Commercial real estate

Buying commercial real estate can provide security and a wealth base for your small business, giving you a solid foundation to grow and prosper.

What is commercial real estate?

The term ‘commercial real estate’ (CRE) refers to properties that are utilized for business purposes and are primarily leased out to tenants who use them for income-generating activities. The scope of commercial real estate is very broad and can encompass a wide range of property types, from small individual storefronts and large shopping malls, to factories, office blocks, gas stations, theaters and more.

Alternatively, you could buy commercial real estate as an investment – generate good cash flow from tenant rents and service charges while your property value increases.

Commercial real estate types

What are the different types of commercial real estate property?

Any kind of building or property that is used for business purposes can be classed as commercial real estate. Most CRE falls into the following categories of property:

1. Office

Office buildings may be categorized as either urban or suburban. Urban office buildings often include skyscrapers and high-rise properties, sometimes covering millions of square feet. These type of properties are usually located in city centers. Suburban office buildings are typically smaller, often grouped in office parks and may be multi-tenanted or single-tenanted, with many being build-to-suit.

Office properties are ranked into three classes:

Class A are prestigious buildings competing for premier office users with rent prices above the area average. These buildings feature high-quality finishes, state-of-the-art systems, exceptional accessibility, and a strong market presence.
Class B buildings are suitable for a wide range of users with rents at the area average. Finishes are fair to good, systems are adequate, but they do not compete with Class A buildings.
Class C buildings offer functional spaces at below-average rents, often catering to tenants with specific requirements. Medical office buildings are typical of this sector.

2. Retail

Retail spaces host shops, restaurants and other popular locations such as spas and hair salons. They can be multi-tenant or single-use buildings. Multi-tenant retail spaces often feature an anchor tenant that drives traffic to the property – as you may find with your local shopping mall. Retail types vary based on size, concept, tenant mix, and trade area. Single-tenant buildings include big-box centers (Walmart, Target, Best Buy) and pad sites (banks, restaurants). Retail real estate is diverse, accommodating various business needs and consumer preferences.

3. Industrial

Industrial buildings support a variety of operations and are usually located outside urban areas, near major transportation routes.

These buildings are categorized into four types:

Heavy manufacturing: Highly customized buildings housing machinery for production
Light assembly: Less customized, suitable for assembly or storage
Bulk warehouse: Large distribution centers
Flex industrial: Combining industrial and office spaces

Industrial land use has specialized zoning laws which restrict the kinds of business-use that may be conducted on site.

4. Multi-family

When a property contains five or more residential units owned by a single entity, it is classified as commercial real estate. Multi-family properties include apartments, condos, co-ops, and townhomes, and are often classified into Class A, B, and C.

Freddie Mac categorizes apartment rental buildings as:

High-rise: Nine or more floors with at least one elevator
Mid-rise: Multi-story buildings with elevators in urban areas
Garden-style: One to three-story developments in garden-like settings, possibly without elevators
Walk-up: Four to six-story buildings without elevators
Manufactured housing community: Leased ground sites for manufactured homes
Special-purpose housing: Targets specific populations, including student, senior, and subsidized housing

5. Hotel

The hotel sector includes establishments providing accommodations, meals, and services for travelers. Hotels can be independent (boutique) or part of major chains (flagged).

Hotels can be classified as:

Limited-service: No room service, on-site restaurant, or concierge
Full-service: Includes room service and an on-site restaurant
Boutique: Urban or resort locations, full-service amenities, not part of a national chain, fewer rooms
Casino: Includes gaming facilities
Extended-stay: Limited-service with kitchens and larger rooms for long stays
Resort: Full-service with extensive land, located in resort areas, and often featuring amenities like golf courses or water parks

6. Special Purpose

Special purpose real estate does not fit any of the categories above. Examples include land for fairs, amusement parks, churches, self-storage facilities and bowling alleys.

What are the pros and cons of commercial real estate?

Investing in commercial real estate has advantages and disadvantages:

Pros:

Can generate strong ROI and monthly cash flow
May be a buffer against general inflation
May offer less risk than other forms of investing – such as stocks and bonds
Offers viable diversification for mixed-investment portfolios

Cons:

Can create unmanageable debt burdens
Vulnerable to sudden market or economic downturns
Can carry high maintenance and insurance costs
Relies on income from tenants who may default on their lease
High cost of entry – commercial real estate is typically more expensive than residential properties

How do investors make money on commercial real estate?

