As professional commercial real estate investors, we believe that there is a strong argument to be made for the inclusion of commercial real estate properties in a broadly diversified portfolio of risk assets. But, we have found that there can be some confusion about what exactly commercial real estate is, why it is a good asset to own, and what risks are involved with investing in it.
In this article, we will explain the different types of commercial real estate properties and classes, explain strategies for investing, and outline the risks and benefits of commercial real estate investments.
What Qualifies as “Commercial Real Estate”?
There are two defining characteristics of a commercial real estate asset:
- A commercial real estate asset is purchased with the intent to earn a return through rental income, price appreciation, or both.
- With the exception of multifamily properties, commercial tenants are businesses, not individuals. The key difference between residential multifamily properties and commercial apartment buildings is the number of units. As a general rule of thumb, a commercial multifamily property has 5+ units, while a residential property has less than five.
With these guidelines in mind, there are four widely recognized types of commercial real estate.
Types of Commercial Real Estate Properties
From an investment standpoint, there are material differences between the four types of commercial real estate properties, and investors should be aware of these differences prior to committing capital to a commercial property investment.
Office space is designed for the unique needs of running a business. It could be a high-rise building located in the “central business district” of a big city or it could be a mid-rise property located in a suburban office park. Further, office space could be general in nature – meant to cater to companies like accounting and law firms. Or, it could be meant for a more specific purpose like a doctor’s office.
Commercial real estate investors that invest in office properties benefit from long-term commercial leases and 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.
2. Industrial Properties
An industrial investment property is characterized by properties with an “industrial” purpose and may include standalone warehouses, logistics facilities, or “flex” spaces.
Industrial real estate investors also benefit from favorable lease terms as well as predictable cash flow, lower operational risks, and low CapEx requirements. But, industrial real estate investments can be especially vulnerable to economic disruptions and may have high upfront costs due to their large physical footprints.
3. Multifamily Properties
As described above, a commercial multifamily property is one with five or more units contained within the same property.
Multifamily real estate investors benefit from relative stability during economic downturns, wide availability of debt and lenders who offer generally low interest rates, and a high number of units over which to spread vacancy risk. But, multifamily property owners may face challenges with high renter turnover, short term leases, high property taxes, and increased collection expenses.
4. Retail Properties
Retail properties are designed for tenants who operate direct to consumer businesses like clothing or electronics stores. Classic examples of these commercial real estate properties include strip malls, shopping centers, and standalone bank branches.
Retail real estate investors benefit from high visibility and longer commercial real estate leases. But, the financial strength of tenants can be impacted by changing market tastes and the interior of this type of real estate property is often built for a specific purpose, making the property difficult and/or expensive to re-lease without major renovations.
Types of Commercial Real Estate Classes
Each commercial property type is further subdivided into a “class” that is indicative of its condition, location, risk level, and potential annual return. There are four property classes.
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. Their locations are highly visible and have high traffic counts for both vehicles and pedestrians.
Class A properties have the most luxurious finishes, newest technology, and strongest amenity packages. For example, they may have marble floors, high speed internet, and outdoor patios with fantastic views. In addition, they may be highly energy efficient.
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. 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 have average finishes that may be slightly dated. For example, a Class B multifamily property may have tile floors, laminate counters, carpet in the bedrooms. and a slightly outdated fitness center.
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 commercial 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.
Class D commercial space is the riskiest type for investment. A Class D building may be functionally or economically obsolete and it may need major renovations or to be completely rebuilt. These are distressed properties and the investment opportunities in them represent a classic boom/bust scenario.
Class D properties should be avoided by all but the most experienced investors.
How Commercial Real Estate Is Valued
In order to understand how a commercial property generates investment returns, it is first necessary to understand how they are valued. Unlike residential real estate, which is valued based on comparable sales, commercial properties are valued based on the amount of Net Operating Income (NOI) they produce.
Net Operating Income is calculated as a property’s rental income less its operating expenses like real estate taxes and insurance. A cap rate is applied to a property’s NOI to determine the property’s value. As such, there are two ways that a commercial property can generate investment returns: rising income, rising prices, or both.
How Commercial Real Estate Generates Returns
There are two primary income drivers, one of which the property manager has control over and one in which they do not. First is simply market dynamics. In real estate markets with strong demand and relatively limited supply, rental prices tend to rise, which can improve NOI as long as expenses are relatively flat. The second income driver is rental escalations. Most commercial leases contain a clause that calls for the rent to increase at regular intervals. Over time, these escalations can also contribute to rising net operating income.
