The term “commercial real estate” can be confusing. On one hand it seems pretty self explanatory, but on the other it is an overly broad term that encompasses a wide variety of property types and sizes.
In this article, we are going to clear it up. We will define what commercial real estate is in a broad sense, but we will also be more specific by going into detail about common property types, sizes, and uses. In addition, we will discuss how to invest in it and the benefits/drawbacks of doing so. By the end, readers will have a thorough understanding of what commercial real estate is and can use this information to determine if it is a good fit for their own investment portfolio.
At First National Realty Partners, we are a deal syndicator who specializes in the acquisition and management of grocery store anchored commercial centers. If you are an accredited investor and would like to learn more about our current commercial real estate investment opportunities, click here.
What is Commercial Real Estate?
Broadly, commercial real estate describes income producing properties that are used for business purposes. They are typically purchased for investment purposes and provide a return through a combination of rental income, price appreciation, and tax benefits.
But, as the introduction described, this definition is overly broad and does not account for the significant nuance in commercial properties. To be more specific, they can be further broken down into property types and building classes.
Types of Commercial Real Estate
Generally, there are 8 types of commercial real estate property.
Type #1: Retail
Retail properties are those that are typically located in the shopping areas of cities and they contain customer facing businesses who sell the goods and services that we use in everyday life. For example, common retail properties include:
- Strip Centers & Shopping Centers: As the name suggests, strip centers are smaller shopping centers that are arranged in a “strip” and typically include tenants like clothing stores, coffee shops, or quick service restaurants. Larger shopping centers, like the ones we purchase and manage, may contain an anchor tenant who is a large, well known tenant who “anchors” the property by attracting shopping traffic and paying the majority of the rent.
- Community Retail Centers: These are large properties, often in the range 125,000 – 350,000 SF, and usually contain multiple anchor tenants. These centers are very common in the suburbs of many cities.
- Shopping Malls: These are the classic shopping malls that are in almost every city, in some shape or form. They contain several anchor department stores and a number of interior stores and restaurants. On the small end, these could be 300,000 or 400,000 SF. On the incredibly large side, they could be 1,000,000 SF or more.
- Outparcels: Finally, many retail properties have “outparcels” which are small parcels of land within the boundaries of the larger retail property. Often, they are developed for a tenant that has a complimentary use to the others in the “inline” space. think bank branches, drug stores, or quick service restaurants.
Retail space is popular with real estate investors for their highly visible locations, long term leases, and diversity of the tenant base. We particularly like grocery stores because they provide an essential product (food) and tend to remain steady through all phases of the economic cycle.
Type #2: Office Buildings
Office buildings are places for companies to operate. They can range from general purpose office space, like those used by accounting firms or architects, to highly specialized space like medical office or light manufacturing. In addition, these could be small, single story properties located in the suburbs or multi-story high rise buildings that are so common in the central business districts of cities.
As commercial investment properties, office buildings are preferred for their long term leases, high quality business tenants, and the scale that comes with having all tenants within one property – it makes management much easier.
Type #3: Industrial Property
Industrial real estate is used for storage, logistics and manufacturing. Generally, these types of properties fall into four categories:
- Light Manufacturing: This space is used for final assembly of products and typically include some small amount of storage and/or office space
- Heavy Manufacturing: These are spaces where things are constructed. Think factories with a significant amount of equipment and machinery and some amount of storage for finished goods while they await shipment.
- Flex Space: A flex space is one that has a mix of storage that can easily be converted for different uses. Think like an importer who has a showroom in the front of the building (the office space) and a storage and shipping areas in the back of the building.
- Bulk Warehouse: These are the enormous distribution spaces where goods are stored and shipped. Often, they can be up to 1,000,000 square feet and are used by major logistics companies to store and ship goods. Think about something like an Amazon distribution facility.
Investors like industrial buildings because they are constantly in demand, require a relatively low amount of upkeep, and do not require an expensive buildout.
Type #4: Multifamily
Commercial multifamily apartment buildings have two defining characteristics: (1) they are places where renters live; and (2) they have more than four units. Apartment buildings generally fall into four categories:
- Garden Apartments: These are multi-building properties that are up to four stories in height. In total, garden style apartment complexes usually have somewhere in the range of 200-400 units.
- Mid-Rise: Mid-rise apartment properties usually have 30-100 units, contained within a single 5-12 story building. They are very popular in downtown cores and usually contain at least one or two elevators.
- High-Rise: High rise apartment buildings are more than 12 stories and have 100+ units contained within the same building. They are often found in the central cores of big cities.
Multifamily properties are popular with commercial real estate investors because they tend to have relatively stable occupancy, stable cash flow, and have big institutional demand – which makes it easier when it comes time to sell.
