Why Adding Commercial Investments to Your Portfolio is Easier Than You Think

by | BiggerPockets.com

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If you’re currently a single-family residential (SFR) real estate investor, you may also be curious about the possibilities with commercial real estate (CRE). Here’s the good news: The similarities between the two sectors far outweigh the differences, making CRE a market you can enter with less difficulty than you may think.

That’s because in both residential and commercial markets, you’re investing in the prospect that a piece of real estate will have more value in the future than it does today. In this article, I’ll share a bit of my own experience with my first CRE investment. Then I’ll break down a few of the similarities and differences between these two property types. Finally, I’ll offer a few tips that you might to consider as you invest in CRE for the first time.

As it turns out, a lot of what you’ve learned in residential investments will stand you in good stead as you enter the brave new world of CRE.

An Unexpected Win

I’ll never forget my first commercial investment—because it nearly gave me a heart attack.

The project was a multifamily-to-corporate-housing conversion in Houston. I was excited because I was investing alongside a family member, I believed in the business plan, and I knew the operator was top-flight.

Ironically, one of the reasons I like CRE investing so much today—the fact that it is hands-off—bugged the hell out of me back then. (I should add that, in the years since, I have changed my tune.)

Then history intervened. The year was 2000, and within a few months, we had the dot-com crash, several major corporate bankruptcies, and the Sept. 11 terrorist attacks. I assumed my investment was decimated. However, thanks to the skill of my sponsor and a great 7-year fixed-rate loan, we were able to weather a rough few years.

Related: 4 Ways Technology is Shaking Up Commercial Real Estate (& Why Multifamily Will Pull Ahead)

We sold the property 5 years later at a price that translated to an outstanding 16 percent IRR on my original investment (of course, all investments are different and there’s no guarantee that others would be as successful). My first CRE investment taught me several important lessons, but here are three of the big ones: 1) be patient, 2) mind your debt, 3) and invest with experienced people. These rules alone will help you successfully embark on this new investment adventure.

Why Add in Commercial?

If your SFR portfolio is doing well, first of all, congratulations. But this isn’t necessarily your stopping point. The fact is that commercial real estate is well worth a look, given that it has the potential to provide protection against downside in volatile times. You’ve got options here—for example, let’s take two separate scenarios:

  • You could focus on only large apartment properties, which limits your reliance on any one or two tenants to cover the project’s expenses and pay the mortgage. If you’ve got a 150-unit apartment building, losing a few tenants is not ideal—but assuming your leverage isn’t extreme, you should still have no problem covering your debt service.
  • Another option is focusing on commercial properties with longer-term leases—these include retail, office, and industrial, which typically have leases of 3 years on the short end and as high as 15 to 20 years on the long end. Unless something significantly negative—such as bankruptcy—happens to the tenant, the length of this lease should give you security knowing that your investment could weather rough patches in the market.

These are but two choices for investment on the commercial side. Regardless of your decision, rest assured that adding commercial properties into your portfolio can potentially offer stability as well as heightened income potential.

3 Things to Note About CRE

While there is a world of knowledge surrounding commercial real estate—and I would encourage you to educate yourself as much as possible when venturing into this territory—I would like to point out three essentials as you prepare to invest in this side of things:

  1. CRE investing through a sponsor is hands-off. There is absolutely no ongoing work required when investing in commercial real estate through a sponsor. While I personally like to read my sponsor’s quarterly reports in order to satisfy my curiosity, there are absolutely no action items required of me. This suits me, as I like to focus on lower-risk cash-flowing assets that provide regular checks in the mail and require none of my attention or supervision.
  2. You could focus on the sponsor alone and still succeed. If you focus your attention on only one area, it should unquestionably be the sponsor of the deal. There is no replacement for experience; a track record brings a myriad of past expertise and relationships that can help remedy an otherwise sticky situation. Strong track records don’t just happen—they are built on years of problem-solving. Even if things go sideways on a deal, at least you have the security of knowing that there is experience driving the decisions as you move forward.
  3. Commercial real estate investors are just like you. That is to say, not typically real-estate professionals. Instead, they are doctors, lawyers, product managers, and entrepreneurs. Some are retired; some work three jobs. This category is all over the map—but the difference is that now, thanks to online real estate investing, commercial real estate is accessible to far more people and at entry level check sizes as low as $5k in some cases versus $250k in the past.

Wondering what you should know about your sponsor before you enter into that deal? Read on.

What Should I Ask a Potential Sponsor?

By far the most important factor to investigate when investing in CRE is the person with whom you’ve investing. Here are the major things you need to know:

  • Has the potential sponsor owned comparable properties in the past? How have these investments performed?
  • Where is he or she located—down the street or on the other side of the country?
  • Who will oversee the day-to-day execution of the business plan?
  • How well does the potential sponsor know the market?
  • How long have they been in business?

Regardless of what property type you are considering, I highly recommend that you research your sponsor. As a further step, investing with a group that is able to present a transparent and verifiable track record of solid realized performance pairs you with an expert in the field.

That said, you must be prepared to do your own due diligence. Research your partner—always.

Related: 3 Reasons to Switch From Residential to Commercial Real Estate

What to Know When Getting Started

Ready to make the leap? Here are a few things to keep in mind as you start to investigate the possibilities of CRE investment:

  • In my opinion, one of the biggest mistakes one can make when moving from residential to commercial investment is a singular focus on short-term investments. Such a focus is common in the single-family residential flipping space; high-risk projects tend to have shorter expected hold times to mitigate the time you are exposed to that risk.
  • The same is often true in the commercial space. As a consequence, a commercial investor who focuses solely on short-term investments may unwittingly end up investing only in higher-risk opportunities. I believe it’s important for first-time CRE investors to exercise patience: Fight the urge for immediate return and quell your fears of longer-term investment illiquidity. There is nothing wrong with focusing on annual income and long-term asset appreciation with less emphasis on an immediate exit.
  • You don’t need to be an expert to invest in CRE; honestly, that’s what sponsors are for. That said, I would suggest only investing in what you are comfortable with. If you aren’t comfortable investing in industrial properties—then don’t. Same goes for markets. If your friends tell you that San Antonio is the place to be but you’re not convinced, then look for a different opportunity.
  • Finally, investing in an online investment platform offers newer CRE investors a chance to get their feet wet at a less-steep cost. You get all the benefits as a direct investor, but with a check that is far smaller than the typical $100K-$500K investment minimums that those investors may be subject to.

There’s a lot to learn, but at heart, commercial real estate investing comes down to common sense. By ignoring this sector, you may be missing out on what could be one of your favorite asset classes.

Disclaimer: All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.

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About Author

Brian Esquivel

Brian has over 15 years of commercial real estate investment and finance experience and currently serves as a senior director of product strategy at RealtyShares. He has sourced, underwritten, and closed an estimated total of $75mm in commercial private equity investments across 35 transactions and over $750mm in commercial debt investments.

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