- Commercial real estate is any property that is purchased with the intent to lease space for a profit. Broadly, there are four categories of commercial properties: office, retail, industrial, and multifamily.
- Successful commercial real estate investments can offer many benefits including: passive income, steady cash flow, and the ability to “force” properties to appreciate.
- Potential risks include: vacancy risk, credit risk, and market risk.
- For investors interested in making a commercial real estate investment, there are two ways to do it: actively or passively.
- In an active investment, the investor is very involved in every aspect of the deal and they may prefer this level of control. In a passive investment, the work is delegated to a professional real estate firm.
- For many first time investors, the passive route can be an attractive option. The most common investment vehicles are either a REIT or partnership with a private equity firm.
The world of “commercial real estate investment” is vast. It consists of various property types, asset classes, and investment opportunities. For newcomers, trying to navigate these complexities can be a daunting task. We are here to help.
In this article, we are going to define what commercial real estate is, review the pros and cons of investing in it, and highlight two common investment strategies that can be used to gain exposure to this asset class. By the end, readers should have all of the information they need to take their first steps towards making a commercial real estate investment.
At First National Realty Partners, we are a private equity commercial real estate investment firm who specializes in the acquisition and management of commercial retail centers. To learn more about our current investment opportunities, click here.
What is Commercial Real Estate?
Any discussion about how to get started in commercial real estate investing should start with a definition of exactly what commercial real estate is.
Commercial real estate is any property that is purchased with the intent to lease space for a profit. In most cases, the space is leased to other businesses, but commercial multifamily units are leased to individuals. Broadly, commercial properties fall into four categories:
- Retail: Commercial retail space is characterized by tenants who sell their goods and services directly to consumers through a retail storefront. Classic examples of commercial retail space include grocery stores, home improvement stores, electronics stores, and clothing stores. Often, retail space is grouped together in properties like strip malls and shopping centers to make shopping convenient.
- Industrial: Commercial industrial properties are those that have an “industrial” purpose. Often, these include warehouses and logistics facilities as well as manufacturing plants. Common industrial tenants include companies like UPS, FedEx, and Amazon.
- Office: Office space is leased to companies who may use it for general office purposes like accounting and consulting firms. Or, an office building could be used for a specialized purpose like a medical office.
- Multifamily: Commercial apartment buildings are those that contain 5 or more units. Of the commercial property types, apartment complexes are the only ones that are leased to individuals, not businesses.
NOTE: Mixed use commercial real estate could contain two or more of the above property types.
Each property type has its own complexities and operational quirks. For this reason, commercial real estate investors tend to specialize in one or two of them and develop deep expertise that they can leverage for profitable investments.
Each commercial property type can be further subdivided into a “class” that is indicative of its quality, location, finishes, age, and risk. Class A properties are the newest and nicest and tend to be the least risky. Class D properties are the oldest and in the worst shape so they tend to carry the most risk. Class B and C properties are somewhere in between.
Benefits of Commercial Real Estate Investment
Now that commercial real estate has been defined, potential investors should note that there are material benefits to investing in commercial real estate – especially when compared to residential real estate investment. They include:
- Greater Passive Income & Returns: When comparing commercial investment properties to residential real estate, the primary benefit is scale. Instead of buying a one rental house, a commercial investor can buy multiple units within the same property. This affords greater scale, which can result in higher passive income and returns.
- Increased Cash Flow: From a pure dollars perspective, the amount of cash flow involved in a commercial property can be more than that involved in a residential property.
- Less Competition: Although competitive, the pool of buyers for commercial real estate properties is much smaller than those for residential assets. As a result, there is less competition when it comes to acquiring an asset at an attractive price.
- Lease Length: Commercial leases tend to be longer than traditional residential leases. For example, a standard residential lease is 1 year whereas a standard commercial lease can be in the 3-5 year range. In some cases, strategic locations mean that tenants are willing to sign leases of 25 years or longer.
- Building Relationships With Businesses: Leasing space to businesses means developing long term relationships with those same businesses. This can provide an opportunity to become a trusted partner for a large company who needs to lease space in multiple locations.
- “Forced” Appreciation: Perhaps the biggest benefit of commercial real estate investment (when compared to residential) is that commercial property owners have the ability to “force” a property’s valuation to rise. This is because commercial properties are valued based on the amount of net operating income (NOI) that they produce, which is calculated as gross income less operating expenses. By pursuing projects that increase income, decrease expenses, or both, investors can make a property more valuable through efficient management practices. At a 7% cap rate, every $1 added to NOI will increase the property’s value by $14.
