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Commercial real estate is a type of property that generates cash flow for a business and is generally very expensive. The other common way to achieve exposure to commercial real estate is through REITs. Clearly, the business of commercial real estate is an ever-expanding investment market that is here to stay.

Commercial

Commercial real estate loans are normally long term loans that are very large in size. Commercial real estate investments can be broken down into basic asset classes, each with unique set characteristics that address a wide range of investor needs. Commercial properties are generally classified by type of use, such as Residential Rental, Office, Industrial, Hospitality, Land, and Retail. Commercial real estate is all about supply and demand.

Below are some basic but key terms to understand when considering commercial real estate investments. These terms will help you in your conversations with brokers, owners, appraisers and lenders.

ARV: After repaired value of the piece of property or land.

ADV: After developed value. The new assessed value of the land after the development is completed.

Appraisal: A qualified estimate of the value of land or buildings by a professionally trained person (appraiser).

Class A Building: A commercial building that is esthetically pleasing on the outside, with superior building grades on the shell and inside.

Last week I discussed the financing of the purchase of a residential lot for development with a woman who, with her husband, wanted to build a custom home. As always happens when discussing financing, the conversation turned to interest rates and loan structures. When I described the going rate for a fully indexed land loan on a residential lot, she darn nearly fainted!

She spluttered: “Wha … How could rates possibly be so high?!? My home loan is at 6% and you are telling me that a lender wants over 10% for a land loan? That is ridiculous!”

The main value indicator of commercial real estate is based on how much net income it produces. The key word in this statement is ‘net income.’ An investor is not looking for revenue of $25,000 in rent each month only to find that the expenses amount to $30,000 – this is just a money-losing property. A buyer is looking for a property with a solid income and a good rate of return. Increasing the net income of a commercial property can be achieved in two main ways.


Increase Rent


The most obvious way to increase the value of a commercial property is to increase the base rent of each unit. Of course, this does not make a landlord a well-liked individual; however, one does not need to add sharp increases to add significant value to the property.


Take for example a 10 unit apartment building with rent set at $800 per unit per month. With a total rent of approximately $8,000 per month or $96,000 per year and expenses at $65,000 per year, the net income would be approximately $31,000 per year. Based on a 9% expected return on investment (ROI) this property would be worth $344,444 to a buyer. If the rent on each unit can be raised by only 2.5% ($20) the net income would rise to $33,400 and the building would now be worth $371,111. That’s a $26,666 increase in value for only $20 per month!


While the rents are the easiest place to add both cash flow and value to a building, this is not always the best option. By raising rents a landlord will run the risk of having people leave the building, thus creating vacancies in the process – a key consideration in any rental market.


Decrease Expenses


Another great way to increase property value, and does not directly affect the tenants, is to decrease monthly expenses. This is an often-overlooked item because it is much harder to accomplish than simply writing a rent adjustment letter and distributing it throughout the building. Decreasing costs should be an ongoing duty of the property manager and building owner.


To begin this option, utilize the help of a Certified Professional Accountant. A professional accountant can usually uncover additional ways to successful cut costs, taxes and fees in your operation. They will also help you look at all outgoing expenses and determine which could be reduced or eliminated.


Reduced Expenses: these may include utility invoices (reduce water and electrical consumption in public areas), cleaning (outsource to the lowest qualified bidder) and advertising costs (ask for referrals from good tenants)


Eliminated Expenses: gas or heating costs (write these as owner responsibility), yard maintenance (remove grass and add decorative stone) and energy (eliminate free electrical outlets for parking)


Final Thoughts


The wealth that can be generated by commercial real estate is almost limitless. Over time, having the ability to increase the net income from a property will result in a much higher value and sale price when the time comes. By using different techniques to either increase revenue generated from the property or reduce expenses, these small changes will lead to much larger sale prices.