real estate property before buying or selling a property. Generally speaking, there are three methods to valuate commercial real estate properties: cost approach, income approach, and direct comparison approach. Each method has its limitations.
In the cost approach, the value of the property is considered equal to the cost of the land, plus the cost of construction, less depreciation. The cost approach is most reliable when there is a reliable estimate for the land value and any improvements on the property. The limitation of this method is that the estimation of building depreciation may be subjective.
The income approach estimates property value based on the income generated by the property. This method is very useful for estimating the value of rental income -generating properties. The downside of this method is that it is difficult to predict future income and expenses. The assumptions on vacancy rate and required rate of return can significantly impact the estimated value of the property. In addition, this approach may not be applicable for the property that are owner occupied (cannot determine rental income).
In the direct comparison approach, the property being appraised is compared with similar properties that have been recently sold. The downside to this method is that no two properties are alike and adjusting based on the deficiencies and the advantages of the building in comparison to others can be difficult.
The values that emerge out of each of the approaches should be reasonably close but not necessarily the same. Due to the nuances of the three different types of approaches, the commercial real estate appraiser can come up with three different values. Usually, the appraiser will apply at least two approaches to validate their findings and determine the final estimated value of the property.
Since commercial real estate transactions have higher risk than most residential real estate transactions, extensive due diligence is required to mitigate the transaction risk. The following due diligence works are necessary for most commercial real estate transactions.
Check municipality zoning bylaws to ensure the intended use of the commercial property is permitted under the zoning bylaws. Zoning by-law regulate the use of land, the bulk, height, location, erection and use of buildings and structures, the provision of parking spaces, loading spaces and other associated matters. If the property is located in the City of Toronto, you can contact a Toronto Building Customer Service counter to ask about the zoning of that specific property. You may call their phone number 416-397-5330 from 8:30 a.m. to 4:30 p.m., Monday to Friday.
Conduct environmental site assessment to ensure the property doesn't have any potential environmental issues. The value and the intended use of the commercial property could be significantly impacted by environmental problems.
Review the property's building permit history to ensure that building permits were obtained for any leasehold improvements or build-outs that were done. A building permit is municipality's formal permission to begin the construction, demolition, addition or renovation on the property. You need to make sure all the building permits for the property are closed, meaning municipality inspectors are satisfied that the work has been completed according to the building permit.
Review property service contracts (landscaping, garbage and snow removal, cleaning, etc. ) to check whether the property are paying prevailing market price for those contracts and whether the property buyer can take over / back out from those contracts.
Review property lease agreements to check whether the property is earning prevailing market rental revenue, whether the landlord can increase rent through escalation clause, and how soon existing lease agreements will expire. All these factors may have potential impact on the value of the property.
Review property financial statements to check the financial status of the property. Review the revenue items to identify any potential additional revenue streams, and review expense items to identify any potential expense saving opportunities once the property is acquired.
Depending on the arrangement and calculation of the rent involved, commercial leases can be classified into several different types: gross lease, net lease (including single net lease, double net lease, and triple net lease), percentage lease, and retail ground lease.
A gross lease is an agreement in which the tenant pays a fixed rent and the landlord pays all operating expenses associated with the property. Under a gross lease, the landlords cannot pass any unexpected increases in operating expenses to the tenants unless there is an escalation clause built-in the lease agreement. Therefore, most landlords would shy away from gross leases to reduce risk. However, landlord may offer gross leases when it is impossible to set up separate billing for hydro and heat per tenant because of physical constraints of the building, or it is prohibitively expensive to separate and install individual heating and cooling of premises.
In a net lease, the tenant pays a portion of expenses associated with the leased property. There are three major categories of operating expenses that could be paid by the tenant: property tax, maintenance, and insurance (TMI). Depending on the arrangement of rent, there are three types of net leases: single net (Net), double net (Net Net), and triple net (Net Net Net) leases.
Under a single net lease, tenant pays the base (minimum) rent plus any one category of TMI. Landlord pays the remaining expenses.
Under a double net lease, tenant pays the base (minimum) rent plus any two categories of TMI. Landlord pays the remaining expenses.
Under a triple net lease, tenant pays base (minimum) rent plus all three categories of TMI.
Under a percentage lease, the tenant is required to pay a fixed minimum monthly rent (i.e., to cover taxes, maintenance, and insurance as the bare minimum), plus a percentage of gross monthly income in excess of base sales calculated using the minimum rent. This type of lease is mainly found in the retail property market. From the landlords’ perspective, this type of lease is riskier as the tenants may not achieve anticipated sales target. In addition, landlords may have to make extra efforts to monitor the sales performance of its tenants. Tenants, especially start-ups, would prefer this type of lease as it effectively reduces its financial risk.
A retail ground lease refers to the rental of land only, and is also known as a land lease or pad lease. Despite the name, retail ground leases are also found in office, industrial, and recreational sectors, and are common for standalone retail or restaurant sites. A retail ground lease is often of a long duration involving a tenant who covenants to build a structure on the leased land.