While there are many benefits of buying commercial real estate, there are also natural drawbacks. Many of these drawbacks stem from the fact that commercial real estate is a hard asset and is therefore an illiquid investment.
1. Upfront Capital Requirements
When you buy commercial real estate you’ll typically have to invest as much as 6x more in upfront costs when compared to leasing commercial real estate. This is due to the fact that most people who purchase commercial real estate finance the purchase with a loan that requires up to at least 10-20% as a down payment (but his number can easily climb to 40%).
Other upfront costs include:
- Due diligence fees
- Closing costs
This is the largest drawback to purchasing commercial real estate since many businesses don’t have the capital requirements necessary to cover the costs.
2. Increased Liability
Owning a commercial property also comes with increases in liability. First, you’ll be responsible for the health and safety of the people inside it. You’ll also have to deal with the repairs and maintenance of the property itself.
If you decide to rent out a portion of your property to other tenants, you’ll also have to assume the liability of property manager, which forces you to take out additional insurance policies and comply with more stringent legal requirements.
Some business owners find this to be too much of a headache. Instead, they’d rather lease a commercial real estate building and focus on their core business.
3. Downside Risks
Just like with any investment, there is the risk that the asset can actually decline in value. When this is the case businesses actually lose money on their investment.
For example, if you purchase a property for $250,000 and the value of the property declines over a 5-year period to $225,000, you’ll lose $25,000 if you decide to sell. In recession environments, it might be cheaper to lease rather than buy due to the risk of owning an asset that might decline in value.
4. Lack of Flexibility
Since commercial real estate is an illiquid investment, there’s less flexibility when compared to a commercial real estate lease. For example, lease terms can be as short as 3 years while mortgages can last for 15 – 30 years. This means that when you buy commercial real estate it’ll be harder to move to a new location or expand your current space.
This also means that your capital is tied up for a long period of time, creating potential opportunity costs. For example, the down payment needed to buy the property could be allocated elsewhere in the business, possibly generating a higher return.