Commercial Real Estate (CRE) continues to gain popularity in the sector of real estate investing. While CRE can be an appealing investment class, it is essential to know the pitfalls and risks and the benefits of CRE investing. Therefore, you need to understand a technical aspect of it, such as passive income. In this article, don’t worry about the complexity it entails because we have rounded up the ultimate guide to passive income.
Learn more about how to generate it and the benefits it offers to commercial real estate investing.
Understanding Passive Income
Let’s go back to the basics, shall we? Passive income refers to earnings from a rental property, limited partnership, or other business where a person is not actively involved. While passive income has been used loosely in recent years, it has been used to define money being earned regularly with little to no effort on the person receiving it. Technically, however, it has been described as either “net rental income,” “income in which a taxpayer does not materially participate,” or “self-charged interest.” In passive income, there is no material participation on the part of the investor of the business. How cool is that?
How to Generate Income in Commercial Real Estate
For investors, the goal lies in investing in properties that generate passive income. It is relevant to earn enough passive income through channels that could surpass their active income, leading to more financial freedom. And one such channel is commercial properties.
Investing in commercial properties, such as retail, multifamily apartment buildings, medical office space and industrial warehouses can generate returns for investors in two ways: income and appreciation.
Briefly, in generating returns through income, commercial real estate properties have tenants that can generate monthly rental income; a percentage thereof may be shared with investors as part of ongoing cash flow. Thus, if earning passive income as soon as possible is on top of the investor’s propriety list, he may want to look for properties already fully leased by quality tenants and generate stable cash flow. Conversely, properties that require significant upgrades or renovations can cut into the owner’s cash flow, and therefore an investor’s monthly distributions, i.e., can reduce the investor’s passive income earnings up front.
On the other hand, in generating returns through appreciation, appreciation refers to the increase of the property’s value over time. Appreciation can happen in different ways, like favorable market conditions, capital improvements to the property. The investors’ return on the investment is fully realized when the property is sold or refinanced at a higher value.
Another way of understanding passive income in CRE is by key metrics. Key metrics refer to measures of quantitative assessment commonly used for comparing and tracking performance or production. Insofar as investing in commercial real estate is concerned, these key metrics may be taken into consideration:
Targeted Cash Returns – To make the most out of the investment, an investor of commercial real estate may consider his targeted cash returns on his investment. For example, he may either target a return close to the value of the property or higher when he knows that the value of the property will increase due to an increase in the net operating income of the commercial real estate.
Targeted Internal Rate of Return – Internal rate of return, simply put, refers to that rate of return which a real estate grows or shrinks. This annual targeted return spreads the investor’s cash flows at an even rate throughout the holding period of the investment. This is sometimes known as the “time value of money” to consider the opportunity cost of the invested capital being locked in a particular investment. It is worth noting that since real estate assets are illiquid, i.e., they are not quickly sold in the market, the capital invested therein is not quickly reinvested before the holding period is over.
Benefits of Passively Investing in Commercial Real Estate
Commercial real estate investing has a ton of benefits than other investment modalities. An investor in commercial real estate will receive passive income and appreciation of the property concerned and tax benefits, more substantial purchasing power, etc. That being said, here are the benefits of passively investing in commercial real estate:
- Increased purchasing power through leverage– One benefit of investing in commercial real estate is the increased purchasing power through leverage. Leverage refers to utilizing borrowed capital, i.e., loans or debts, to invest. For example, by using leverage, an investor can make a simple 50% down payment on a specific property and invest the other 50% in another property. In stark contrast, a person may only invest 100% of his funds in one property without leverage. Hence, highlighting the benefit of the increased purchasing power of a passive commercial real estate investor through leverage.
- Risk Diversification– Risk diversification is the embodiment of not putting your eggs in one basket. The rationale behind this technique is that a portfolio of different kinds of assets will yield a longer term of returns and lower risk of the investments.
In commercial real estate – as a passive investment – there are specific ways of diversifying an investor’s portfolio, such as having more tenants. As you know, the more tenants, the lesser the risk of not receiving payment for rent. Another way of diversifying risk is by selecting different asset types. For example, investing in commercial retail buildings carries an additional risk than investing in commercial industrial buildings.
- Appreciation of the commercial real estate – It is worth remembering that in commercial real estate, the property’s value is directly related to its net operating income. By raising the net operating income, the value of the property will likewise increase or appreciate. This increase in value is enticing to new investors, thereby garnering more profit, ad infinitum. The intrinsic increase in value is mainly due to the investor’s cap rate and the degree of control in commercial real estate. Like stocks and bonds, other investments do not allow the investor to influence the investment other than buying or selling based on the market.
- Tax Benefits – Investing in commercial real estate garner a couple of tax advantages, such as the ability to deduct interest payments on the mortgage to the tax payments. The depreciation of the real estate building is likewise a tax-deductible expense, further reducing the investor’s total tax payment.
- Passive Income – The most enticing part of commercial real estate investing is receiving passive income opportunities. The more passive income is earned, the more financial freedom an investor has because he need not work to generate profit as the returns on the commercial real estate do it for the investor.
Based on the information provided in this article on CRE investing and passive income, we hope we have cleared any doubt you may be having. So, to establish a cornerstone of growing your money in the long run, without taking too much of your time, consider investing in Commercial Real Estate to start growing passive income today.
Even after outlining all the information above, investing in CRE can still seem daunting. That’s why the Leveraged CRE Investment Team at Commercial Properties, Inc. is here to help you achieve your investment goals. Contact us at (480) 330-8897 or send us an email at request@leveragedcre.com.
Need help on how to get started investing in commercial real estate? We got you covered! We prepared a free e-book that will serve as your guide to achieve your long-term business goals or obtain that property you’ve always been dreaming of!
Phill Tomlinson is a commercial real estate broker with Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, and owner of the Leveraged CRE Investment Team specializing in investment sales and tenant/landlord representation in the Phoenix and Scottsdale submarkets. Phill applies over 21 years of experience in the Real Estate industry helping investors and owners maximize their returns.
Bookmark www.leveragedcre.com to learn more about the Commercial Real Estate market and keep informed of relevant real estate strategies designed to maximize your income property investment results. Connect and follow Phill on Social Media at sm.leveragedcre.com/smplatform. #LeveragedCRE