Commercial Rental Property: A Comprehensive Guide

The global commercial real estate market, which includes properties like office spaces, retail stores, and industrial buildings, is a massive and growing sector. The current size of this market is around USD 13.5 trillion, with a forecasted compound annual growth rate (CAGR) of over 4% through 2029. This growth highlights the increasing demand for these investment properties and the potential opportunities for diversifying portfolios.

For those seeking to take their investment strategy to the next level, commercial rental properties may be the answer. Commercial real estate differs from residential real estate properties in several key aspects, such as longer lease terms, higher rental yields, and a focus on generating income through business activities. These unique characteristics make business real estate an attractive option for investors seeking to expand their horizons beyond the residential market.

In this article, we'll provide an overview of the commercial real estate market, exploring its various property types and investment considerations. We'll also examine the key considerations that influence the value and performance of these properties. By the end of this article, you'll have a solid foundation in this investing strategy and be able to assess whether this sector aligns with your overall goals.

Understanding commercial real estate

Commercial real estate refers to properties designed for business activities. This broad category includes spaces for retail, offices, hospitality, and industrial uses, among others. It's distinct from residential real estate, with investments driven by the potential for income through leasing to businesses. The value and profitability depend on commercial building quality, location, accessibility, and tenant demand.

Commercial real estate classifications

There are three main classifications of commercial real estate. The property's age, quality, condition, and amenities determine these designations.

• Class A: Class A buildings are usually less than 10 years old, have great features, and are in good locations. They offer modern facilities, the latest technology, energy-efficient systems, and upgraded finishes, allowing landlords to charge high rents.
• Class B: These buildings are a step down in quality. They're older, typically around 10 to 20 years old, and might need updates to meet current standards. While they're not as upscale as Class A buildings and lack some amenities, they can still generate income.
• Class C: These are the oldest and often require the most renovation work. They're usually located in less desirable areas like older industrial neighborhoods and have the lowest rents. These buildings have outdated systems, appear run-down, and lack amenities. A Class C building can provide value-added opportunities through a commercial real estate development project.

Types of commercial real estate

There are several building types that investors may consider in the commercial space:

Hospitality

Hospitality properties offer temporary stays and services for travelers. They include hotels, motels, resorts, bed & breakfasts, and hostels. The type of hospitality property depends on factors such as the level of service, location, and target market.

Industrial

Industrial properties provide space for manufacturing, distribution, assembly, and storage. They are usually big buildings, sometimes hundreds of thousands of square feet. Industrial spaces are located near transportation centers like highways and airports.

Mixed-use

Mixed-use properties combine different kinds of businesses, such as retail space, offices, and homes, in one place. They offer many services in a convenient and centralized location.

Multifamily

Multifamily properties, like apartment buildings, condos, and senior living facilities, are slightly different. While each unit is intended for residential use, the entire property is a commercial investment because it earns rental income from multiple tenants.

Many new commercial investors start with multifamily properties if they have prior experience with single-family homes in the residential market.

Office

Office space can differ in size and style. Some have just one tenant leasing the whole building, while others have many tenants renting separate suites or floors.

Office building types can range from regular offices to specialized spaces like medical offices or co-working spaces.

Retail

Retail spaces are where businesses sell products directly to customers. They're typically in busy areas that are easy for customers to get to. Examples include strip malls, shopping centers, standalone stores, and lifestyle centers.

Special purpose

Special-purpose commercial properties are for specific uses, such as bowling alleys, churches, schools, or entertainment venues. They are built for a specific purpose and can be difficult to convert for other purposes.

Commercial lease types

Lease agreements in commercial spaces are different than residential real estate agreements. Some of the typical structures can include:

Gross lease

With a gross lease, the tenant pays a base rent per square foot that covers most expenses, including insurance, maintenance, and utilities.

Tenants prefer gross leases for their straightforward and consistent payments. This type of lease provides landlords with regular income. However, if operating costs increase, this can impact the landlord's revenue.