Rising income, regardless of the source, leads to rising Net Operating Income, which causes a property’s price to appreciate. This appreciation can accelerate when “forced” appreciation is combined with favorable market dynamics to drive prices even higher.
Strategies for Investing in Commercial Real Estate
Broadly, there are two strategies that can be used to invest in commercial rental property: direct and indirect.
In a direct strategy, an investor – or group of commercial real estate investors – purchases a property directly. In doing so, they have direct control over all purchase and management decisions. However, they are also exposed to diversification risk and may be surprised by the amount of time and expertise it takes to manage a commercial property effectively.
Indirect or Passive Investment
If an investor is looking for a more passive approach, they may choose to invest indirectly. With this strategy, they outsource all property identification and leasing/property management tasks to a professional investment firm. The benefit of this approach is that an individual investor gets all the benefits of property ownership without the hassle of managing it. However, they give up a lot of control to do so.
In either case, there are a number of pros and cons of investing in commercial real estate.
Benefits of Investing In Commercial Real Estate
The advantages of commercial real estate investing can be significant. The twelve main pros include:
1. Income Potential
Commercial real estate owners are entitled to the cash that remains after property expenses and debt service are paid. This can provide a steady stream of income if the property is managed profitably.
2. Lease Escalations
As mentioned above, commercial leases typically come with built-in lease escalations, which call for rental price increases at regular intervals. Over time, these escalations make their way to net operating income and serve to increase the property’s value.
3. “Forced” Appreciation
Because a commercial real estate property’s value is based on the amount of Net Operating Income it produces, a manager has the ability to “force” it to increase. This can be done through value-add projects to increase income (like renovations), through expense management, or both.
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 income, decrease expenses, or both, an owner can increase Net Operating Income, thereby “forcing” the value of the property to rise.
4. Tax Advantages
Real estate is a physical asset whose condition degrades over time. To account for this, tax rules allow an owner to “depreciate” the value of the property a little bit each year. Depreciation is a non-cash expense that serves to reduce taxable income and these advantages are passed through to investors as a result of commercial real estate’s tax efficient ownership structure.
In addition, commercial properties are purchased through a tax-efficient entity and capital gains taxes can be deferred indefinitely through the “1031 Exchange” program as long as sale proceeds are reinvested into another property of “like kind.”
Commercial real estate prices tend to have a low level of correlation to other investment portfolio mainstays like stocks and bonds. This means that this asset class can offer another layer of diversification to the traditional stock/bond portfolio. Commercial real estate investments can be further diversified through different property types, locations, classes, and investment managers.
6. Triple Net Leases
Certain properties have a specialized type of lease structure known as a “triple-net lease”, which requires the tenant to pay a base rental amount plus all costs associated with taxes, utilities, and maintenance. This decreases the management responsibilities on the owner and results in a mostly passive income stream.
7. Passive Income
With an indirect investment strategy or with a triple-net leased property, investors can achieve a passive income stream, similar to that of a bond, but with a higher overall return.
8. 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 their lease will have a smaller impact on vacancy rates than it would in a residential property. For example, the decision of one tenant not to renew a lease in a 300-unit multifamily property is a relative non-issue. In a single family residential property, this decision could reduce occupancy to 0% overnight. The bottom line is that commercial properties allow investors to distribute their vacancy risk over multiple units, making them less reliant on any one unit for income.
9. Stable Investments
Because of their loose correlation to stock and bond prices, commercial real estate investments tend to be a stabilizing influence on portfolio performance. Their prices tend to be less volatile because they aren’t publicly traded and certain asset classes – like multifamily – tend to be resilient through all phases of the economic cycle.
Despite their significant benefits, there are also a number of risks to consider when making a commercial real estate investment.
10. Inflation Protection
Because commercial real estate 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 against inflation.
11. Long-Term Leases
A typical residential tenant signs a one year lease. A typical commercial tenant signs a multi-year lease, which creates more stability for the property’s stream of income. This is particularly helpful during times of economic distress (like the COVID-19 pandemic).
12. 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.
