Commercial Real Estate Basics
Commercial real estate can be a great business to get into. Unfortunately, while there are many people who succeed in this business, there are also a great number of people who fail. By understanding some of the basics of the real estate business, you can help ensure success.
One of the most important factors in any business is the cash flow provided by the business. The cash flow is the amount of money left over after all of the expenses have been covered. If this number is negative, you are spending more on your business than you are getting back out of it. In commercial real estate, this number would be calculated by taking the gross income (amount of rent collected), minus the operating expenses (utility bills, landscape care, etc.), minus the amount of money you owe on the building. Your total, after subtracting the operating expenses and mortgage, would be your cash flow, and should always be positive.
When calculating your potential cash flow, it is a good idea to check with the previous owner and find out how many units in the building are usually full. For example, if you have 25 units in the building, but only 20 are usually full, you will need to calculate your estimated cash flow based only on the 20 full units. If you estimated it by assuming all 25 would be full, you may overestimate your cash flow and find yourself in trouble later.
Another way of determining the value of a property is by calculating the capitalization rate (cap rate). In order to calculate the cap rate you take the net operating income of the property (excess income after expenses) and divide it by the asking price. So, if your property has a net operating income of $100,000 and the asking price of the property is $1,000,000, your capitalization rate would be 10%. Ideally, it is best to have the cap rate above 12%.
Finally, cash on cash return is important to understand when looking at commercial real estate. Cash on cash return is calculated by taking your cash flow and dividing it by your total cost for the building, including down payment, closing costs, etc. This will tell you how long it will take you to make back the money you originally spent on your investment.
Commercial real estate is a great business with excellent income potential. However, it is important to buy a building at a price that will allow you to succeed with a positive cash flow instead of a price that will place you in more debt than you can afford.