6 Concepts to Understand About Commercial Real Estate Financing
Commercial real estate can be a lucrative way to invest your money. Many investors who consider real estate among their focal points favor commercial, but that additional reward does carry with it more initial risk. With that in mind, let us consider six important commercial real estate concepts.
1. Financial Modeling
Financial modeling is an important tool throughout the real estate world but particularly with commercial real estate. Such transactions can be quite complex. To truly appreciate them, models must be built by scratch, and they must be dynamic so that you can see the ripple effect should a particular value be changed.
2. Annual Yield
Annual yield is the portion of the initial investment that you can expect returned to you as income each year. When you invest in a commercial lot, you will expect a certain yearly return based on your mortgage or purchase price, the rent you charge and the expenses you expect to incur. Be mindful that appreciation will move independent of yield post-purchase.
3. Expense Ratio
Commercial real estate investments bring with them expenses, such as the interest you pay on your loan and the maintenance that the site will require. A general rule for investors leasing commercial properties is that you should expect expenses to be near 50 percent of the monthly rent.
4. Management Expenses
Beyond costs associated with financing and upkeep, you will have management expenses. Commercial properties are not simple to manage even if you have just one. If you have a portfolio, then the management requirements and thus your expenses can grow considerably. If you were to hire a property management firm, you should expect a free equal to up to 10 percent of the rent.
5. P/E Ratio
While the price-to-earnings ratio calculations for real estate are different than with stocks, the core principle is the same. It lets you calculate net revenue from a commercial rental, which you can then use to compare against other investments to determine if financing this particular commercial property is worth it.
When financing commercial real estate, there is both positive and negative leverage. The most obvious form of leverage in the real estate world is the mortgage. In the simplest sense, the longer a loan must exist, the more interest will accrue and the more you will owe. Leverage as a concept is a means of determining whether particular financing is worthwhile.
All of the concepts listed are important to have a firm grasp of when it comes to commercial real estate. But there are many other as well, including some that build on these concepts. Some of the other concepts you may want to explore include the time value of money, inflation and compounding.