- Individuals looking to invest their own funds have a variety of options to choose from. They could invest in stocks, bonds, collectibles, currency, or precious metals. We believe that the best option for most is a broadly diversified portfolio of risk assets, that includes commercial real estate.
- Commercial real estate is a class of real estate assets that are purchased with the intent to profit from income, capital gains, or both. There are four property types that are popular with investors: Office, Industrial, Retail, and Multifamily.
- Commercial real estate investors can potentially benefit from: portfolio diversification, income, capital gains, tax benefits, inflation protection, and availability of debt. However, there are also risks that include: high costs, market changes, and credit risk.
- For those that choose to pursue a commercial real estate investment, the options can be grouped into three buckets: Direct purchase, Real Estate Investment Trust, and Private Equity.
If an investor is looking to deploy capital into an investment, there are many options. They could chase the liquidity of the stock market. They might seek relative safety in the treasury bond market. They could purchase any number of collectibles, currency, or precious metals.
Naturally, they can also consider investing in real estate.
As a best practice, we believe that investors should create a broadly diversified portfolio of multiple risk assets, but the question remains if real estate should be part of your investment strategy. So, given your existing portfolio and risk tolerance, is residential or commercial real estate a good investment?
This article goes into more detail about the pros and cons of investing in commercial real estate and why investors choose to partner with private equity commercial real estate firms like FNRP. If you are an accredited investor and you would like to learn more about the commercial real estate investment opportunities our firm is currently offering, click here.
What is Commercial Real Estate?
The term “commercial real estate” describes a broad class of real estate assets that are acquired with the intent to earn a profit through rental income, price appreciation or both. There are four types of commercial real estate properties that are popular with real estate investors, each of which has its own unique risk profile and operational quirks:
- Office: Office space is designed for the unique needs of running a business. An office building could be general, meant to cater to the business needs of companies like accounting and law firms. Or, it could be specific, designed to meet the unique needs of a specialized tenant, such as a doctor’s office or medical imaging center. Office investors benefit from long term leases and generally low tenant turnover because it can be difficult and expensive to move a business. However, those same leases may come with infrequent rental increases and expensive tenant improvements.
- Industrial: 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 and demand characteristics. But industrial spaces can be especially vulnerable to economic disruptions, and they may have high upfront costs due to their large physical footprints.
- Retail: 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 leasing activity. 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, which can make these properties difficult and often expensive to re-lease without major renovations.
- Multifamily: A commercial multifamily property is an apartment building with 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 increased collection expenses.
As an asset class, commercial real estate (CRE) has a strong track record of delivering favorable returns over time, which, coupled with other benefits, makes it an attractive investment option.
The Pros of Investing in Commercial Real Estate
For those who choose to make a commercial real estate investment, they could potentially realize several significant benefits:
- Diversification: Commercial real estate price movements tend to have a low level of correlation with traditional asset classes like stocks and bonds. Because of this, ownership can lend an investment portfolio another level of diversification, which is helpful in an economic downturn.
- “Forced” Appreciation: Unlike residential properties, which are valued on sales comparables, commercial properties are valued on the amount of Net Operating Income (NOI) they produce. Because Net Operating Income is calculated as a property’s income, less operating expenses, the property owner can have a direct impact on this equation and the overall value of the property. By pursuing strategies that seek to increase revenue (rent), reduce expenses, or both, an owner can increase Net Operating Income, thereby “forcing” the value of the property to rise.
- Dispersion of Vacancy Risk: Most commercial properties have more than one tenant, which means that a decision by any one of them not to renew a lease will be less impactful than it would in a residential property. For example, in a 300-unit multifamily property, the decision of one tenant not to renew a lease is a relative non-issue. Commercial properties allow investors to distribute their vacancy risk over multiple units, making them less reliant on any one unit for income.
- Income: Because tenants pay monthly rent to the property owner, one of the major benefits of commercial real estate ownership is the stream of income produced by these ongoing payments. And if the property is purchased at an attractive price, income alone can provide a solid return.
- Lease Escalations: Commercial leases commonly include “escalation” clauses that mandate rent increases at set intervals over the term of the lease. Assuming that expenses stay relatively constant, contractually mandated lease escalations mean that the income produced by the property will continue to increase over time.
- Tax Advantages: Because the physical condition of real estate degrades over time, the owner is allowed to “expense” a portion of its value each year to account for it. This expense is known as “depreciation” and it can be used to reduce the property’s tax liability. Further, capital gains taxes realized upon sale can be deferred indefinitely through the “1031 Exchange” program as long as sale proceeds are reinvested into another real estate property of “like kind.”
- Inflation Protection: Because commercial real is a physical, “tangible” asset, it tends to be a good hedge against inflation. This is because real estate developers target a certain return on cost before committing their funds. If the numerator in this calculation (Net Operating Income) does not rise fast enough to offset an increase in costs (driven by inflation), developers will postpone the start of new projects, which limits the supply of available inventory. And in a supply-constrained market, rental prices tend to rise, driving property valuations higher. These value increases tend to keep pace with inflation, which is why commercial real estate can be a good hedge.
- Availability of Debt: Finally, the income producing nature of commercial properties make them a comfortable risk for commercial real estate lenders. Regardless of property type, debt is widely available at generally favorable terms for commercial real estate investors.
