Investing in commercial real estate can be a lucrative venture, offering significant returns and portfolio diversification opportunities. However, it's not without its pitfalls and challenges. Whether you're a seasoned investor or just starting, understanding what to avoid is crucial for success. In this resource, we'll explore key mistakes and common traps that can derail your commercial real estate investments. By learning from these potential missteps, you can better navigate the complex landscape of commercial property and make more informed decisions.
Things to Avoid When Investing in Commercial Real Estate
There are many different types of real estate investment risks. Being aware of these risks and the main things to avoid when investing in commercial real estate can help to mitigate this risk and ensure that any investments align with your goals and objectives.
Choosing the Wrong Property Type
There are various types of commercial real estate, but the four primary categories are Office, Industrial, Retail, and Multifamily. Investors can also acquire undeveloped land, mixed-use properties, and special use properties, such as storage units and RV parks. Each property type is distinct in its applications, risks, and benefits. For example, multifamily properties typically yield higher returns but demand more maintenance and management. Conversely, industrial properties require minimal oversight but may not perform as well financially over time.
Understanding these property types is crucial for success as a commercial real estate investor. While there is no universally right or wrong investment, there is a right and wrong investment property for you. Selecting a property that does not align with your expectations could result in lower returns, inadequate management, and unsatisfactory outcomes. Clearly defining your financial and personal goals is essential before starting your property search. You may need to weigh the pros and cons of each property type to determine which will be the best investment for you.
Improper Valuations
Each commercial property is unique, requiring investors to meticulously account for variances in each asset. Overlooking details in asset valuation can lead to financial disaster. Thus, commercial real estate investors must have a comprehensive understanding of what they are purchasing and at what cost. Accurately assessing the true value of a property is crucial, as it impacts every subsequent step. Therefore, precision at the time of acquisition is paramount.
Financial Ignorance
Misunderstanding the financial complexities of commercial real estate investing can lead to disastrous outcomes. Always keep in mind that real estate is a long-term game. Purchasing the first affordable property without a strategic plan for long-term profitability is a poor financial choice. There are many pros and cons of commercial real estate investing, so effective investment planning includes conducting market research, understanding real estate comparables, and developing a pro forma. Investors should try to avoid rushing into investments without grasping the fundamentals. For example, try to avoid a combination of the following: high interest rates, high monthly payments, balloon payments, adjustable interest rates, and personal recourse.
Not Working With a Team
Many investors try to cut costs by handling everything themselves. However, collaborating with a team is undeniably more effective than going solo. Although it might seem like you're saving money, you're likely losing both time and money in the long run. Therefore, align yourself with a skilled team and trust them to execute the tasks you hired them for. They likely possess deeper expertise in each process than you do, so working with professionals such as accountants, attorneys, and brokers is critical for mitigating risks.
Investors should work with knowledgeable real estate agents with experience with commercial real estate specifically. Does your real estate agent know the area you’re buying/selling in well? Have they dealt with the type of property you’re interested in before? Real estate agents, like all other professionals, have specialisms. Don’t go to a real estate agent who specializes in single-family homes when you're investing in commercial property, for example.
Underestimating Expenses
Savvy investors anticipate the inevitable. During your due diligence, meticulously identify any renovations or repairs the building might require. Then, consult contractors to obtain precise bids for the work. Incorporate these costs into your cost-benefit analysis to assess the investment's viability.
After acquiring an investment property, prepare for ongoing maintenance, repairs, and potential unforeseen renovations. Commercial real estate investments inherently come with unexpected expenses. This is part and parcel of owning rental properties. Expect regular minor repairs and anticipate significant costs—such as water leaks, infrastructure issues, or electrical problems—at least once during your ownership.
Poor Tax Planning
Many commercial real estate investors are attracted to the sector due to its tax benefits, such as deductions, depreciation, and opportunities for 1031 Exchanges or Opportunity Zone Investments. However, these tax perks can sometimes overshadow other important factors. While enticing, potential tax liabilities must also be considered. For instance, property taxes can rise over time, leading to unexpected costs. Therefore, tax planning should be a key consideration when purchasing CRE properties.
Additionally, capital gains taxes can occur if a property is sold for more than its purchase price. Thus, it's essential to develop a long-term strategy that accounts for both tax benefits and liabilities. Understanding these implications is crucial. Consulting with a licensed real estate tax professional can provide invaluable assistance in tax planning and help navigate the complexities of commercial real estate investing.
