What Makes a Good Commercial Real Estate Investment?
There are two different types of real estate investors: those that are speculative and take higher risks and those that are more conservative and desire safe, long-term investments.
While speculative investing can be fun and exciting, it can also result in financial ruin. It is necessary that speculative investors thoroughly analyze investments before committing to property purchases.
The most common formula used in commercial real estate investment properties is the capitalization rate. Otherwise simply known as CAP, this rate compares a property’s annual income, factoring in operating and vacancy expenses, and ultimately equates this in net operating income (NOIP) terms, comparing sales price ratios. The CAP rate does not reflect the individual investment’s return percentage, but if no financing is involved, the CAP rate will be relatively close in number.
The CAP rate can be found by dividing the NOI by the price or value of the property. This number is expressed as a percentage. Many banking institutions and hard money lenders focus on the CAP rate when lending money to investors.
If a property investment has long-term tenants, lengthy leases and limited commitment for landlords (low building maintenance costs and repairs), then it may be sufficient for an investor to accept a lower CAP rate. If a property, however, has unstable tenants and a volatile local real estate market, a higher CAP rate is reflected. A higher CAP rate reflects a higher investor risk.
There are five factors that define good commercial real estate investments.
- Income – Commercial properties produce income. Stockholders only see income when stocks are sold; however, real estate investors receive income through rent payments.
- Capital Appreciation – This financial concept revolves around if rent prices increase, then property values by default also increase.
- Leverage – With nearly 70- to 80-percent of commercial property funding in the form of mortgages, investors are able to free up other capital for additional investments.
- Security – While stocks are based on the simple price-to-earning concept, real estate is based strictly on demand.
- Diversity – Commercial properties often house diverse tenants, ranging from grocery stores, clothing vendors, restaurants and gift shops to retail businesses. This allows landlords to diverse their holdings, not putting all of their eggs in a single basket.
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