Historically, commercial real estate investing has been more of an investing strategy for millionaires than a millionaire-maker investing strategy. Business owners and other wealthy people have the connections and capital to build their own little commercial real estate empire. But large down payment requirements and even larger purchase prices may put the strategy just out of reach of individual investors.
Improved lending options and an ever-expanding market have made it possible for individual investors to dip their feet into the commercial market. And I don’t mean just through REITs, or real estate investment trusts. Small business owners can buy their own building easier than ever. Upper-middle class investors can purchase and operate retail strip malls or self-storage facilities.
Is it worth getting involved in commercial real estate investing? What are its advantages over simply investing in stocks? Let’s go over three ways commercial real estate investing builds wealth better than stocks.
If you just compared real estate sale prices to stock prices over decades, stocks would be the clear winner. You make money in real estate with leverage, and maybe more importantly, with someone else paying off the leverage.
Let’s say you purchase a $1 million property with $200,000 down. Over five years, the market price of the property increases 20%, to $1.2 million. This is a 3.7% return, certainly nothing to write home about.
The cash-on-cash return is what matters. If the loan has been paid down by $50,000, your $200,000 investment turned into $450,000. That’s a 17.7% annual return, and it doesn’t include any cash flow that you earned in the interim.
So why not just use that kind of leverage in the stock market? If leverage can turn a 3.7% return into a 17.7% return, what can it do to stock returns? The answer is price stability.
Real estate prices don’t go up much, but they also (excepting rare instances like the 2008 market crash) don’t go down much. You can routinely get 5:1 leverage in commercial real estate because the bank doesn’t have to worry much about the price of the property cratering. Brokerages aren’t even allowed to approach that level of leverage. And if they did, you’d risk getting margin called at any time when emotions get the better of the market and stock prices dip.
There’s also the debt pay down. When you finance an investment property, the tenant is effectively making the payments for you. Over time, you build increasing equity in the property without having to shell out more cash. The next step to building wealth is to access that equity to grow your empire even further.
2. Exponential growth
The first commercial property is the hardest. You’ll likely need to save over six figures for the down payment, and the lending process can take months. Each additional property will come easier and provide quicker cash flow.
One strategy you can use is to purchase a distressed property with an adjustable-rate loan and a balloon payment after five years. This sounds extreme but is relatively common in commercial real estate. Over the five years, you fix up the property and get a long-term lease in place. By the time you’re ready to refinance, the property should appraise for far more than it did originally (because the appraiser can use the rent price to determine the value), and you can pull cash out from the additional equity.
That cash can be used as part of a down payment for the next property. Over time, you’ll amass several properties that both produce cash flow and allow for periodic refinances to take equity out. As long as you have a capable property manager keeping the properties occupied, you can continue to use them to help purchase more properties.
Eventually, you’ll turn the faucet off. When you’re in a growth phase, there are several ways to use properties that you already own to keep building assets. Once you near retirement, switch to debt pay down phase and prepare to reap in passive income.
The biggest fear for retirement savers is running out of money. You save your whole life to live it up for 20 years postretirement and then kick the bucket. But what happens if you live for 25 years?
Stocks can be a great engine for growth in a retirement account, but they aren’t necessarily a great retirement asset. It’s rare to find a good company that yields more than 3% or 4% each year. If living it up means spending $80,000 a year in retirement, you’ll need a portfolio worth $2 million minimum to generate that amount of income in dividends. And if the market crashes, you’ll have to cut expenses quickly or sell shares of stock and risk running out of money later on.
If you build a mini-empire in commercial real estate, you may not need to sell anything to support the retirement lifestyle that you choose. As long as you shift into debt pay down mode over the last five to 10 years before retirement, you could be sitting on several wholly owned, income-producing commercial properties.
With no debt payments to make, it’s possible that the same $2 million invested in commercial real estate would provide six figures in annual income and the opportunity to access the equity with a loan (paid by the tenant) at any time.
How to get started in commercial real estate
Commercial real estate deserves its place in every investor’s portfolio. If that means buying REITs for you, that’s fine, as many of the economics of commercial real estate investing that we discussed are also applied in the REIT space. It could also mean buying your office if you’re a business owner, or even keeping your residence to rent it out when you move. The sooner you get started, the sooner you’ll get to exponential growth mode.