5. Have a contingency and capital reserve fund
There is always uncertainty with any investment. Regardless of how much you researched, verified, or prepared, there will always be unknown factors that can positively or negatively affect your overall yield. One way to hedge this uncertainty is to account for cost contingencies.
These are additional funds you set aside as a part of your initial acquisition costs to help with unexpected expenses that arise as you sign leases, raise rents, change management, renovate, rezone, or build. They can also help cover your debt service until the property is stabilized.
Cost contingencies are especially helpful if there will be negative cash flow during the property's improvement. In commercial real estate, the standard contingency budget is 5% to 15%, but it varies depending on the asset and whether it is underperforming.
A best practice in real estate is to create a capital reserve or replacement reserves fund for long-term improvements or unexpected expenses beyond your initial capital improvements. This is money you set aside before netting any positive cash flow, typically anywhere from 3% to 5% of gross rents. Budgeting for both factors will increase the likelihood of profitability and ensure funds are available when unexpected events arise.
6. Be prepared for setbacks and extended timelines
Just as there are uncertainties with costs, there are also uncertainties with the timeline. Most people set unrealistic timelines for building, renovating, fully leasing, or reaching market rents for their CRE investment. There will almost always be setbacks and challenges that stall progress.
- Try to identify the potential obstacles in your due diligence period.
- Prepare for these obstacles as part of your contingency costs or with a plan of action for delays.
- If you are investing in CRE through a more passive vehicle, such as a REIT, crowdfunding, a partnership, or a fund, be flexible with your return expectations and timelines.
Asset performance can fluctuate due to economic factors, market cycles, or challenges that arise after acquisition. It's ultimately the fund manager's job to inform you of this risk, but it's good to be aware of it yourself.
Commercial real estate investing mistakes
One of the biggest mistakes in CRE is skipping thorough due diligence, such as failing to verify a property's physical condition or the accuracy of its financial records. Investors also frequently underestimate ongoing operational costs, such as maintenance, property management, and taxes.
Many beginners over-leverage themselves by taking on too much debt, leaving them vulnerable if interest rates rise or vacancy rates are high. Finally, relying on emotion rather than hard data or failing to have a clear exit strategy can lead to overpaying for an asset that doesn't align with your long-term financial goals.
Emerging trends and the future of commercial real estate investing
The industrial real estate sector is strong and benefiting from numerous sustained tailwinds. Case in point: Demand for data centers is outpacing supply due to the explosive growth of artificial intelligence (AI) and cloud computing.
This imbalance is a major factor in the continued expansion of the industrial sector. The need for logistics and e-commerce infrastructure, including warehouses, distribution centers, and efficient supply chains, is also benefiting the industrial real estate sector.
The retail sector also remains strong due to robust demand for stable assets such as grocery centers and a growing consumer preference for engaging, experience-based retail. E-commerce is not replacing physical stores, but it's definitely incentivizing retailers to adapt their physical footprints to prioritize high-traffic, open-air centers and optimize store layouts for cohesive omnichannel experiences.
Alternative commercial real estate sectors, including data centers, life sciences facilities, and self-storage, are demonstrating resilient growth, attracting significant investor interest and, in many cases, outperforming traditional properties such as office properties. This momentum is largely driven by structural trends, such as the high demand for digital infrastructure fueled by AI and cloud computing.
Tax benefits of commercial real estate investing
Commercial real estate offers powerful tax advantages that can enhance an investor's net returns.
Depreciation is a key tax strategy that allows investors to reduce their taxable rental income without incurring actual cash outlay, often referred to as a "phantom expense." The IRS allows owners to deduct the cost of purchasing and improving a commercial building over 39 years using the straight-line method, which assumes a consistent, gradual wear and tear.
This annual depreciation expense is deducted from taxable rental income, reducing the investor's overall tax liability. Just know that the IRS may recapture this depreciation when the property is sold, taxing the accumulated deductions at a maximum rate of 25%.
For those looking to grow their portfolio, the 1031 exchange is a critical tool that defers capital gains taxes when selling one property and reinvesting the proceeds into another like-kind asset.
Additionally, the Qualified Business Income (QBI) deduction may allow eligible investors to deduct up to 20% of their pass-through rental income.
Then there are Opportunity Zone programs, which offer specialized paths to defer or even eliminate capital gains taxes on long-term investments. As always, you should consult with a qualified tax expert to ensure you maximize the tax advantages of your real estate investments.
The bottom line
Hopefully, this guide to investing in commercial real estate will help you identify profitable investments and guard against some potential setbacks, risks, and downsides.
