Every investor, regardless of asset class, has a different set of goals. While a young investor with a long-term outlook may be looking to maximize capital growth and appreciation, an older investor’s top priority may be income and/or capital preservation.
For individuals considering a commercial real estate investment, one of the first questions that should be asked of themselves is “why?” The answer will likely drive the ultimate asset choice.
In this article, we’ll explain the pros and cons of commercial real estate investing for beginners.
Pros of Commercial Real Estate Investing
While each individual may have their own unique investment goals, there are a number of reasons why commercial real estate is an option worthy of consideration:
1. Diversification
Commercial real estate price movements tend to have a low level of correlation with those of publicly traded securities like stocks and bonds. As such, commercial real estate can provide diversification in a traditional stock/bond portfolio.
In addition, there are a number of opportunities for diversification within commercial real estate with different property types, locations, and asset classes.
2. Income
By definition, the purpose of a “commercial” real estate asset is to generate income for its owner. In many cases, this is achieved by renting space in the property to produce a relatively stable income stream. As long as the income is greater than the property’s expenses (including loan payments), the owner will receive monthly cash distributions.
3. Taxes
There are two major tax benefits that may drive an investor to consider commercial real estate. The first is the use of an accounting concept known as “depreciation” that allows the property owner to expense a portion of the property’s value each year to account for its physical deterioration. The second is the use of a provision in the US tax code known as the 1031 Exchange, which allows a property owner to defer capital gains taxes on a profitable sale as long they reinvest the proceeds into another property of “like kind.”
4. “Forced” Appreciation
While residential real estate prices are rooted in the concept of “comparable sales,” commercial real estate prices are derived from the amount of Net Operating Income (NOI) that a property produces. Because NOI is defined as a property’s income, less expenses, the owner has the ability to pursue strategies to increase it. This direct operational control allows the property to “force” the value to appreciate through efficient management practices.
5. Ease of Financing
Given the prices for commercial real estate, most investors require the assistance of a loan to purchase a commercial property, and financing for them is widely available under generally favorable terms. This can be especially true for an asset class like multifamily, which offers government backed, non-recourse loan programs.
6. Variety of Investment Options
Depending on an investor’s individual needs, there are a variety of ways to gain exposure to the commercial real estate asset class. Well funded investors with a significant amount of knowledge can purchase properties directly. Others can work with a private equity firm (like ours) or individual deal syndicators. Further, individual investors can purchase shares of Real Estate Investment Trusts (REITs) that are either publicly or non-publicly traded.
So, there are many reasons why a commercial real estate investment may be a good fit for an individual investor. The key is to find the right fit between the why and the investment opportunity.
Cons of Commercial Real Estate Investing
While there are a number of reasons why an investor may be interested in commercial real estate, there are also a few downsides that may give them pause.
1. Market Risk
Like any investment, there are a number of market driven risks that could affect the price of a commercial property and many of them are driven by macroeconomic factors that are out of the control of the property owner. For example, the COVID-19 pandemic led public health authorities to strongly discourage people from gathering indoors and/or in large groups. This guidance had been particularly impactful for the restaurant and hotel industries who rely on these types of gatherings to run their business.
2. Liquidity
Commercial real estate business plans to increase a property’s Net Operating Income are best executed over the long term. In addition, prices for commercial properties mean that the pool of potential buyers can be relatively small. Combined, these factors make a commercial real estate investment relatively illiquid. In some cases, an investor’s capital may be tied up for 5 or more years so it may not be the best fit for an individual with a short term investment horizon.
3. Price
Simply, commercial real estate is expensive and may be out of reach for many individual investors.
For all of the reasons why commercial real estate can be a good investment option, it isn’t without risk. Potential investors should be aware of the potential risks and have a plan for how to mitigate each one of them.
How First National Realty Partners Can Help
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.
We work with each individual investor to understand their “why” and actively seek to match it with the most suitable investment opportunity. For those who are risk averse and prioritize capital preservation, we may recommend a triple-net lease property with a credit tenant, which is as safe as a commercial real estate investment gets. For those with a longer term time horizon and more risk tolerance, we may discuss a variety of value-add opportunities that have a higher risk/return profile.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
