Commercial Real Estate (CRE) has gained significant popularity as a valuable investment class. While it offers lucrative opportunities, it’s essential to understand both the risks and benefits involved. One key aspect of CRE investing is generating passive income. In this guide, we’ll simplify the concept of passive income and explore how it applies to commercial real estate.
What is Passive Income?
To begin with, passive income refers to earnings derived from a rental property, limited partnership, or other business ventures where you are not actively involved. While the term is often loosely used, it specifically refers to income generated with minimal to no active effort. In real estate, this typically includes “net rental income” or “income in which the taxpayer does not materially participate.” The key point is that you can earn money without constant involvement. How great is that?
How to Generate Passive Income in Commercial Real Estate
For CRE investors, the primary goal is to invest in properties that consistently generate passive income. Ideally, this passive income surpasses active income, leading to greater financial freedom. Let’s explore two main ways to generate income from commercial properties: rental income and appreciation.
Generating Income Through Rentals
Commercial properties—such as retail buildings, multifamily apartments, medical office spaces, and industrial warehouses—offer returns through monthly rental income. Tenants pay rent, and a portion of this income is shared with investors as part of the ongoing cash flow. If you’re looking for immediate passive income, you may want to focus on fully leased properties with stable cash flow. On the other hand, properties requiring significant upgrades or renovations can reduce upfront passive income due to higher costs.
Generating Returns Through Appreciation
Appreciation refers to the increase in property value over time, driven by favorable market conditions or improvements made to the property. Investors realize full returns from appreciation when they sell or refinance the property at a higher value. Thus, properties that experience significant appreciation can provide a strong source of long-term passive income.
Key Metrics for Passive Income in CRE
In commercial real estate, several key metrics are used to assess and compare investment performance. Understanding these metrics can help you make informed decisions when investing.
Targeted Cash Returns
To maximize investment, investors should focus on targeted cash returns. This refers to the income earned from the property relative to its value. Higher cash returns are particularly attractive when the net operating income of the property increases over time.
Targeted Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) measures the annual rate of return a real estate investment generates over its holding period. This metric factors in the time value of money and the opportunity cost of having capital locked in the investment. Since real estate assets are generally illiquid, IRR helps investors evaluate whether the investment is worthwhile.
Benefits of Passively Investing in Commercial Real Estate
Investing in CRE offers several benefits beyond just earning passive income. Here are some advantages of passive CRE investments:
Increased Purchasing Power Through Leverage
Leverage, or using borrowed capital, allows investors to increase their purchasing power. For example, an investor could use a 50% down payment to acquire two properties instead of investing the full amount into one property. This approach enhances the potential for greater returns.
Risk Diversification
Risk diversification is another benefit of passive CRE investing. By spreading investments across different types of properties and tenants, investors can reduce their exposure to risk. For example, having multiple tenants reduces the likelihood of missed rent payments. Additionally, investing in various asset types—such as retail, industrial, or office spaces—further diversifies the risk.
Property Appreciation
In CRE, property value directly correlates with its net operating income. By increasing this income, property value rises, leading to appreciation. Unlike stocks or bonds, commercial real estate allows investors to influence the property’s performance, providing more control over the investment.
Tax Benefits
CRE investments come with tax advantages. Investors can deduct interest payments on mortgages, and depreciation on the property is also tax-deductible. These deductions lower the overall tax burden for investors, making CRE a tax-efficient investment.
Passive Income
Finally, the most attractive aspect of CRE is the ability to generate passive income. As passive income grows, investors gain financial freedom and no longer need to rely on active work to generate profits.
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Meet The LeveragedCRE Investment Team
Phill Tomlinson and Eric Butler are seasoned commercial real estate brokers with over 44 years of combined experience. They lead the LeveragedCRE Investment Team at Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, specializing in investment sales and tenant/landlord representation across the Phoenix and Scottsdale submarkets.
The team leverages their extensive knowledge and expertise to help investors and property owners maximize their returns and navigate complex real estate transactions with confidence.
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