Question:  I have been a real estate investor for several years now.  I own 11 residential properties and I am considering investing in commercial properties for the first time.  What are the primary differences between commercial and residential investments?

Answer: First of all, I think you’re making a wise investment decision. I think the commercial growth and returns over the next decade will be outstanding. As far as the differences go, there are many. I wouldn’t let that dissuade you from your commercial investment aspirations, but you would be well served to seek a knowledgeable mentor to walk you through your first transactions. You’re probably going to use the services of a real estate agent anyway so you may as well get the services of a qualified expert…it doesn’t cost any more (seller pays) and you’ll be way ahead of the game.

Since I don’t have the space here to adequately cover all the differences, I’ll highlight a few of the bigger ones. Use this as an introduction and ask your qualified agent to go into more depth with you. Commercial investing is exciting and financially rewarding; however you’ll have more responsibility for making your investments work.

Right off the bat you’ll probably realize that commercial investments are valued differently than residential. Residential properties are typically valued according to recent home sales in the area. Whether you have a tenant or not makes little difference to a residential property value.

Most commercial properties, however, are valued using some form of return-on-investment criteria. This could be a capitalization (cap) rate, which is very common, a gross rent multiplier (GRM) or various other ways. Cap rate is probably the most common. Simply speaking, the cap rate is the whole-dollar cash-on-cash return on investment each year after operating expenses and before financing costs.

What this means is commercial investments are much more sensitive to the quality of the tenant, rent rates, vacancy rates, lease terms, etc. Generally speaking, commercial investments should have positive cash flow from the beginning and will be valued accordingly. Sometimes the properties will be sold according to projections, replacement cost, etc., but whether you are acquiring a new office condo or a tenanted industrial warehouse, you’ll definitely want to do your homework on the various valuation techniques so you can truly understand your ROI.

Once you are past the valuation you’ll find that financing is significantly different than residential financing. That’s both good news and bad news.

On the one hand, commercial lenders will be more interested in the investment opportunity than your personal credit worthiness. Of course, with a residential loan it is the reverse of that…your personal ability to qualify is of paramount importance. Many investors are surprised at the size and quality of the commercial investments they can qualify for because you’re letting the property do the qualifying.

On the other hand, you’ll likely need to come up with substantially more money to acquire the commercial property. Most commercial lenders will require a minimum of 25-30% down on a non-owner-occupied property and will amortize the loan for just 25 years. Most commercial loans are adjustable and will have a balloon payment that causes most owners to refinance fairly regularly. I don’t view this as a negative, just something to take into account.

If you’re a small-business owner, however, you have some excellent advantages available to you. If you are purchasing a building for your business you may be able to get SBA or bank financing for as little as 10% down. There are various requirements for how much space your business must use, but that’s a great way to grow the value of your business by buying more than you need and leasing the additional space to other businesses. Small business owners should definitely check out the possibilities for owning their own real estate. It’s a great investment. If you don’t think you can afford it make sure and talk to an investment expert that can show you other options, including business lease-purchase programs.

Residential property values ebb and flow very slowly and typically rise with middle-class over time. They are consistent and follow relatively predictable trends historically. Your commercial investments will usually be more sensitive to economic conditions and local business health. In a down economy you may have to sustain extended or unexpected vacancies. Your carrying costs will be higher and you need to account for this in your investment plans.

While that may be a turnoff for some, I think it is more than offset by the positive cash returns, significantly longer tenancies (often decades), automatic rent increases and revaluations, lower maintenance requirements and higher-quality tenants (businesses instead of individuals).

Stick with your strategy. There is definitely an education involved, but the returns and expanded opportunities will be well worth it. Find a great mentor and go for it!

Question: I want to make sure that my tenants take good care of my property so I don’t allow pets or smoking and I prefer they not have small children. What else can I do to assure my tenants don’t damage the property?

Answer: Those of you that read my column yesterday know this is actually the second part of this article. I promised I would touch more on the subject of “babysitting” tenants, and here it is. The question’s different, but the same principles apply. First off, although this isn’t directly related to the general topic we’ve been discussing, you should know that it violates fair housing laws to disallow tenants based on familial status. You shouldn’t show a bias against families with small children.

The other part of your question, however, is what I want to discuss. My opinion is that it’s not a good idea to restrict smoking or pets in your rental property. And just so we’re clear, this doesn’t have anything to do with my personal preferences. It’s just an investment decision.

Stay Focused

As an investor you have to learn to focus on the investment, not your personal preferences. I wrote yesterday about how it doesn’t work to babysit your tenants. They’ll resent it at best and leave at worst. Babysitting, in the long run, negatively impacts your investment returns. You may still want to control your tenants, but you should really learn to just get over it.

The smoking and pet question falls into this same category. I’ll share my experience with this. First, I know I’ve turned away a lot of qualified tenants simply because they had a pet or someone smoked. 20-20 hindsight tells me I would have rather had a great tenant with a pet than a lousy tenant without one. This is an investment. Focus on finding a tenant that will make your investment work for you.

Here’s something else I found…most tenants will tell you want they think you want to hear. I don’t think this makes them bad people (we all do this to some extent), but don’t kid yourself. They will be as positive as possible when it comes to stating their income, past rental history, etc. They will also tell you they don’t smoke and have no pets if they think that will negatively affect their ability to qualify.

I want to give my potential tenants every opportunity to be honest with me. The more accurate information I have, the more effective I can be at determining what it will take for my investment to work. For example, if my tenants know I have a no pet policy they are more likely to say they have no pets. That doesn’t mean everyone will lie, simply that I am creating pressure for them to be less than honest. I am far better off telling them I allow pets and create a space for them to be honest. Then I adjust my lease agreement to accommodate their situation. Once I know the truth I can perhaps charge additional security deposits for pets and at least make an informed investment decision.

The same applies with smoking. I would rather know and have additional cleaning deposits than not know and leave my investment exposed to unknown risk. It’s a simple investment decision.

Let Go

Stop trying to judge and control the way your tenants live their lives. It’s somewhat amusing to me the number of investors that come into my office with all kinds of judgments about renters. They assume renters are irresponsible people who don’t take care of things either physically or financially. First off, I can just about promise you that if that’s what you believe it’s probably also what you’ll get. Second, I can tell you that it just isn’t true.

This may sound odd, but I love my tenants. Even when I disagree with some of the decisions they make, I love my tenants. For one thing, I believe loving them is a better way to live than stressing about them. Also, my tenants have allowed me to experience phenomenal returns with my investments. And those returns never truly skyrocketed until I stopped judging them and just let them live their lives.

At the end of the day, what I want is a tenant who keeps their word and pays rent. Yes, I would like for them to care for my investment the way I would, but I can’t control that so I’m not going to expend any energy trying. If they don’t pay, they don’t stay. If they do pay, I just want to do what I can to keep them there. I want to make their lives easier, not harder.

Next Please

I’m somewhat famous around the office for my low-energy approach to tenants and problems. I know my investments are working for me. Sure, there are hiccups and unexpected events that come up. But I’m too busy focusing on the positive to worry about the negative. In fact, as most people who know me have heard, I’m all about “Next Please.” That’s my phrase for when faced with those inevitable surprises in my investing. “Next Please.” I move on and make the best decision I can make for my investments.

One thing I know doesn’t work, judging or punishing my next tenants because my last tenants had a dog that scratched up the back door. I just want to make the best investment decision I can make. You would do well to do the same.