No Exit Strategy
Having an exit strategy is crucial when investing in commercial real estate. Options include selling the property, refinancing, or repurposing it for a different use. Without a clear exit plan, you risk being saddled with a property that is challenging to sell or manage. Market conditions and personal circumstances can fluctuate, but it's crucial to consider the following: How long do you intend to hold this property? Do you have an estimated selling value? What are your best- and worst-case scenarios, and can you live with both? Wise investing offers significant benefits, but in an ultra-competitive market, thorough preparation is essential for efficiency.
Analysis Paralysis
New investors often feel overwhelmed by the multitude of decisions they need to make, leading to inaction. They get trapped in a cycle of number-crunching, constantly waiting for conditions to improve or become safer. They think reading one more book, attending another seminar, or waiting another week will boost their confidence. However, any seasoned investor will tell you that waiting for perfect conditions means you'll never make a purchase.
Investors grappling with analysis paralysis should focus on building relationships with lenders and seasoned mentors. Listen to their insights and learn from their triumphs. Accept that failure is part of the journey and embrace the growth that comes from your mistakes. Investors should also set themselves up for success by taking control of their finances so that if purchases do not go as planned, you're not putting yourself in financial distress.
Failing to Diversify
Investment experts consistently emphasize that diversifying your portfolio is crucial to minimizing risk. This principle holds true in real estate investing as well. For newcomers to commercial real estate, it’s advisable to start with a single property type in one specific area. As you gain confidence or if you have substantial capital, you might consider branching out into multiple property types across various locations.
Moreover, direct investment in real estate properties isn't your sole option. You can further diversify by investing in REITs, ETFs, or other real estate funds. For personalized advice on portfolio diversification, consider consulting with a financial advisor.
Neglecting Market Research
A fundamental error in real estate investment is neglecting thorough market research. The real estate market is dynamic and can vary significantly from one location to another. Demand in one area may differ greatly from another. Ignoring market research can result in investing in properties that may not appreciate or generate the expected rental income. To avoid this pitfall, it is crucial to stay informed about local market trends, economic indicators, and future developments. Be sure to research the top cities for commercial real estate investing as well! Understanding current housing demand and property prices will empower you to make well-informed investment decisions.
Neglecting Due Diligence
Neglecting due diligence is one of the gravest mistakes an investor can make. The process of due diligence involves a comprehensive examination and analysis of various aspects of a property to assess its viability, potential risks and financial performance. Due diligence involves thoroughly researching the property’s condition, ensuring clear title, understanding zoning laws, assessing environmental and contamination risks, and analyzing tenant quality. Without this meticulous process, you may overlook critical issues that could impact the property's profitability and your legal responsibilities as a property owner. Performing an in-depth analysis helps uncover potential red flags, such as structural deficiencies or legal encumbrances, allowing you to renegotiate terms or walk away if necessary.
It’s crucial to verify the financials of the property when conducting due diligence. Review income and expense statements, tax returns, and pending leases to ensure the financial stability of the anticipated income stream. Be sure to scrutinize all documentation to understand the actual vs. projected cash flow, as discrepancies could indicate potential problems.
Lastly, while sellers are legally required to disclose certain physical characteristics of a property, such as easements, encumbrances, and other restrictions, investors should diligently review and validate each item personally. A best practice in acquiring commercial real estate is to never assume the same level of disclosure provided in residential transactions- significant differences exist.
Prior to financing a transaction, lenders typically require an environmental suitability assessment. It is advisable to conduct this evaluation regardless of financing concerns. Engage a reputable environmental engineering firm to investigate the property's history, identify potential contaminants like mold, lead, and asbestos, and check for underground storage tanks. What may seem safe and compliant in a visual inspection can later turn into a litigation nightmare, as the investor will inherit these liabilities and be legally obligated to address any discovered issues.
LandApp is a great tool to help commercial real estate investors conduct initial due diligence, especially from the environmental due diligence standpoint. To find out if a property is contaminated, they can easily assess any property's contamination risk while evaluating its proximity to Superfund sites, contaminated sites, underground tanks, and abandoned wells. Additionally, LandApp's marketplace offers listings for commercial properties for sale across the country. Users can filter by price, location, and more. Subscribe to LandApp for just $10 per month below:
