Investing Fundamentals

Generating Passive Income with Commercial Real Estate

Commercial properties generate returns for investors in two ways: income and appreciation.

by Shawna Wright-Smith

Most people have one source of income–their job. But in Tom Corley’s five-year study of self-made millionaires, he found that 65% had three streams of income, 45% had four streams of income, and 29% had five or more streams of income. One way some individuals build an additional stream of income is to purchase and rent residential properties. 

But while buying and renting out an apartment or house to a tenant can generate passive income–income earned with little to no effort from the person receiving it–it may not be a passive investment if you’re involved with the ongoing management of the property. 

Commercial versus residential properties

As Joseph Greene, a financial writer for the personal finance site MoneyCrashers put it, “For many investors, the goal is to create enough passive income streams that eventually their passive income surpasses their earned income, leading to more financial freedom. There are multiple ways to build passive income streams, but commercial real estate investments can be a valuable piece of the puzzle.”

Commercial properties can include anything from multifamily apartment buildings to medical office space to industrial warehouses, and can generate returns for investors in two ways: income and appreciation.

Income: Just like a residential real estate property, commercial real estate properties have tenants and can generate monthly rental income, a percentage of which may be shared with investors as ongoing cash flow. If earning passive income sooner rather than later is important, investors would want to look for properties that are already fully leased by quality tenants and generating stable cash flow.

On the other hand, properties that require significant upgrades or renovations can cut into the owner’s cash flow and therefore an investor’s monthly distributions. 

Appreciation: Appreciation, which is the increase in a property’s value over time, can happen in many different ways; favorable market conditions, capital improvements made to the property, and savvy management by ownership, to name a few. 

For many investors, the big payday comes when the investment is fully realized, meaning the property is sold or refinanced.

Opportunistic deals, like ground-up developments, will likely not generate much (if any) cash flow if the property doesn’t have renters, but investors may receive a large pay-out when the property eventually exits.

Greene also adds that, as an asset class, commercial real estate has a few other advantages over residential:

  • Commercial leases tend to be for longer terms than residential leases, three to five years in many cases, as opposed to the standard one-year lease for residences.
  • Commercial buildings typically generate significantly higher rates per square foot than residences in the same areas. 
  • Legal protections for residential tenants tend to strongly favor residents over landlords. That’s not usually true for commercial leases.

Understanding what the targeted metrics mean for your commercial real estate investment

On the CrowdStreet Marketplace, each offering detail page lists a few key metrics that can help individual investors evaluate potential investment opportunities.

Targeted Average Cash Return

Cash return tells you how much of your out-of-pocket investment you’re earning back each year. The equation is very simple: (Annual Cash Flow / Initial Cash Outlay) x 100 = % Cash Return. Depending on the business plan, some properties may target close to the same cash flow each year, while others predict higher cash flows over time as the property’s net operating income increases. 

Targeted Investor IRR (IRR)

Put simply, IRR is the rate at which a real estate investment grows (or shrinks). This annualized return metric spreads your cash flows and equity return over the course of your entire holding period and incorporates a concept called the “time-value of money” to account for the opportunity cost of your capital being locked up during that time. Since commercial real estate investments are illiquid, you can’t sell off your investment before the hold period is over, meaning you can’t invest those funds in something else.

However, IRR may not accurately reflect how much income the property generates each year. 

For instance, an opportunistic medical office development project may generate no (or very little) monthly cash flow for the first four years, but one large payout to investors when the property eventually exits (i.e. sells). This means that when you spread the total, final return across the five years, the final IRR might amount to 17% per year, even if you didn’t get any cash distributions until the very end. IRR is the most useful metric for comparing the returns of different projects that have different length holding periods.

Targeted Investor Equity Multiple

Equity multiple tells you the total expected return of your investment. For example, if you invest $25,000 and achieve an equity multiple of 2.0x over five years, that means the cumulative money ultimately distributed to you over the entire holding period will be $50,000.

The key thing to understand about targeted metrics is that they are targets. And it’s important to remember that riskier investment opportunities often target a high return as a way to justify the risk to investors. Less risky investments target lower returns but are generally considered a “safer bet.” Commercial real estate investments can fall anywhere on that spectrum depending on the type of project.

Earning (and Re-Investing) Passive Income with Commercial Real Estate

Even though your initial investment is illiquid, should your commercial real estate investment generate monthly distributions, it is possible to re-invest that passive income into another passive income generating source and expand your investment portfolio even further. For instance, if your commercial real estate investment generated $8,000 per year in cash flow, you could invest that capital into a high-yield portfolio. In time, the interest and dividends of those assets might produce enough additional passive income for you to invest in a second commercial real estate deal. And so on and so on.

As Greene points out, “From an objective standpoint, any profit earned from a new passive income stream is over and above the income you might have been living on before. You can put it toward portfolio income that much more easily, continuing an upward spiral of wealth.” 

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