Financial advice regarding savings and investment tends to focus on the creation of a retirement account like an IRA or Roth IRA and the investment of its funds in a traditional stock/bond portfolio. Many advisors advocate that younger investors start with a higher percentage in the stock market – say 80% – and a lower percentage in the bond market – say 20% – and to gradually shift this mix towards bonds as retirement draws near.
Within the stock and bond buckets, advisors also recommend a broad degree of diversification across many different investment options to ensure that declines in some names can be offset by gains in others. Over time, this advice has proven to be sound, but we think it omits an important asset class – real estate – for which we believe there is a strong argument for inclusion in a diversified portfolio of risk assets.
Residential Real Estate (RRE) vs. Commercial Real Estate (CRE)
For many investors, the most logical entry point into real estate investment is a residential rental property, which could be anything from a single family home to a “quadplex”, which is a property that has four separate living spaces. For new investors, a residential investment property offers many benefits including: low price points, widely available financing at favorable terms, and the potential for a stable stream of cash flow. But, for investors who prioritize growth and scale, they can also offer several drawbacks including: short term leases (~12 Months), difficulty in scaling, time consuming management, high “turn” costs, and difficulty in finding creditworthy tenants. For these reasons, some investors prefer commercial real estate investing.
Commercial real estate investment properties are different from a residential properties in a number of ways. First, with the exception of multifamily, it involves space that is leased to businesses, not people. Second, there are a variety of “asset classes”, Office, Retail, Industrial, and Multifamily, each of which have their own unique investment and operational characteristics. Third, the leases tend to have longer terms that can go up to 25 years in certain circumstances. Finally, rental income and expenses tend to be booked in a separate legal entity which can provide several tax advantages over the residential alternative.
In our case, we believe that commercial real estate is the superior option for investors who have the required risk tolerance, time horizon, and interest in scaling their portfolio.
Ways to Invest in Commercial Real Estate (CRE)
Broadly, there are two ways to invest in commercial real estate. It can be done directly or indirectly.
In a direct investment, an individual or group of individuals will purchase a property (like an apartment building) in their own name or through a Limited Liability Corporation. As such, they are responsible for property selection, arranging the financing, and property management once the purchase is closed. While this method offers the investor direct leasing and operational control over the property, it also limits their ability to diversify their portfolio as much of their assets were likely used to purchase the property.
The other way to invest, indirectly, is when an individual investor places their funds with an asset manager or investment firm (like ours) and outsources the tasks of finding the property, arranging the financing, and managing the asset to them. Frequently, the asset manager will pool funds from a number of different investors and use them to purchase commercial real estate properties that none of them could afford on their own. This approach has its own set of advantages: it allows the investor to leverage the network, experience, and expertise of the asset manager, it provides the benefits of property ownership without the hassle of managing it, and it provides access to a professional grade asset with a stable income stream. However, there are also risks to this approach. An investment with a professional asset manager can require a commitment of 5-10 years during which time the money is not accessible and the manager charges fees that can reduce the amount of the overall return.
Regardless of how an individual chooses to invest in commercial real estate, there are a number of benefits to doing so.
Benefits of Investing in Commercial Real Estate
Commercial real estate investors may realize some or all of the following benefits from their investment:
- Portfolio Diversification: Price movements for commercial real estate assets tend to have a low level of correlation with those in the traditional stock/bond portfolio. So, they add a degree of diversification, meaning that their prices could go up while the others are following or vice versa. Additional diversification can be obtained by investing in various property types like office buildings, industrial buildings, retail buildings, multifamily buildings, and strip malls.
- Leverage: When investing directly, commercial real estate can be financed with a relatively small down payment, which can help to magnify or “lever” returns. In addition, the individual gets the added benefit of leveraging the asset manager’s experience, expertise, tenant relationships, banking relationships, and network of brokers to maximize the chance of a profitable return.
- Income: By definition, commercial spaces are leased to tenants who pay rent. Because commercial leases are longer than residential ones, the income potential is greater than residential properties. Investors benefit from a relatively stable stream of income throughout the duration of the investment. This can be relatively passive income when the investment is made through an asset manager.
- Taxes: Property income and expenses are booked to a separate, pass-through, entity (usually an LLC) which provides a series of tax benefits. Among them, expenses offset income, which lowers the tax liability passed on to individual investors. And, one line item, Depreciation, is a non-cash expense that allows the property owner to take an annual charge to reflect the deterioration in the physical condition of the property. It serves to further reduce the tax liability while not affecting the cash available to distribute to investors.
- 1031 Exchanges: If the investment is profitable, meaning the sales price is greater than the purchase price, investors can be on the hook for a sizable tax bill based on the gain. They can choose to pay it. Or, they can choose to defer it by taking advantage of section 1031 in the Internal Revenue Code, which allows the individual to defer the taxes due on the gain when they use the sale proceeds to purchase another property that is considered to be “like kind” to the sold asset. The deferral can be done once or over and over again to allow a portfolio to grow tax deferred.
- “Forced” Appreciation: Unlike residential real estate, which is valued based on the sales prices of comparable properties, commercial properties are valued based on the amount of Net Operating Income that they produce. Net Operating Income is calculated as a property’s income minus expenses. As such, the property owner can implement strategies designed to increase income, reduce expenses, or both. In so doing, they seek to increase Net Operating Income and “force” the value of the property to appreciate.
While the benefits of commercial real estate can be significant, there are also a number of risks to be aware of.
Risks of Investing in Commercial Real Estate
Like any investment, allocating money to commercial real estate carries some level of risk. Among others, investor should be aware of:
- Credit Risk: The ability of a tenant to pay their contractually mandated rent is key to the success of the investment. If they can’t, or won’t, pay their rent, the property’s income (and value) could suffer. As such, it is important to analyze the financial strength of each tenant before investing in a property or signing a new lease.
- Market Risk: Commercial real estate markets are dynamic and ever changing. When a tenant lease expires, there is a risk that prevailing rental rates could be lower than the amount the tenant was paying and that the space may have to be re-leased at a lower rate. To avoid this, it is important to understand the supply and demand characteristics of each market and submarket prior to committing to it.
- Liability: Public commercial spaces like warehouses, hotels, and shopping centers can create some level of liability for their owners. If someone were to slip and fall or get injured in some other manner, the property owner (and their insurance company) could be found liable for some amount of damages.
- Replacement Risk: There is an interesting paradox that can be found in high growth markets. In markets with high demand, rents tend to rise in response. But, they can reach some level where it can make financial sense for a developer to build a new property. If given the choice between an existing property with outdated finishes and technology or a new property with modern amenities for the same price, a rational tenant would choose the new property. So, Replacement Risk is the chance that the supply and demand characteristics of a market are such that an existing property could be replaced with a new one at the same price.
- Regulatory Risk: State and local governments have the ability to pass legislation that can make it more difficult or more expensive to manage a commercial asset, which can have an adverse impact on Net Operating Income (and value).
Commercial real estate investing will never be free from risk. The key is to be aware of them and to actively work to mitigate them during the term of the investment.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.