Net lease

In net leases, the tenants pay a base rent plus extra fees for specific property expenses like taxes, insurance, and maintenance. There are three types of net leases:

• Single net lease: In this arrangement, tenants are responsible for paying their base rent and property taxes. This type of lease adds a bit more financial responsibility on the tenant's part compared to a simple rent agreement.
• Double net lease: Under a double net lease, tenants take on the cost of the base rent along with property taxes and insurance. This agreement places a moderate level of financial obligation on the tenant, covering significant property expenses beyond just the rent.
• Triple net lease: This lease type requires tenants to pay the base rent, property taxes, and insurance. The tenant is also responsible for maintenance and repairs. Triple net is the most comprehensive of these lease types, placing the majority of property-related financial responsibilities directly on the tenant.

Percentage lease

In a percentage lease, the tenant's rent depends on a percentage of their sales, along with a minimum rent. The landlord and tenant benefit if the business does well, because when the business increases revenue, the rent goes up.

Commercial vs. residential real estate

Both commercial and residential real estate involve buying and managing properties, but the differences between the two include:

• Lease length: Business leases typically last longer, usually between 3 to 10 years, whereas residential leases are typically one year or less. The longer commercial lease agreement gives property owners more stability, because they can count on rent revenue for a longer time. Residential leases can be less stable, as tenants move more frequently.
• Price: The price of commercial real estate is determined by income potential, factoring in rent, occupancy levels, and operating expenses. This calculation includes the net operating income (NOI) and the capitalization rate (cap rate), which help assess the property's value based on its income. The purchase price of residential properties usually depends on the sale prices of similar homes in the area without the same focus on income and cap rates.
• Purchase: Acquiring business property requires a different loan process. Lenders focus on how much rent the property can make, its profitability, and its overall cash flow rather than just the buyer's credit history. Getting loans for commercial real estate is tougher and usually requires a bigger down payment than buying a house.
• Size: Business properties are generally bigger than residential properties. This is because they have to meet the specific needs and operations of businesses, which are usually larger and have different requirements than residential living spaces.
• Use: Commercial properties are used exclusively for business purposes, while residential properties are mainly for people to live in by themselves or with their families.

Building wealth with commercial real estate

Investing in commercial real estate offers several ways to build wealth. This includes direct income streams, tax advantages, and asset appreciation. Some of the ways that investors can benefit from business properties include:

1. Renting out commercial spaces to businesses: Naturally, leasing space to businesses is a straightforward way to earn income.
2. Optimizing space utilization: You can creatively make more space available for rent by dividing large areas, creating flexible layouts, or adding shared amenities to attract tenants.
3. Offering additional services: You can provide fee-based services like parking, waste management, or on-site amenities such as gyms and meeting rooms.
4. Renting out advertising space: If your building is in a high-traffic area, you can sell advertising space on walls, signs, or digital screens.
5. Taking advantage of tax deductions: Commercial real estate investors can reduce taxes by deducting depreciation, interest, and operating costs.
6. Capitalizing on real estate appreciation: Business properties situated in prime locations typically appreciate, enhancing asset value and wealth accumulation for investors.

Profiting from a commercial lease property

Commercial real estate offers a wide range of investment opportunities for those looking to diversify beyond residential properties. Learning about different property types, lease structures, and wealth-building strategies can help you approach this market with confidence.

The global commercial real estate market continues to grow, driven by increasing demand and changing business needs. Investors who stay informed about current trends can position themselves to benefit from this sector. Thorough research and seeking expert advice can help you make profitable decisions and work towards your financial goals. So, if you're eager to expand your investment horizons and capitalize on the opportunities in this market, now is the perfect time to start exploring business real estate.

Commercial rental property FAQs

What is the most used commercial lease?

The most used type of commercial lease is the gross lease. In a gross lease, the landlord covers expenses such as taxes, insurance, and maintenance, while the tenant pays a set monthly rent.

How do you know if a commercial property is a good investment?

To evaluate a business property, focus on its location, market condition, building quality, tenant caliber, and growth potential. Review its financial health through net operating income and capitalization rate.

What is a good ROI for commercial real estate?

A good return on investment (ROI) for commercial property can differ depending on the location, property type, and level of risk. Generally, an ROI between 6% and 12% is considered good.