Although these benefits can be significant, potential investors should weigh them against the downsides of a commercial real estate investment.
Risks of Commercial Real Estate Investment
No investment is without risk, but the best investors are able to pinpoint where the risks lie in a particular investment and actively work to minimize them. Potential commercial real estate investment risks include:
- Market Risk: Commercial real estate markets are not static. They are constantly changing in response to macroeconomic conditions. For example, falling lease rates or rising cap rates pose a risk to rental property owners because it could adversely impact the value of the property.
- Vacancy Risk: When a tenant decides not to renew their lease, for whatever reason, the resulting vacancy poses a risk to the property owner in two ways. First, the lost income can result in lower cash available for distribution. Second, there is no guarantee that the space can be re-leased at a rate that is the same as or higher than the rate the vacating tenant paid. This risk is particularly prevalent for single-tenant properties in which a departing tenant means that the property goes from 100% occupied to 0% occupied overnight.
- Credit Risk: Businesses occasionally get to a point where they can’t or won’t make their monthly rent payment. The risk of this happening is known as “credit risk” and it can cause headaches for the property owner. For this reason, it is a best practice to perform a significant amount of due diligence on the tenant’s financial condition and business model prior to signing a lease with them.
- Liability Risk: Commercial properties are where people go to work, shop, and live, which exposes owners to potential liability. For example, suppose that a car accident in the parking lot of a multifamily property resulted in injuries. There is potential liability in a situation like this that could result in financial loss for the property owner. However, this risk can be partially mitigated by adequate liability insurance coverage.
If, after weighing the benefits against the risks, an investor decides that they want to make their first commercial real estate investment, there are two ways that they could do it.
Active vs. Passive Commercial Real Estate Investment
Commercial real estate investors come with all levels of resources, experience, knowledge, and objectives. As a result, there are a wide variety of investment opportunities meant to accommodate an equally wide variety of investor needs. Broadly, these opportunities can be grouped into two buckets, active and passive.
What is Active Investment?
In an active investment, one or more real estate investors come together to purchase a property directly, for their own account. The primary benefit of this approach is control because the investor controls the property identification, selection, financing, due diligence, and property management processes. While this can certainly yield favorable results, it can also be incredibly time consuming and it requires experience and expertise in the three phases of a transaction.
Finding and Assessing CRE Properties
In order to purchase real estate, active investors must first find one. In some cases, this can be the most time consuming part of the entire investment process. Properties can be found by doing internet searches on sites like Loopnet.com or CRExi.com. Or, they can be found through established broker relationships.
What makes this phase so time consuming for active real estate investors is that finding a property can involve going through dozens or even hundreds of deals to find just one that is acceptable. For each property, investors must do things like: analyze financial statements, make financial projections, review existing lease terms, and negotiate an acceptable purchase price. Imagine how much work this is for just one property and then multiply it by dozens, knowing that much of that work will be for naught.
How To Finance Commercial Real Estate Investments
Once an acceptable property is found, the next step is to arrange the financing. As a general rule of thumb, the more dollars that are involved in the transaction, the more complicated and time consuming the financing process will be.
Arranging financing includes activities like presenting the deal to potential lenders, negotiating the required down payment and interest rates, gathering the documents requested by the lender, and responding to lender questions and concerns. Borrowers may have to go through this process with 3 or four different lenders before their deal is approved. Again, it can be incredibly time consuming.
How To Develop Steady Cash Flows
Once a property has been purchased, the real work of property management begins and it is not a one time event. It is a set of activities that need to take place every day. These tasks include things like: collecting rent, chasing late payments, routine repairs and maintenance, responding to tenant issues, and managing leasing activity and vacancy rates. Some active investors prefer to outsource this activity to a third party property manager and others like to do it themselves. In either case, the intent of managing a property is to stabilize it to the point that it produces a steady stream of cash flow for its owners/investors.
Final Thoughts on Active Investment
The point about active real estate investment is this. For many investors, maintaining control over the entire investment process is attractive. But, they must be realistic about the amount of work, experience, and expertise that it requires. Not everyone has it. For this reason, a passive investment may be a more suitable alternative for many.
What is Passive Investment?
From an individual investor standpoint, a passive investment is exactly what it sounds like. All of the above described work to find, finance, purchase, and manage commercial properties must still be done. It is just done by someone else. In short, a passive investment provides all of the benefits of real estate ownership without the hassle of actually managing it. The day to day work of finding and managing real estate deals is done by professional firms who have the experience and expertise needed to do it well.
