Commercial real estate is a completely different animal from residential real estate. As a first-time investor, there are some things that you might not know about commercial real estate transactions – so we’re here to fill you in.
Commercial real estate can encompass anything from an office building to a residential duplex, or even a restaurant or warehouse. Office space, hotels, resorts, strip malls, and healthcare facilities are all considered “commercial,” not residential.
As you might imagine, purchasing commercial real estate is not like buying a residential home. You’ll encounter different procedures and regulations, and you’ll need to work with a trained commercial real estate agent.
Thinking about buying your first commercial property? Here are five things that you might not know about commercial real estate transactions.
1. There Are 3 Commercial Real Estate Categories
When looking at commercial real estate, there are three types of buildings. These classifications refer to the quality and rating of the property in question. As an investor, the classifications are important because they represent different levels of risk and potential return.
- Class A
- Class B
- Class C
Class A buildings are the highest quality building in their markets. Generally, they are newer (built within the last 10-15 years) and include high-quality amenities and high-income tenants. They also usually sport low vacancy rates.
These buildings are in the best areas and can be professionally managed. Historically, these properties have the highest rent and little to no maintenance issues.
Class B properties are a step down from Class A buildings and are usually older and have lower-income tenants. You won’t see the same quality amenities in these buildings and they may or may not be professionally managed. Some maintenance issues may also exist in these properties. From an investment point of view, Class B properties are riskier than class A.
Class C properties are usually more than 20 years old and located in not as desirable locations as either Class A or Class B. These buildings need renovations to bring them up to date or even up to code, likely revolving around structural issues. Class C has the lowest rental rates of all three classifications and usually requires work to maintain vacancies and steady income.
2. You Need to Calculate Your NOI
Net Operating Income (NOI) is one indicator that is used to determine whether or not a property will be a good investment. Before any commercial real estate transaction, this is an important number to know so you can understand if a property will help your bottom line – or if it will be a money pit.
In short, NOI is a formula used to determine the revenue and profitability of your property after operating expenses are subtracted.
There are several factors to include when figuring out your NOI. For instance, you’ll want to account for:
- Any revenue generated by the property in addition to rental income
- Money generated by the property’s parking structures, laundry facilities, etc.
- Operating expenses (maintenance, insurance, utilities, etc.)
NOI is a key factor when determining if a property is a good investment. However, it’s difficult to think of everything you need to consider during your calculations. That’s where we come in.
Gonyea Commercial Properties has been helping investors manage and buy their commercial properties since 1989. We’ve executed thousands of commercial real estate leases and sales, and we’ll help you through the purchase process – including calculating your NOI
3. Commercial Property Purchases Have Tax Benefits
Many people invest in commercial properties because of their valuable tax benefits. Whether you’re buying a small apartment building or a large corporate property, the purchase can offer you some pretty substantial tax breaks.
Here are some examples of typical tax savings when purchasing a commercial property.
- Any interest you pay on the mortgage for your commercial property is tax deductible. This means that if you pay a $10,000 monthly mortgage and approximately $4,000 of it is interest, by the end of the year, you’ll have $48,000 of tax-deductible interest.
- The IRS allows depreciation of a residential building over 27.5 years – but commercial buildings are allowed over 39 years. Just like that new car you drove off the lot, your new commercial real estate property depreciates the minute you buy it. Depending on the cost of your property, the annual depreciation would roughly offset the tax you owe on your profit.
- Many non-mortgage expenses arere potential deductions. Renovations, maintenance, ongoing upgrades, and even condo fees can be deducted.
- Capital gains are another way to provide tax savings. Some business owners invest in commercial real estate as retirement assets. When purchased as a retirement investment and held over one year or longer, the tax rate can be significantly lower than if you were to access an IRA fund. This means that you’ll keep more of your money in your pocket.
Another thing to be aware of is a 1031 exchange. A 1031 exchange swaps one real estate investment property for another one. This allows for the capital gains taxes to be deferred. It’s named after Section 131 of the IRS code.
To qualify for a 1031 exchange, the properties involved need to be similar. There are also limitations when vacation rentals are involved. If done correctly, there are no limitations on the number of 1031 exchanges you can perform.
4. Commercial Transactions Are Less Competitive
Here’s something you probably already know: the residential real estate business is booming. You can’t turn on the news without hearing a story about a home buyer putting their house on the market, only to have multiple offers within the hour.
A recent study by Realtor.com showed that a typical home spent 22 fewer days on the market in August 2022 than pre-pandemic. On top of that, the inventory of homes for sale continues to increase. In other words, it’s an extremely competitive market.
What about the commercial real estate market? It’s certainly less competitive. In fact, it’s easier to find lucrative commercial properties to invest in than to buy a residential home. Why is that? Well, there are fewer buyers to beat.
Additionally, investing in commercial real estate takes more capital, more research, and more patience than buying a personal house. It’s not for everyone. That’s why you need the right real estate team on your side to have a stronger chance of securing a great property.
5. Investing in Commercial Properties Takes Patience.
You don’t see commercial properties sold in 24 hours as you do in the residential home market. If you’re buying a commercial property, you need patience – and a lot of it. It’s a fairly lengthy process – the sales cycles and transactions tend to take more time than in the residential market.
When buying a home, the buyer has 10 to 14 days to conduct a home inspection and it can take up to 30 days to obtain a mortgage. An inspection for a commercial real estate purchase can take up to 60 to 90 days and the financing approvals can take 60 days or longer.
You also must remember that there may be other issues with the property that you need to consider, such as:
- Environmental concerns
- Zoning and code problems
- Tax complications
- Infrastructure problems
As a first-time commercial real estate investor or purchase, this can all be daunting. It’s easy to feel overwhelmed at the prospect of forgetting something important. That’s another big reason to work with an experienced commercial property team.
Looking for More Information?
Commercial real estate transactions can be great investments for you, your business, or even your family. However, they are not like residential real estate purchases, and there are many things you to remember when searching for and purchasing commercial real estate.
For over three decades, Gonyea Commercial Properties has helped buyers find, purchase, manage, and sell their commercial properties in the Minneapolis and St. Paul Metro area. We currently have over 30 buildings in our portfolio, but our most valuable assets are the relationships we’ve forged with clients and people like you.
Contact our team today at 612-500-7997 or email [email protected]. You can also schedule an appointment with us online. We’ll answer all your questions and help you find a commercial space that’s right for you.