As well as providing a safety valve against the volatility of other investment vehicles, such as stock and shares, commercial real estate can generate good returns for investors if they buy the right property at the right price and manage it efficiently. Investors usually make money off CRE through property appreciation – the rising value of the real estate over time – and from tenant rents, service fees and other management charges.

How is commercial real estate valued?

There are various ways to value commercial real estate valuation, but most valuers use the Cost, Sales Comparison, and Income approaches.

Cost approach – this method separates the building’s cost from the land’s value. It assesses the land based on sales of similar properties, then adds the replacement cost of the building, considering age, size, condition, and features. This approach is useful when comparable properties are scarce, but its accuracy diminishes if similar vacant land is unavailable.
Sales Comparison approach – also known as the ‘market approach’, this method uses recent sales of similar properties to estimate a property’s value. Adjustments are made for differences in age, size, and condition. It’s effective when many comparable properties are available but less suitable for unique properties with distinct features.
Income approach – this method, also called ‘income capitalization’, values a property based on its income. The formula is net operating income (NOI) divided by the capitalization rate (cap rate. It’s ideal for office, retail, and multifamily properties. This method analyzes income generation, operational efficiency, and property condition to determine market value.

Other Valuation Methods:

Gross Rent Multiplier (GRM) – this ratio compares a property’s price to its annual gross rental income. For example, a property purchased for $1 million with $140,000 annual gross rents has a GRM of 7.14. ($1m divided by $140k). The lower the GRM number is the better. Most investors want a GRM between 4 and 7. The gross rate multiplier method helps identify properties with a low price relative to potential income but excludes vacancy rates and expenses.
Value per door – used for multifamily properties, this method values buildings based on the number of units. For instance, a 20-unit building priced at $4 million is valued at $200,000 per unit.
Cost per rentable square foot – this method assesses value by combining usable square footage with common areas. For example, a 10,000 square foot building renting at $12 per square foot annually, with a purchase price of $1.7 million, yields a 7% gross rental yield.

What is the difference between commercial and residential real estate?

Commercial real estate is owned and used by businesses for commercial money-generating purposes. Residential real estate refers to homes for private citizens.

How can I buy commercial real estate?

It rarely makes sense to buy commercial real estate with cash. Instead, most business owners, investors and real estate developers will use a mix of cash and a commercial mortgage to buy the property they need. The benefits of this strategy are multiple – it reduces strain on cashflow, protects cash reserves, and may give the borrower the option of buying more property if they can meet lender credit requirements and demonstrate their ability to meet scheduled loan payments.

Types of commercial real estate mortgage

Owner-Occupied Commercial Mortgages are provided to businesses that trade from and own the property they wish to borrow money against. This type of financing is often used to support the organization’s working capital or to cover the cost of property renovations and major repairs.
Commercial Investment Property Mortgages are provided to property owners who are investors and receive a rental income from a third-party tenant or licensee. In most scenarios the rental income the property generates is used to repay the loan over time.
Property Portfolio Loans are provided to property professionals and investors. The lender will take some or all of the client’s property investments as security (this may be residential, commercial or mixed-use property, or a combination of all within the portfolio) and provide one umbrella loan. The lender calculates the borrower’s ability to meet scheduled loan payments by combining the total income from the portfolio – usually a mix tenants’ rent payments, service fees, interest income and profit-sharing revenues.

Where can I get a commercial mortgage?

To get a commercial mortgage you can approach banks, credit unions and online lenders one by one, or you can use the services of a loan marketplace that will immediately introduce you to a choice of real estate loans from different lenders. Some marketplace platforms can also give you advice and help you with the application process. This can be especially useful for borrowers who have never taken out a commercial mortgage before.

How Swoop can help

For a commercial mortgage or any type of business loan, working with business finance experts can make all the difference when applying for funding. Contact Swoop to discuss your borrowing needs, get help with your application and to compare high-quality commercial mortgages and business loans from a choice of lenders. Claim your piece of the commercial real estate pie. Register with Swoop today.

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