If the passive route sounds more appealing, there are two common paths that individual investors can take to gain exposure to commercial real estate assets.
Real Estate Investment Trusts (REITs)
A real estate investment trust is a specialized type of real estate company that buys, sells, manages, and/or finances commercial real estate. The primary advantage to investing in a REIT is the tax benefits associated with doing so. As long as they comply with a specific set of IRA rules, REIT investments are not taxed at the entity level. Instead, property cash flow is distributed to investors who are taxed at the individual level.
REITs tend to specialize in specific property types and they can be publicly or privately traded. For example, one of the largest publicly traded REITs is American Tower, Inc who specializes in the acquisition and management of communications infrastructure equipment like cell phone towers.
Publicly traded REITs can be bought or sold by any investor with a brokerage account and the minimum investment requirement is whatever it costs to purchase at least one share. Investors like REITs for their low minimums, liquidity, passive income streams, and good returns.
Privately traded REITs offer the same tax advantaged structure, but they can only be purchased by “accredited investors,” who meet minimum income and net worth requirements. Investors like privately traded REITs for their specialization, expertise, and their ability to leverage relationships to find the best deals.
If, for whatever reason, real estate investors are not interested in the REIT structure, the other passive alternative is to work with a Private Equity firm.
Private Equity Commercial Real Estate Investments
Private equity firms and REITs have a similar mandate – to deploy investor capital into commercial real estate assets, but they are structurally very different. For example, private equity firms do not have the same tax advantaged structure as REITs and they are not required to distribute a high percentage of their income and profits.
Private equity investments come in two flavors, funds and deals. In a fund structure, investors contribute capital for the general purpose of real estate investment and the private equity firm decides how it will be deployed. In a deal structure, capital is raised to purchase a specific property. This way investors know exactly what their money will be used for and they can complete their own due diligence on the asset before making a capital commitment.
Whether passive investors choose the REIT path or the private equity path, both require placing trust in the real estate investment firm to deploy investor funds responsibly. To that end, passive investors should perform their own due diligence on the investment firm they are planning to partner with.
Trusting Experienced CRE Professionals
For commercial real estate investing beginners, the major benefit of working with a REIT or private equity firm is the ability to leverage their knowledge, experience, expertise, and connections in pursuit of a high rate of return. To accomplish this, there must be a tremendous amount of trust between the firm and the investor.
To ensure they are trustworthy, investors should perform their own due diligence on the investment firm by reviewing the following aspects of their history and performance:
- History & Experience: How long has the firm been in business? Do they have relevant experience in the desired property types?
- Reputation: Does the firm have a good reputation in the marketplace? Have there been any complaints filed against them with regulatory authorities?
- Track Record: Can the firm demonstrate a track record of delivering steady returns to their investors?
- Outliers: It can be helpful to ask the firm about their best and worst deals and what they learned from each. But, this information should be taken with a grain of salt because they tend to be outliers. The true measure of success is consistency, which is demonstrated by years of stable returns.
- Communication: The best investment firms have open and transparent lines of communication to their investors. Communication should be frequent and consistent and should always leave investors with a clear picture of their investment’s performance.
When there is a strong relationship between a firm and its investors, it can be mutually beneficial for both parties.
If the above information has made a convincing case that commercial real estate investment can be a satisfying and lucrative endeavor, beginners can take five concrete steps towards making their first investment.
- Choose a Strategy: First, investors must choose whether they want to pursue a passive or active investment path. For most investors who are getting started, the passive path may make the most sense. But, for those who have a bit more experience and/or expertise, the active path may be a viable option.
- Choose an Investment Amount: Commercial real estate should be part of a broadly diversified investment portfolio. So, investors should review the size of their portfolio and determine how much of it they would like to allocate to CRE assets.
- Choose An Investment Vehicle: For active investors, the most logical investment vehicle is a direct purchase. For passive investors, the most common choice is between a REIT or private equity firm.
- Perform Due Diligence: No matter the vehicle chosen, investors should perform a significant amount of due diligence on potential opportunities to ensure they are a good fit for their own objectives. In an active approach, this means researching properties and markets directly. With a passive strategy, this means researching investment firms and their respective individual opportunities.
- Commit & Wait: Once a suitable opportunity has been found, the last thing to do is to commit capital to it and then wait for the returns. In general, CRE returns are made over the long run so it can take months or years for investors to get their capital back. As such, investors are best served to be patient and to actively do what they can to maximize the value of their investment.
First time investors are encouraged to be diligent, patient, and disciplined. Finding the right deal and reaping its returns can take time.
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 email@example.com for more information.
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