I have always been a bit afraid of trying to make money with commercial real estate. On the one hand, it is a more logical process, with the motivations of sellers, buyers and renters all pretty clear and easy to understand–unlike selling to multi-motivation home buyers or renting apartments to people who have all sorts of different requirements. But on the other hand, the commercial market is less certain in a key way: demand. People always have to live somewhere, so it will be rare for a town to suddenly only need half as many residential rental units. But when tough economic times come, commercial rental demand can easily drop in half.
Consider that a warning, but it also suggests an opportunity. You see, if enough people see the risk as I do, the returns on commercial real estate should be potentially higher to compensate for that. With that in mind I want to introduce a short excerpt from an article I just found on KCComericalOnline.com, titled Making Money With Commercial Real Estate:
“If an investor purchased a building for $1,000,000, paid cash for the property and received $100,000 in cash flow he would have a 10% capitalization rate and a 10% cash-on-cash return. On the other hand, if the investor leveraged his money by putting only $200,000 down and borrowing the other $800,000 he would make a better cash-on-cash return. For example, if he is able to borrow the money at 7% interest and a 20 year amortization, his annual mortgage payments will be $73,997. Thus his cash flow is $26,003 and his cash-on-cash return is 13%. He has invested less money but gotten a higher rate of return. In addition, at the end of the 20 years he will have no debt. He has paid off the $800,000 through the income he received. This shows that leverage through debt can greatly increase the return he receives. If he wishes to fully leverage the initial $1,000,000 he could purchase $5,000,000 in real estate instead of only $1,000,000. His cash flow would be $130,015 per year, or an additional $30,015 per year. In addition, he would have paid off the entire $5,000,000 at the end of the loan. This shows the power of leverage. But, leverage increases an investor’s risk. If the income stops the cash buyer simply has no income, but he does not have to fund the mortgage out of other funds. The more leverage used the greater the potential risk to cash flow.”
That give you a decent explanation of the idea of a capitalization rate, and why leverage can be both good and risky. If you think the economy is turning around this may be a good time to make money with commercial real estate. If you have already done so, please add a comment or two below.