Type #5: Hospitality
Hospitality properties are usually hotels. Generally, there are three types:
- Full Service: These are hotels that typically cater to high end leisure or business travelers. They are usually located in the central business district and offer their customers a full range of services from meals, room service, spa treatments, exercise facilities, and concierge services. Think Marriott or Ritz-Carlton.
- Limited Service Hotels: These are hotels that are typically located just outside of business districts or near airports and they are usually geared towards the budget conscious leisure traveler. Instead of a full restaurant, they may have a small lunch counter or instead of a full gym, they may have a small room with just a few pieces of equipment. Think Courtyard by Marriott or Hilton Garden Inn.
- Extended Stay Hotels: These are hotels that are geared towards longer term stays of a week or more. The rooms may have small kitchenettes, may be slightly larger, or have a sitting area for leisure. Think Residence Inn by Marriott.
Hotels can certainly be very profitable as an investment, which is why investors like them. But, they are at the higher end of the risk scale because they are subject to high levels of variability and are levered to macroeconomic conditions.
Type #6: Mixed-Use Properties
As the name suggests, mixed-use properties are those that combine more than one use. For example, one very common type seen in commercial real estate markets is an apartment building with ground floor retail space.
Mixed-use properties are popular with investors because they serve a need in a market, make efficient use of the available space, and offer a diversity of uses to protect against cyclical economic conditions.
Type #7: Land
Land is vacant property that has not yet been developed into a specific use. Sometimes the land could be “raw” which means that it does not have any infrastructure (power, water, roads, etc) or it may be developed with all of the infrastructure necessary (including zoning) to offer a turnkey property to developers.
Real estate investors like land because, as the saying goes – they aren’t making any more of it. It is a scarce commodity, especially in dense urban areas, and can become very valuable over time.
Type #8: Special Purpose
Finally, special purpose commercial properties are those that do not generally fall into one of the categories above. They have some sort of unique use or feature that makes them special. For example, airports or amusement parks could fall into the category of special purpose.
Investors like special purpose properties because they are unique and very difficult to replicate, which helps preserve value.
Each of these property types has their own property management quirks so investors often specialize in one or two types to get to know them inside and out. This type of expertise means that they can maximize their chance for a profitable outcome.
For investors looking to gain exposure to a commercial asset, the property type is just one consideration. The other major one is to consider the building class.
CRE Building Classes
Within each of the property types described above, there are four “classes” of buildings that can help investors narrow down exactly what type of property that they are looking for. The classes are identified by letters, A-D.
Class A
Class A properties are the newest, cleanest, properties with the best locations. They have the best finishes, the most dependable tenants, and the longest leases. They are also the most expensive.
Class A properties are popular with institutional investors who are looking for stable, dependable cash flow. Class A properties can certainly rise in value, but their upside may be somewhat limited given the premium that must be paid to acquire them. This is more of a cash flow play.
Class B
Class B properties are very solid properties that have a strong tenant base, a good (if not great) location, and nice (if slightly dated) finishes. However, they may have some basic deferred maintenance, tenants with expiring leases, or some small amount of vacancy which is what drives the B classification.
Class B properties are popular with investors who are looking for some mix of cash flow stability and potential for appreciation. Class B properties are slightly less expensive than their Class A counterparts.
Class C
Class C properties have some deficiency that causes them to not be able to achieve top dollar. For example, they may have an inferior location or, more likely, they have a good location but the property is in need of repairs and renovations to bring it up to Class A or B condition. In addition, they may have higher than market levels of vacancy or major tenants whose lease is close to expiration with no guarantee of renewal.
Class C properties are popular with so-called value-add investors who purchase the property and invest a significant amount of time and money into repairs, renovations, and negotiations with tenants to renew or extend their commercial leases. Once complete, the property may become Class A or B and the owner may have some built in profit if they were able to buy the property at a good price.
Class D
Generally, Class D properties are not investable, but they may present an attractive high risk, high reward scenario for some individuals. These properties may have major structural deficiencies, could be completely vacant, or have a location that is far from roads or commercial corridors.
But, some investors have a vision, a high risk tolerance, and a lot of patience to make these properties work. If successful, they can be very profitable, but they can also be a total bust.
Getting Started Investing in CRE
To get started investing in commercial properties, there are four things that each individual should first consider:
- Property Type: Investors should study each of the types described to determine which is the best fit for their own investment strategy. Some may like the stability of the kind of grocery store anchored retail centers we invest in while others may like the high risk/high reward of a special purpose property.
