Fix-and-flip investors are increasingly drawn to commercial real estate due to several factors. One compelling reason is the potential for higher returns per deal, depending on the size and use of the property. Commercial buyers also have more negotiating power, which can sometimes translate into enhanced flipping profits.
The commercial real estate market has less competition compared to the residential market because the pool of potential buyers is smaller and there is more inventory available. The residential fix-and-flip market is fairly saturated, and with the housing shortage, homebuyers are more willing to purchase fixer-uppers, increasing the competition even more.
Although home inventories are tight, many markets still have large pools of distressed and commercial REOs, creating an opportunity for commercial fix-and-flip investors. If less competition and the potential for greater profits sound appealing to you, check out these tips for flipping commercial real estate.
1. Build your network.
The easiest way to find bargains when flipping commercial real estate is to seek out property owners struggling to pay their bills. Build relationships with real estate attorneys who specialize in helping owners of distressed commercial properties to learn about potential deals before they’re listed. Another source for leads is banks that own distressed commercial properties because they are often eager to sell and avoid the high costs of a foreclosure.
When it’s time to sell, commercial realtors, brokers, and leasing agents are good sources of information about local commercial property markets. Plus, they can help you secure tenants and buyers.
2. Understand commercial property types.
When it comes to determining commercial property values and rental rates, local supply and demand are the most important factors. Areas that have few commercial properties available and high demand for space support rising values and high rental rates—the ideal recipe for flipping commercial real estate. Look for commercial properties located in an area where vacancy is low and there is limited space available for new development.
It’s also important to understand the characteristics that make specific types of properties ideal for flipping. Commercial real estate is an umbrella term for office, industrial, retail, and mixed-use properties, and each of these have different needs. For example, attractive office properties are centrally located with plenty of parking. Industrial buildings should be sited near major roads and/or rail terminals and have large, well-maintained loading docks. Retail properties should have good visibility, easy parking, and plenty of foot traffic.
3. Understand commercial property values.
Unlike single-family homes, commercial properties are valued using multiple approaches, with a heavy weight on their cap rates, gross rent multipliers, and cash-on-cash returns.
Cap Rates
Cap rates are calculated by dividing the property’s price by its net operating income. For example, the cap rate on a $1 million property generating $100,000 of annual income is 10 percent. Cap rates measure investor returns on a debt-free purchase and tend to be higher for riskier properties. This metric is influenced by the type of tenant and their credit rating, lease terms, property condition, and the strength of the local market.
Gross Rent Multipliers
Gross rent multiplier is measured by dividing the property’s sale price by its gross rental income. This metric is sometimes used to screen for properties that are bargain priced relative to their earning power.
Cash-on-Cash Returns
Cash-on-cash returns are figured by dividing the property’s pre-tax cash flows by invested cash. For example, a property that was purchased for $1 million ($800,000 debt plus $200,000 equity) that generates $50,000 in cash flow has a 25 percent cash-on-cash return (50,000/200,000 = 25 percent).
The advantage of this formula is that it takes into account debt financing. However, one drawback is that only one year of cash flow is considered.
4. Consider a buy-and-hold strategy.
If you purchase a commercial property in a recovering market, leasing may be a better strategy than flipping because property values could increase substantially as the business climate improves. Additionally, commercial real estate typically provides more cash flow and higher yields per square foot than residential properties.
Commercial leases are also longer than residential leases, creating more secure cash flow and fewer turnover expenses. Even if your original intent is flipping commercial real estate, if the market shifts or your strategy changes, you can refinance your fix-and-flip loan if you decide to buy and hold.
5. Understand commercial real estate loan terms.
The good news for borrowers is that financing a commercial property is often easier than financing a home because lenders have more flexibility due to fewer regulatory constraints. On the other hand, commercial property loans often have shorter terms (5-20 years) and balloon payments due at the 5- or 10-year mark. Most investors refinance the loan when balloon payments come due, but that strategy can backfire if lending markets tighten.
6. Expect a longer sales cycle.
Another major difference between commercial and residential flipping is that commercial property sales usually take longer. It might take 6 months or more to flip an industrial space, 8 months for an office space, and 12 months for a retail space. Factor this into your calculations when determining if flipping commercial real estate is right for you.
Flipping Commercial Real Estate with Socotra Capital
Generating profits from commercial property flips requires the ability to spot bargains and/or improve cap rates. If you have a deal in mind but don’t have the cash to make the purchase, Socotra Capital can help. We offer hard money loans that close fast, giving you an edge over the competition.
Read our free guide on fix-and-flip hard money loans to learn more about how it works.