Risks of Commercial Real Estate Investments
Like any investment, there are a number of risks that commercial real estate investors should consider. Prior to committing capital, each individual should complete their own due diligence to ensure there is a plan to address each one of them. The cons of CRE investing include:
Commercial properties – especially the most desirable ones – are very expensive and typically only affordable to the most well funded investors and firms. There are two risks on this point. First, because commercial properties are so expensive, they require a significant amount of capital, which means that there is also the potential to lose a significant amount of capital. Second, because commercial properties are so expensive, the amount of resources needed to purchase one may limit an investor’s ability to diversify their portfolio.
2. Management Intensive
Because of the size, scale, and number of tenants involved with a commercial property, managing them is a full time job. Commercial properties require concentrated focus and a significant amount of expertise to manage efficiently. The quality of management can have a material impact on commercial real estate investment returns.
3. Increased Vacancy
Vacancy is always a risk because it represents lost income for the property. This risk is particularly prevalent for commercial properties with a small number of tenants because the loss of one of them can create an income shock for the property.
4. Credit Risk
Credit risk is the risk that a tenant can’t or won’t make their rent payment. This could be a result of declining sales or a strategic closure, but the result is the same. Non-paying tenants decrease a property’s income and value. They also increase the costs associated with collecting rent, particularly if it becomes litigious.
5. Market Risk
Market risk is the risk that market conditions could adversely impact the property’s value. This includes changes in things like rental rates, interest rates, property taxes, and absorption of space. Often these changes can happen quickly or unexpectedly, so investors must attempt to anticipate them and protect against their impacts.
6. Public Safety
Finally, commercial spaces – especially retail shopping centers – are places where individuals go to gather, celebrate, and relax. As a result, they are also places where individuals could be injured in doing so. These incidents could be relatively minor – like a slip and fall – or they could be larger. Either way, they represent a liability for the individual or firm who owns the asset.
For each commercial real estate investment opportunity and for each investor, the benefits must be weighed against the risks to ensure that there is comfort in the risk/return profile of the transaction.
Current Trends in Commercial Real Estate Investing (2022)
Commercial real estate investment is an exciting field and one that is constantly growing and evolving. Looking forward into 2023 and beyond, there are several trends that commercial real estate investors should be aware of when making capital allocation decisions:
- Trend #1 – Multifamily Will Continue to Grow: Housing is a primary need and individuals tend to prioritize their rent payments above all else during times of economic distress. Because multifamily is the form of housing with the lowest barriers to entry, it is expected that it will continue to grow.
- Trend #2 – Interest Rates Will Remain Low: In an unprecedented effort to provide stimulus to the US economy, the Federal Reserve has cut interest rates to all-time lows. In addition, they expect to maintain these historically low levels through 2022 and possibly even into 2023. This is a tailwind for commercial real estate.
- Trend #3: Demand for Industrial Properties Will Remain Strong: Sharp rises in e-commerce/Amazon purchases and demand for “last mile” deliveries will continue to drive strong interest in industrial real estate. According to CBRE research, it was estimated that there would be 250 million SF of industrial space absorbed in 2021, well above the historical absorption of 211 million SF annually.
- Trend #4 – Omnichannel Fulfillment: In order to fulfill the orders coming in through multiple channels, retailers – especially the smaller ones that lack centralized distribution – will continue to convert sales floor space into miniature distribution centers in the stock room. Here they will pull, pack, and ship orders that come in through digital channels.
- Trend #5: Increased Spacing & Enhanced Cleanliness Protocols: At least in the near term, it is anticipated that consumers will continue to expect enhanced safety and wellness protocols from retailers to minimize the risk of entering a public shopping space.
Firms that are able to harness these trends will benefit in the form of higher demand for their properties and higher returns for their investors.
Residential vs. Commercial Real Estate Investments
At a high level, real estate investments fall into one of two categories: residential or commercial properties.
Residential Property 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 buyer makes a down payment to purchase a property, which is then rented to an individual or family. The income earned from the rental then pays the property’s operational expenses like taxes, insurance, and mortgage payments and any remaining funds get 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. However, residential property investment is not easily scalable and requires a significant amount of work 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.
Commercial Property Investments
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 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 gets 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.
So, Is Commercial Real Estate A Good Investment?
Given the pros and cons, commercial real estate can absolutely be a good investment. However, it is important for investors to carefully review their own risk tolerance, investment objectives, and time horizon to determine which type of commercial real estate investment is most suitable for their own situation.
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.