While the benefits of commercial real estate investing can be significant, they are not without risk.
The Cons of Investing in Commercial Real Estate
Like any investment, investing in commercial real estate carries a number of risks and challenges that potential commercial real estate investors should consider before committing capital to a deal. A few of these risks are:
- Cost: Generally, commercial properties are more expensive than residential ones, meaning that they require a larger upfront investment. This may place them out of reach for some investors, but this is mitigated by the fact that there are a number of options that allow investors to pool their money to purchase a commercial asset.
- Management Intensity: Due to their size and complexity, commercial properties require more management oversight than residential ones. In a large commercial property, there may be dozens of tenants, meaning traditional management issues like rent collection and maintenance can require full-time support and oversight.
- Credit Risk: Each commercial property carries credit risk, which is the risk that a tenant can’t—or won’t—pay their contractually obligated rent. To mitigate this, it’s critical to perform a significant amount of due diligence on the financial condition of each existing and potential tenant.
- Market Risk: Real estate markets are dynamic and ever-changing in response to broader macroeconomic conditions. During a tenant’s lease period, commercial properties are somewhat protected from these changes. But when an individual lease comes up for renewal, market risk means that there is a possibility that the tenant may decide not to renew the lease, or that the prevailing market lease rate at that time is lower than what the tenant was paying during the original lease term. For these reasons, it is important to understand the specifics of each market prior to making an investment.
- Public Safety: By definition, commercial properties are leased to businesses, which means that there are likely to be a number of people coming and going daily. This raises the risk that someone may have a car accident in the parking lot, for example, or they may slip and fall on an icy sidewalk. Generally speaking, there could be a number of other public safety issues that could expose the property owner to liability. To manage this risk, it is always a best practice to obtain the proper insurance coverages.
There is no such thing as a risk-free investment, but experience, expertise, and active mitigation strategies can reduce overall risk exposure.
Commercial Real Estate Investment Options
For those who are convinced that a commercial real estate investment is a good fit for their risk tolerance, time horizon, and return objectives, the options can be grouped into three categories:
In a direct purchase, an individual or group of individuals form a Limited Liability Company (LLC) and use it to purchase a commercial investment property directly. With this option, the individuals involved in the transaction are responsible for finding the property, leasing it, working with lenders to line up financing, sourcing the down payment, and all subsequent property management activities from there. While this can be an attractive prospect for many, direct purchases require a significant amount of time, expertise, and capital to be effective. Individual investors rarely possess all three criteria, and may be better suited to another option.
Real Estate Investment Trust (REIT)
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 assets. In some cases, 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, higher management fees, and a longer term commitment.
REITs tend to be a good option for investors who don’t have the time, expertise, or capital to make a direct purchase. This option provides the passive income of real estate ownership without the time commitment or hassle needed to manage a property on a day-to-day basis. Generally, there are 4 types of REITs that investors can choose from:
- 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. Equity REITs can specialize in specific property types like apartment complexes, office buildings or 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 do 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, investors 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.
Private Equity Commercial Real Estate Firms
Private Equity Real Estate firms and REITs have a similar mandate—to pool investor money and deploy it into 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 rental 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.
When working with a Private Equity firm (like ours), investors are able to leverage the institutional expertise and experience of the firm. In addition, they can expect that the transaction will be structured in a tax-efficient manner and that the financial incentives of the firm will be aligned with those of the investor.
Private equity firms offer a number of different and investment options, products, and strategies. Individuals should ensure that the chosen investment is a good fit for their own needs and objectives.
Residential vs. Commercial Real Estate Investments
For many, the easiest way to invest in real estate is with the purchase of a residential investment property. The premise behind this investment is simple: a down payment is made to purchase a property, which is then rented to an individual or family. The income earned from the rental is used to pay the property’s operational expenses like taxes, insurance, and mortgage payments, and any remaining funds are distributed to the owner(s) as a return on their investment. Residential properties can be rented on a short-term basis as vacation homes or an Airbnb, or on a long-term basis of 12 months or more.
Residential real estate investors benefit from low barriers to entry (e.g. affordable purchase price), income, price appreciation, and wide availability of debt, at low interest rates, from a number of different lenders to finance the transaction. However, residential property investment is not scalable and a significant amount of work is required to screen potential renters to ensure they have a good credit score, in addition to the time and effort needed for maintenance, upkeep, and general property management. For investors seeking scale and passive income, they may find that commercial real estate is their best investment option.
Commercial real estate properties are those that are purchased and leased to other businesses with the intent to earn a return through income, appreciation, or both. The investment thesis is the same as a residential property, but the scale and complexity is magnified. There are four types of commercial properties: retail, multifamily, office, and industrial—and each comes with its own set of risks and operational quirks.
Commercial investors benefit from income, capital gains, tax advantages, and portfolio diversification. But commercial properties are expensive and typically available only to individual investors with a high net worth when purchased directly. These investments are also operationally complex and tend to demand a lot of time from their owners. In fact, many commercial properties require a full time property manager in order to maintain property value.
We believe that a commercial real estate investment is the best option for individuals seeking passive income through exposure to real estate assets. Generally, passive commercial real estate investment options fall into one of two buckets: Real Estate Investment Trusts (REITs) or Private Equity.
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 investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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