Welcome to the 127th episode of the Alternative Investing Podcast!
In this episode, I will explain why commercial real estate isn't the perfect solution to the property investment problems you're experiencing right now.
If you're an investor who wants to hear an unfiltered perspective on commercial property, then make sure to listen to this episode!
People invest in property for all sorts of reasons. Some people like the fact that you can use small amounts of money to control a large asset and build a significant net worth or working capital. Afterall, it can be extremely rewarding.
However, one big limitation of residential property, especially in Australia and New Zealand, is the issue of cash flow. If you’re someone who wants to make a good income from property, it’s possible, but it takes a long time.
Based on my personal experience and from talking to plenty of other investors, there is always the risk of earning very little money from investing, even if you've been doing it for 25 or more years in some cases. You just have to know the right way to go about it.
Can You REALLY Solve Cash Flow Problems with Commercial Property?
I’ve seen a trend in recent years of people investing in commercial property as a way to solve their extensive cash flow issues. While 5 to 10 years ago, it was easier to find good commercial property investments to dabble with, the returns were simply better and the risks lower.
Then, if you’re to speak to a commercial property expert, they will usually tell you all the good things, and not a whole lot about the bad. And that’s when you miss out on understanding the risks that go hand in hand with commercial property.
One of the most important things investors must do is educate themselves before investing in any new asset class, whether they believe it will solve their cash flow problems or not.
Unfortunately, some people buy a commercial property without understanding that it may not be as profitable as they thought.
Do Your Due Diligence on Commercial Property Before Jumping In
If you want to do your research about commercial property as an asset class, make sure you learn more about the buyer’s agent you’re dealing with first. Most people jump onto the bandwagon with
limited experience or who don't know their stuff.
Some people I've talked to recently are even working with buyers' agents who are very famous and great at their jobs, but because they’ve gotten so busy, they don't have the time to care about their clients as much as they should. And that’s when problems occur — this means that they are just looking for any available property to buy.
There are more buyers than deals in the commercial real estate market, so some agents present their clients with deals that may not be what the client wants in the first place. That’s a risk you need to keep in mind.
Beyond that, there’s no question that commercial property has become extremely popular in the last few years. I’ve seen a plethora of ads on Facebook and YouTube about why commercial real estate is better than residential.
What they’re saying is partly true, but there are some things that just aren’t.
For example, commercial real estate can be a great investment, but it has its own challenges that you must be aware of before investing. A red flag here is when commercial buyer’s agents talk about net returns.
If I were to buy a business, I would want to know how much money the business makes after all the expenses. So when I say "net operating income”, want that number to reflect how much the business makes after all the expenses.
Unfortunately, many people talk about "net returns" when talking about an asset's net income.
This number includes the money that comes in from the asset itself but does not include interest or other costs.
So, if you hear someone say an asset has a net return of $80,000, be aware that this may not be as good as it sounds. After considering interest and other costs, this number might be closer to $20,000.
The truth of the matter is that commercial real estate returns are getting smaller, and this happens when there’s a lot of business uncertainty in the market. The result is that you might end up with an asset that doesn't perform as well as you want it to.
Finally, commercial real estate grows differently from other real estate types — and location, asset class, and sub-asset classes make a big difference in the end result.
Let me tell you a couple of stories that reflect this.
Commercial Property Case Study #1
I have a client who received a large portfolio of commercial properties. One of the properties was very large and went vacant for three or four years. Even though it was well-located, they couldn’t find a tenant.
One of the problems was that the property manager they appointed wasn't trying hard enough to find someone to rent it.
At the end of the day, if you’re an investor, having a good property manager is important when dealing with commercial real estate. In fact, it’s integral. You want someone who will go out and find new tenants for your property or who knows the market well enough that they can always be ahead of the game.
If your property happens to end up becoming vacant, they should have contingency plans in place to combat this.
In my client’s case, their property fell vacant after four years. The banks got antsy and started foreclosing on the main commercial property, then proceeded to foreclose on the rest of their portfolio.
This was because other assets in the portfolio weren't making enough money to cover the main commercial property.
Luckily, they were able to fix the problem. But it gave me a dark view of what could happen with commercial property if it’s not approached correctly.
Commercial Property Case Study #2
As a less drastic example, a couple of my clients purchased commercial properties after sitting on the thought for at least a year.
To kick off their journey, they hired a buyer's agent and agreed to pay the commission, so they felt they had to go through with it.
Fast-forward to now, and two of them who bought properties have found that the cash flow from the investments has gone down to almost nothing because of interest rate hikes. And considering they wanted to increase their cash flow, this leaves them in a difficult position.
While the assets are holding their value, the long-term viability of the tenants is uncertain, and it’s also hard to sell them right now because of current market conditions.
Predictable Income is the Goal of Commercial Real Estate
People are choosing to invest in commercial real estate because they believe it can give them a way to make more stable money than other investments. But the goal should always be to have a more consistent income, even in times of high uncertainty and volatility.
Some people think the commercial property market can help them achieve this goal, but it’s not true, and you should always be careful if you invest in this asset class.
Make sure the people you're investing with have your best interests at heart and that they understand your risk profile and what kinds of deals are a good fit for you.
Three Big Red Flags in Commercial Property Investing
Just like any investment stream, there are always red flags to deal with. For commercial property, these are:
Together, these risk factors make me feel naturally nervous about this asset class from the beginning.
If you're earning 2% right now, that could quickly become zero, or even negative if the banks push you to a higher principal and interest repayment schedule. And what if the market falls and interest rates go up again?
With all this said and done, it’s obvious that any investor — seasoned or not — needs to be careful about entering the commercial real estate market. It’s not all rainbows and butterflies. However, there are great opportunities out there, it’s just about identifying any risk factors associated with them.
Make sure you create a list of important characteristics that you will not compromise on before you commit to any real estate deal in this space. You’ll thank yourself later.