- Generally, there are two categories of real estate into which an investor can deploy funds, commercial real estate and residential real estate.
- Regardless of class, the point of commercial real estate ownership is to generate cash flow and/or profits from leasing the space in the property.
- Risks will always be present in commercial real estate investment, but investors with the requisite amount of experience and knowledge can proactively manage them in an effort to deliver strong returns.
Generally, there are two categories of real estate into which an investor can deploy funds, commercial real estate and residential real estate. One isn’t necessarily better than the other, but they each offer a distinct set of benefits and risks that should be matched to the risk tolerance and time horizon of the investor.
Residential real estate investment is characterized by the ownership of investment property meant for a residential purpose. Typically, these would include assets like single-family homes, duplexes, triplexes, and quadplexes. Real estate investors like residential real estate for their rental income, relatively low property expenses, low interest rates, and reasonable real estate taxes. Lenders like residential real estate because the mortgages can be packaged and sold into the secondary market.
Commercial real estate investment is characterized by ownership of properties with a commercial use. Typically, this includes dedicated properties with commercial tenants or mixed-use properties whose zoning allows for a variety of use cases. Investors like commercial real estate for their historically strong annual returns, longer leases, and the ability to outsource property management.
For the reasons outlined below, we believe that an investment in commercial property can offer an attractive risk/return profile for the right investor.
Types of Commercial Property
Broadly, there are four “classes” of commercial real estate:
- Retail: Space is leased to customer facing, retail businesses
- Office: Space is leased to tenants like accounting firms and medical professionals
- Industrial: Space is leased to distribution/logistics companies
- Multifamily: Apartment buildings with 5 or more residential units, leased to individual renters
Regardless of class, the point of commercial real estate ownership is to generate cash flow and/or profits from leasing the space in the property.
Benefits of Investing In Commercial Real Estate
There are a number of benefits that a commercial property owner may realize as a result of their investment:
- Income Potential: 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 payments. If the property is purchased at an attractive price, income alone can provide a solid return.
- Lease Escalations: It is common for commercial leases to include an “escalation” clause that increases the rent 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 increases over time.
- “Forced” Appreciation: Unlike residential properties, which are valued on comparable sales, commercial properties are valued on the amount of Net Operating Income that they produce. Because Net Operating Income is calculated as the property’s income less expenses, the owner has the ability to control it. For example, assuming the amount of income is fixed, a property owner could work to reduce expenses, thereby increasing Net Operating Income and the property’s value. This process is known as “forced appreciation.”
- 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.
- 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 of it can provide an investment portfolio with another level of diversification, which is helpful in an economic downturn.
For the right investor, these benefits can be significant and we believe that commercial real estate deserves an allocation in a broadly diversified portfolio of risk assets.
Risks of Commercial Real Estate Investment
Although the benefits of commercial real estate investment can be significant, it isn’t without risk. Below are the risks and challenges that potential investors should consider before committing capital to a deal:
- Cost: Generally, commercial properties are more expensive than residential ones, which means that they require a larger upfront investment. This may put 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 Intensive: 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 so traditional management issues like rent collection and maintenance can require full time support and oversight. We are a “vertically integrated” firm so we prefer to leverage our significant knowledge and experience to manage our own properties.
- Credit Risk: On occasion, a situation may arise where a tenant can’t – or won’t – pay their rent and this is known as Credit Risk. To mitigate this, a significant amount of due diligence should be performed on the financial condition of each tenant and their payment history.
- 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 a lease comes up for renewal, market risk means that there is a possibility that the tenant may decide not to renew their lease, or that the prevailing market lease rate at that time is lower than what the tenant was paying during the 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 going 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 or they may slip and fall on an icy sidewalk. Or, there could be a number of other public safety issues that could expose the property owner to liability. To mitigate this risk, it is always a best practice to obtain the proper insurance coverages.
Risks will always be present in commercial real estate investment, but investors with the requisite amount of experience and knowledge can proactively manage them in an effort to deliver strong returns.
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 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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