Commercial real estate (CRE) is a broad category with a wide variety of property types, property classes, and investment vehicles. For individuals new to investing in commercial real estate, the number of options can be overwhelming and confusing, but they don’t have to be.
By following a few steps, an investor can quickly filter through the available commercial real estate options and narrow the list of choices to just a few that are suitable for their individual preferences, return requirements, risk tolerance, and time horizon.
In this article, we give a quick overview of how to invest in commercial real estate.
Step 1: Establish Return Requirements
When thinking about return requirements, it is first important to establish that there is a distinct relationship between the level of risk an investor is willing to take on and the potential return that they can earn. So, if one investor prioritizes stability and income, they must be willing to accept a lower return because the investments that have this risk profile do not have a high upside. Conversely, if an investor demands a higher return, they must be willing to accept a higher level of risk to achieve it.
So, the first question that investors should ask themselves concerning commercial real estate investing is, “what type of return am I looking to earn?” If the answer to this question is on the lower end of the spectrum, say 4% – 8%, this will mandate a relatively safe commercial real estate investment.
For example, recently constructed multifamily properties, office buildings with long term leases, or retail properties with high quality tenants that produce positive cash flow. If the answer to this question is a higher number, say 10% – 20%, then more risk is required. For example, value-add multifamily, office space, or any other type of commercial property where there is a renovation or reposition component can raise the risk profile of the deal and require a higher return.
The choice of return requirements will be a major driver in the second step, which is choosing what type of property to invest in.
Step 2: Choose a Property Type
Broadly, there are four types of commercial properties that a commercial real estate investor could invest in and they each come with their own set of risks and benefits.
Office space is designed for the unique needs of running a business. The building may be a glass and steel high-rise located in the “central business district” of a big city like New York or a low or mid-rise property located in a suburban office park. In addition, the space could be general, meant to cater to companies like accounting and law firms. Or, it could be designed to meet the unique needs of a specialized type of tenant like a doctor’s office.
Office investors benefit from long term leases and generally low tenant turnover because it is difficult and/or expensive to move a business. But, those same leases may come with infrequent rental increases and expensive tenant improvements to entice a company to move.
An industrial property is characterized by properties with an “industrial” purpose and may include standalone warehouses, logistics facilities, or “flex” spaces.
Industrial investors benefit from predictable cash flow, lower operational risks, low CapEx requirements, and generally favorable supply/demand characteristics. But, industrial spaces can be especially vulnerable to economic disruptions and may have high upfront costs due to their large physical footprints.
Retail properties are designed for tenants who operate direct to consumer 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 tenant leases. But, the financial strength of tenants can be impacted by changing market tastes and the interior of a retail property is often built for a specific purpose making the property difficult and/or expensive to re-lease without major renovations.
A commercial multifamily property is an apartment building with five or more units.
Multifamily rental property investors benefit from relative stability in times of economic distress, but they may face challenges with high tenant turnover, short term leases, and increased collection expenses.
So, the first way to categorize a commercial property is by identifying the “type” and the risks and benefits that come with it. The next step in how to invest in commercial real estate is to identify the “class.”
Step 3: Choose a Property Class
There are also four commonly recognized commercial property “classes,” but only three of them are considered investment grade. Details on each are below:
Class A buildings are the newest and highest quality. They tend to be less than ten years old and are typically located in or near the Central Business Districts and/or most desirable locations of major cities (like New York City). Their locations are highly visible and have high traffic counts for both vehicles and pedestrians.
Class A properties tend to be in new, or like new, condition and don’t require any major renovations. As a result, they command the highest rents and are typically only affordable to the most profitable companies or highest income earners. On a per unit or per square foot basis, they also command the highest sales prices with cap rates typically in the 4% to 5% range.
Class A properties are considered to be the least risky investment class due to their physical condition and stable cash flow supported by their high earning tenant base. But, they also have limited upside and tend to appeal to “cash flow” investors who prioritize stable income over price appreciation.
Class B buildings are well maintained, but may be slightly dated and in need of light renovations. They are usually between 10 and 20 years old and typically located in good, but not great markets.
Class B properties tend to be in good condition with fully functioning mechanical and HVAC systems, but may need light repairs or modernization. Class B rents are lower than Class A and are typically within reach of small to medium businesses and median income earners.
On a per unit or per square foot basis, sales prices are lower than Class A properties and returns consist of a mix of price appreciation and income.
Class C buildings are older vintage, dated, and in need of moderate to significant repairs. They are between 20 and 30 years old and are typically located in less desirable areas that are far from major highways, shopping districts, employment centers, and public transportation.
On a per square foot or per unit basis, Class C properties are less expensive than Class B, but they carry an elevated level of risk due to the capital investment required and vulnerable nature of tenant income sources. However, they often present an attractive opportunity for investors with an elevated risk tolerance and the operational expertise to execute a modernization program.
Step 4: Choose an Investment Vehicle
For individuals interested in commercial real estate investing and the portfolio diversification that it brings, there are two ways to deploy capital, directly or indirectly.
In a direct investment scenario, an individual or group of individuals forms an LLC or other entity to purchase a property directly. Using this as an investment vehicle allows the investor(s) to retain control over the property identification, selection, due diligence, financing, and closing processes. While some individuals prefer to retain this level of control, it also means they have to act as their own property management company once the purchase is complete. Doing so requires a significant commitment of time and a high degree of operational expertise to do it effectively. For individual investors looking for a truly passive commercial real estate investment opportunity, a direct investment is likely not the preferred option. They may prefer to go the indirect route.
