Every commercial property investor is unique, and undoubtedly their individual approach to real estate is too. Each investor has his or her own return requirements, diversification preferences, risk tolerance, time horizon, and individual beliefs about which strategies might offer the chance for the highest return. For this reason, there are a wide variety of commercial real estate (CRE) investment options from which to choose. But for first-time investors seeking to understand their myriad options, the process can be confusing and, at times, overwhelming. We’ve found that the best way to narrow these options is by using a multi-step process.
Step 1: Understand Your Own Investment Objectives
Understanding that every investor is unique, we believe that the most logical first step is for an investor to take inventory of their own investment goals and objectives. Generally, this means taking stock of the following:
- Return Objectives: Broadly speaking, return objectives for commercial real estate investors tend to fall into two categories: Growth or Income. Those investors seeking growth will necessarily need to take on more risk to achieve it, while those seeking income and stability may opt for investments with less risk.
- Risk Tolerance: The risk of investing in commercial real estate exists on a spectrum. On the low end are properties with stable cash flow, long-term leases and high-quality tenants, while on the high end are ground-up developments or distressed purchases. The relationship between risk and return is highly correlated, and investors should determine for themselves where their personal risk tolerance lies along this spectrum.
- Time Horizon: Commercial real estate investments come in short-, medium-, and long-term time horizons. Generally, short-term is considered to be around one year or less, medium-term is between one and five years, and long-term is five years or more. Individual investors should determine how long they are comfortable with their money being committed to the investment.
- Strategy: There are a number of popular commercial real estate investment strategies. For example, a turnkey or yield strategy seeks to purchase existing high-quality real estate properties with stable cash flow and long-term leases; such properties are a good fit for investors seeking income. Alternatively,we prefer a value-add strategy wherein we seek to purchase properties at a discount to their intrinsic value, and use our operational expertise to make renovations and implement management efficiencies in an effort to “add value” to the property. This approach is a fit for investors with more of a growth objective.
- Active vs. Passive: Commercial properties require near constant attention and management. Accordingly, the last question that investors should ask themselves is how much time and/or expertise they have to contribute to the day-to-day operations of the asset. An active investor may wish to exert direct operational control over the property for a variety of reasons, while an investor seeking passive income may have neither the time nor expertise to do so.
Once an investor has identified his or her own personal objectives, the next step is to decide whether to pursue a public or private investment.
Step 2: Public or Private?
There are both public and private options when it comes to commercial real estate investment opportunities.
A public option means investing in the publicly traded securities of a company that owns and operates commercial real estate. The most common example of this is a publicly traded real estate investment trust (REIT) or ETF, for which the securities trade on major stock exchanges. The primary benefit of publicly traded securities is that they are highly liquid and can be bought or sold quickly and easily on the exchanges. These investments are a great fit for investors with a short-term time horizon. On the other hand, there is no public market for privately traded securities. They are only available to investors who meet certain income and net worth requirements (generally “accredited investors”), and they may require a time commitment of five years or even longer. This option tends to be a better fit for investors with a long-term time horizon.
NOTE: An investment made on a crowdfunding platform is considered to be a type of private investment, but is not considered relevant for the purposes of this article.
Step 3: Choose a Property Type/Asset Class
Broadly, there are four common types of commercial real estate investment rental properties, each of which comes with its own risks, benefits, and operational quirks. As a result, investors generally tend to specialize in one or two of the property types below:
- Office: Office space is designed for the unique needs of running a business. The office building could be general in nature, meant to cater to the business needs of companies like accounting and law firms. Or, it could be designed to meet the unique needs of a more specialized tenant, such as a doctor’s office or medical imaging center. Office investors benefit from long-term leases and relatively low tenant turnover because of the difficulty and expense of moving a physical business. But, those same leases may necessitate infrequent rental increases and expensive tenant improvements to entice a company to move there in the first place.
- Industrial: An industrial property is characterized by having an “industrial” purpose, and may include standalone warehouses, logistics facilities, or “flex” spaces. Examples of industrial tenants include shipping companies, such as UPS or Amazon, as well as light manufacturers. Industrial investors benefit from predictable cash flow, lower operational risks, low CapEx requirements, and generally favorable supply and demand characteristics. However, industrial spaces can be especially vulnerable to economic disruptions and may have high upfront costs due to their large physical footprints.
- Retail: Retail properties are designed for tenants who operate direct-to-consumer (DTC) businesses like clothing or electronics stores. Classic examples of retail properties include strip malls, shopping centers, and standalone bank branches. Retail investors benefit from high visibility and long-term leasing activity. But the financial strength of tenants can be greatly impacted by changing market tastes, and the interior of a retail property is often built for a specific purpose, which can make these properties difficult as well as costly to re-lease without major renovations.
- Multifamily: A commercial multifamily property is an apartment building defined as having five or more units. Multifamily apartment complex investors benefit from relative stability in times of economic distress, but they may face challenges with high tenant turnover, short-term leases, and relatively high collection expenses depending on the market.
NOTE: Some commercial real estate investment managers offer opportunities to invest in residential property, but these are not considered relevant for this article.
Step 4: Direct or Indirect Purchase
With a direct purchase, the investor forms an LLC and purchases a property directly. This is an active strategy that requires the owner to be involved in every aspect of the operation, from selecting a management company, and monitoring maintenance costs and vacancy rates, to analyzing the purchase price, and ensuring that the property taxes are paid each year. This strategy requires a significant amount of time and expertise to execute efficiently, and as a result, it is not a great fit for every investor.
In an indirect purchase, the investor commits his or her capital to a third party who manages the logistics of the transaction on the investor’s behalf. This third-party chooses the real estate market, evaluates the financing options, and makes sure they are purchasing at a favorable cap rate on behalf of the investor. This is a better option for investors seeking more of a passive role.
Step 5: Put it All Together
For an individual investor, the output from the first three steps provides valuable clues as to which investment options to choose—and there are a few popular combinations to consider:
- For accredited investors who prioritize income over growth, who have a low risk tolerance, with a long-term time horizon, and no time to manage a property on a day-to-day basis, the best option will likely be a private equity investment in a relatively low-risk asset class like multifamily.
- For non-accredited investors who have a short-term time horizon and high risk tolerance, an investment in an Office or Industrial REIT may be the best fit.
- For non-accredited investors who have a long-term time horizon and a high risk tolerance, the best option may be an active investment or purchase of a property directly.
The number of investment option combinations can be significant, and these are only a few of the more relevant approaches. The key is for individual investors to understand what their own objectives are, and to choose an investment type that best fits those priorities and desired outcomes. Prior to committing capital to any investment, a significant amount of due diligence should be performed to ensure that the property and the manager (if applicable) are consistent with the desired objectives of the overall 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 info@fnrpusa.com for more information.
