Historically, commercial real estate investing has been more of an investment strategy for millionaires than an investment strategy for millionaires. Business owners and other wealthy people have the connections and capital to build their own small commercial real estate empires. But large capital outlay requirements and even higher purchase prices can put the strategy out of reach for individual investors.
Improved lending options and an ever-expanding market have allowed individual investors to enter the commercial market. And I’m not just talking about REITs or real estate investment trusts. Small business owners can buy their own building easier than ever. Upper-middle-class investors can buy and operate 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 review three ways commercial real estate investing creates wealth better than stocks.
If you just compared real estate sales prices to stock prices over decades, stocks would be a clear winner. You make money in real estate with leverage, and perhaps more importantly, with someone else paying for the leverage.
Let’s say you buy a $1 million property with a $200,000 down payment. Over five years, the market price of the property increases by 20%, to $1.2 million. That’s a 3.7% return, certainly nothing to write home about.
The cash back is what matters. If the loan was repaid by $50,000, your investment of $200,000 turned into $450,000. That’s a 17.7% annual return, and it doesn’t include any cash flow you’ve earned in the meantime.
So why not just use this kind of leverage in the stock market? If leverage can turn a 3.7% return into a 17.7% return, what can it do for stock returns? The answer is price stability.
Real estate prices don’t go up much, but they don’t go down either (except for rare cases like the stock market crash of 2008). You can regularly 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 are not even allowed to approach this level of leverage. And if they did, you risk getting called anytime when emotions prevail in the market and stock prices fall.
There is also debt repayment. When you finance an investment property, the tenant actually makes the payments for you. Over time, you build growing equity in the property without having to shell out more money. The next step to building wealth is accessing that equity to grow your empire even further.
2. Exponential growth
The first commercial property is the most difficult. You’ll likely need to save more than six figures for the down payment, and the loan process can take months. Each additional property will be easier and provide faster cash flow.
One strategy you can use is to buy a distressed property with an adjustable rate loan and a lump sum payment after five years. This sounds extreme, but is relatively common in commercial real estate. Over the five years you fix the property and get a long term lease in place. By the time you’re ready to refinance, the property should value much more than it originally did (because the appraiser can use the rent price to determine value), and you can cash out extra net worth money.
This money can be used as part of a down payment for the next property. Over time, you’ll accumulate multiple properties that both produce cash flow and allow for periodic refinances to draw equity. As long as you have a property manager who can keep properties occupied, you can continue to use them to help you buy more properties.
Eventually, you will turn off the tap. When you are in a growth phase, there are several ways to use the properties you already own to continue building assets. Once you approach retirement, move into the debt repayment phase and get ready to reap some passive income.
The biggest fear of retirement savers is running out of money. You save your whole life to live it for 20 years after retirement, then toss the bucket. But what if you live to be 25?
Stocks can be a great engine of growth in a retirement account, but they’re not necessarily a great retirement asset. It’s rare to find a good company that earns more than 3% or 4% every year. If living this means spending $80,000 a year in retirement, you’ll need a portfolio worth at least $2 million to generate that amount of dividend income. And if the market crashes, you’ll have to cut spending quickly or sell stocks and risk running out of money later.
If you’re building a mini empire in commercial real estate, you may not need to sell anything to support the retirement lifestyle you choose. As long as you go into debt repayment mode in the last five to 10 years before retirement, you could be sitting on several wholly owned income-generating commercial properties.
With no debt repayments to make, it’s possible that the same $2 million invested in commercial real estate could generate six-figure annual income and the ability to access 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 great, because many of the economics of commercial real estate investing we’ve discussed are also applied in the REIT space. It can also mean buying your office if you own a business, or even keeping your residence to rent out when you move. The sooner you start, the sooner you will go into exponential growth mode.