This summer I’ve written three “Real Estate Investing” columns covering single family residential properties; duplexes, four-plexes and apartment complexes with fewer than five units; and larger apartment complexes (with up to sixteen units). I recently received a request to write a column on investing in commercial real estate, so here you go.
Commercial property is not for the faint of heart. It’s not too different from the other types of real estate investing, but because of the longer depreciable life there are lower tax benefits and the bigger investment makes it a bigger risk (if you’ve heard of the risk/return trade off, that’s what I’m talking about: bigger risks can lead to bigger returns or profit. Of course, bigger risks can also lead to bigger losses, so it’s best to do your homework to minimize risk where possible.)
When investing in commercial real estate, you’ll want to run a thorough background check of any potential tenant(s), including a credit check and rental history. Don’t give the keys to anyone until the history and credit check come back clean. I’d also screen potential tenant(s) for business experience for the type of lease you’re offering. For example, if the whole reason a potential tenant is opening a restaurant is because his sister-in-law says he’s a great cook, the business plan may not be sound.
Although you may feel uncomfortable asking specific questions about the person’s business plan (especially if you haven’t done this type of lease agreement before), you’d be negligent not to inquire. When turning over an asset worth hundreds of thousands, or even millions of dollars, you want to be certain that the prospective tenant can and will perform the full agreement.
In commercial real estate, you’ll deal primarily with two types of leases: gross leases and triple-net leases. With a gross lease, the landlord is responsible for most expenses, including taxes, insurance, and routine maintenance (the tenant fixes things he breaks). With a triple-net lease, the tenant takes care of virtually all expenses, including taxes, insurance, and all maintenance.
There are pros and cons with both. As a landlord, a primary benefit of the triple-net lease is not having to deal with much property management. You’ll get no calls about a broken window or clogged sewer on a Saturday afternoon. However, if your tenant doesn’t keep up with routine maintenance over the course of several years, the long-term damage can be substantial. And, if the tenant’s business struggles, routine building maintenance is likely to be one of the first expenses to go. Sometimes the ill effects of poor maintenance are not immediately obvious, so trying to recoup expenses years after a lease begins is difficult (bordering on impossible).
As a rule, finding a tenant for a commercial building can take more time than for a residential property, so vacancies can last longer, but because commercial leases are typically multi-year contracts, vacancies are less frequent. As you consider negotiating a commercial lease, it will likely be quite different from the experience you may have had with a residential lease. Commercial tenants may be more along the lines of, “Have attorney; will travel.” If you’re lucky enough to have a major credit tenant (e.g., major grocery store, federal agency, national chain store), you’ll benefit from additional foot traffic and more stable rent. If your building allows for multiple tenants, a major credit tenant will attract other tenants. Because they know they bring these benefits, major credit tenants often play hardball when it comes to lease negotiations. They expect their rents to be lower than other tenants, and even than operating costs for that space. Depending on how much lower, you’d be smart to play ball.
If you have questions about real estate or property management, feel free to contact me at firstname.lastname@example.org or visit our website at www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you’re a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.