- Property Class: Of the classes described above, investors should determine which is the best fit for their own investment thesis. Class A properties are going to be the most expensive in the most stable, but limited upside, whereas Class C may have more volatility, but a much higher upside.
- Risk Tolerance: Every investor has their own level of comfort with regard to risk. For those that like stable cash flow, they may want to stick with the types of commercial properties that have triple net leases (NNN) and high quality single tenants. Or, at the higher end of the risk spectrum, an investor could opt for a hotel property in an emerging market.
- Time Horizon: Some investments, especially the riskier ones could take years before they really start to deliver a return or may require a long term commitment before they can get their money back. Others are far more liquid.
With these items determined, investors can start to dial in what type of vehicle to use to invest in commercial real estate.
Ways to Invest
Depending on an investor’s preferences, there are a number of ways that an investor can gain exposure to commercial real estate assets:
- Direct Purchase: The easiest and most obvious way is to buy a property directly. The benefit of this is that an investor has full control over the purchase and management process and they are the sole beneficiary of the income and profits produced by the property. The downside is that commercial properties are very expensive and very time consuming to manage. It may be too much for just one person. This approach requires a significant amount of time, capital, and expertise.
- Real Estate Investment Trusts: A Real Estate Investment Trust – REIT for short – is a specialized type of company that owns, operates, or finances commercial space (NOTE: Some REITs may work with residential properties). Many REITs are publicly traded, which means that shares in them can be bought and sold in public markets, and they entitle investors to their proportionate share of the income and profits produced by the underlying property. REITs can specialize in certain property types like self-storage or retail storefronts.
The benefit of this approach is that it does not require nearly as much capital to get started and these shares are fairly liquid. But, the downside is that investors have no say in the properties their capital is used to purchase. - Private Equity Syndications: The third major option is to invest with a private equity firm, through the type of syndication structure described above. The benefit of this approach is that individual investors get fractional ownership of an institutional quality asset and do not have to spend any time managing the property. The downside is that this type of opportunity is only available to Accredited Investors and fees charged by the private equity firm may cut into profits.
Of these three, REITS tend to be a good fit for newer investors, non-accredited investors, or those who prioritize liquidity. Syndications tend to be a good fit for high income earners who want exposure to real estate assets, but not the hassle of managing them. Direct purchases are a good fit for individuals with significant resources and the time and/or expertise
How Much Money is Required to Start?
The short answer is, it depends.
At the lower end of the spectrum, REIT shares can be purchased for less than $100 and can give investors a foothold in the CRE investment space.
In the middle of the spectrum, private equity syndications usually have a minimum investment requirement that is somewhere in the $50,000 – $100,000 range. Clearly this is a lot of money, but it is still less than the amount required to make a direct purchase.
Finally, at the highest end of the range, a direct purchase – especially if it is made by one individual – can require a significant amount of capital. There is really no limit, depending on the size of the property being purchased.
Benefits & Drawbacks of CRE Investing
Like any investment, there are both benefits and drawbacks to investing in commercial buildings. The key benefits include:
- Regular income derived from rental payments. The income may be completely passive in a REIT or Private Equity Investment
- Favorable tax treatment through depreciation and 1031 Exchange opportunities
- Portfolio diversification beyond just stocks and bonds
- Tenants with long term leases and regular rental increases
- Good inflation hedge because rents can go up too
But, these benefits also come with risks that investors should be aware of. They include:
- Private equity and direct purchases can be illiquid, especially in times of market distress
- For direct purchases, the properties can be incredibly time consuming to manage
- Tenants defaulting on their lease terms is an ever present risk that can reduce the amount of cash flow available to distribute
- Fees charged by property managers, asset managers, and brokerage staff can cut into profits
- Finally, commercial properties are particularly vulnerable to interest rate changes, which can reduce property values
Potential investors should consider the risks and benefits as part of their due diligence process to determine if CRE is a good fit for their own strategy.
Is Investing in Commercial Real Estate a Good Idea?
The short answer is, it certainly can be. Investors or business owners who are thinking about allocating capital to a commercial real estate investment should consider their own risk tolerance, time horizon, property preferences, risks, and benefits and make their own decision about whether it is the right fit for their own needs.
Summary of Commercial Real Estate
Commercial real estate is a broad term used to describe properties that are purchased for investment and used for business purposes.
There are eight types of commercial properties including multifamily, retail, office, and special purpose. Each one of these types is further subdivided into “classes” that are indicative of the property’s location, condition and finishes.
There are a number of ways to make a CRE investment including private equity, REITs, or just purchasing a property outright. Each method has its own strengths and weaknesses and before choosing one, investors should consider their risk tolerance, time horizon, and property type to find the best fit.
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.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