In an indirect investment, an individual places their capital with a professional asset management firm (like ours) and outsources the property identification, selection, due diligence, financing, closing, and management processes to them. In doing so, they get all of the benefits of commercial real estate ownership (e.g. income and appreciation) without the hassle of managing the asset because someone else is doing the work. For individuals with capital to invest, but not the time and expertise needed to manage the property, an indirect investment is likely to be a better fit because it can produce truly passive income.
For those that pursue the indirect path, there are a number of different passive real estate investing options.
Passive Commercial Real Estate Investment Options
Passive commercial real estate investment options can be grouped into two categories, Real Estate Investment Trusts (“REITs”) and Private Equity transactions (NOTE: An investment made on a crowdfunding platform is another example of an indirect investment, but not considered relevant for the purposes of this article). Additional information on both is below.
Real Estate Investment Trust
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Because REITs are formed as corporate entities, investors are able to purchase shares in them, providing access to the rental income and profits produced by the underlying real estate properties. In addition, as long as the REIT meets certain requirements, there are some tax benefits to this structure. REITs can be publicly traded, which allows investors to buy and sell shares like stocks or mutual funds, providing a high degree of liquidity. Or, they can be private, which provides less liquidity and a longer term commitment.
Generally, passive commercial real estate investors who prefer the REIT structure can choose from one of four types:
- Equity REITs: Equity REITs are publicly traded companies (their shares can be bought and sold in the stock market) that own or operate income-producing real estate for the purpose of distributing dividend income to their shareholders. The majority of REITs fall into this category and are considered attractive because of their liquidity and high dividend yields. REITs can specialize in specific property types like apartment complexes. Some even specialize in residential properties like single-family homes.
- Mortgage REITs (mREITs): Mortgage REITs (mREITs) provide financing for income-producing real estate by originating mortgages or purchasing mortgage-backed securities. They earn income from interest on the loans and/or dividends from security investments.
- Public Non-Listed REITs: Public, non-listed REITs (PNLRs) are registered with the SEC but do not trade on national stock exchanges. However, they follow the same philosophy of investing in income-producing properties for the purpose of distributing dividends to their shareholders.
- Private REITs: Private REITs are exempt from SEC registration requirements and their shares do not trade on national stock exchanges. To invest in a private REIT, an investor must meet income and/or net worth hurdles or demonstrate that they are sophisticated enough to understand the risks of investing in non-publicly traded securities.
Given the number of REIT categories, there are enough options to meet the needs for nearly all investors. However, one of the major drawbacks to investing in a REIT is that an individual has little to no say how or where their capital is deployed. They just contribute funds to a “pool” and it is up to the asset manager to choose the properties and/or loans for investment. For those individuals who want to know exactly what property they are investing in, a private equity commercial real estate investment may be a better fit with their investment objectives.
Private Equity Real Estate firms and REITs have a similar mandate, to pool investor money and deploy it in real estate assets. However, the securities offered by Private Equity Real Estate firms are not publicly traded and they are only available to accredited investors.
Because they aren’t bound by the same regulations as publicly-traded REITs, private equity real estate companies have wide latitude to invest in a variety of real estate asset classes, which may or may not include income-producing properties. In addition, the legal structure may differ significantly from a REIT and they are not required to pay out a high percentage of their income in dividends. Instead, the majority of private equity returns are derived from profitable investment exits in the form of capital gains and carried interest.
A private equity investment comes with a series of impressive benefits:
- Acquisition and Operational Expertise: The identification, selection, acquisition, and operation of a commercial real estate asset requires deep expertise and significant experience, which a private equity real estate firm specializes in. This type of expertise allows the manager to keep a close eye on key operational metrics like: leasing activity, Net Operating Income, vacancy rates, operating expenses, and real estate taxes.
- Tax Efficiency: Private Equity Real Estate investments are structured in a tax-efficient manner allowing investors to reduce taxable income through depreciation.
- Flexibility: Because they aren’t as heavily regulated, private equity firms can be flexible in their investment strategy, giving them the freedom to pursue profitable deals where available.
- Incentive Alignment: Because private equity firms themselves are also invested in their deals, their incentives align with those of the investor in that they both want a profitable outcome. As a result, income and profit splits are often structured in a way that requires the firm to meet certain return “hurdles” before their profit participation kicks in, incentivizing them to manage the asset profitably.
- Exit Plan: Private Equity Real Estate firms enter an investment with the exit in mind giving investors a roadmap to a successful outcome.
- Clear Fees and Compensation: The fee and profit participation structure is clear from the outset and closely correlated to performance, which means that all parties are working together towards a profitable outcome.
Like REITs, there are different types of private equity real estate passive investments that an investor can choose from. There are two main categories to be aware of:
- Fund vs. Deal: Some private equity firms offer “blind fund” investment opportunities that are similar to a REIT in the sense that an investor contributes capital to the private equity firm and the firm decides where, when, and how the capital will be deployed. Or, and this is the case with our firm, an individual could invest in a specific real estate deal. In such cases, they would be able to know exactly which property is going to be purchased, where it is, who the tenants are, what the income statement looks like, and what the business plan is post-purchase. We believe this is the superior option for most individual investors.
- Specialization: Commercial real estate is a broad category so asset managers tend to specialize in certain segments of it. For example, some firms specialize in industrial space, some in office space, some in multifamily, or, as is the case with us, retail assets. There are enough options that an individual can choose one that aligns with their investment objectives, risk tolerance, and time horizon.
A commercial real estate asset requires active involvement in the day to day operations of the property. However, from an investor standpoint, the answer to the question of whether the income produced is truly passive is determined by who actually does the work of managing the property. Individuals who place their capital with an asset management firm, are rewarded with all of the benefits of property ownership without the hassle of actually managing it.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, 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 Investor and would like to learn more about our triple-net leased investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.