The term “commercial real estate” refers to a broad class of real estate assets that are leased to businesses with the intent to earn an investment return through income, price appreciation, or both. The key word in this description is “broad.” There are multiple types and sub-types of commercial real estate, each of which come with their own operational quirks and risk/return profile.
In this article, we are going to describe 8 different types of commercial real estate assets. We will describe what they are, identify their subtypes, and generally describe the risks and benefits of a commercial real estate investment. By the end, readers will have the information needed to determine which type of commercial real estate is the best fit for their individual investment objectives.
At First National Realty Partners, we specialize in the purchase and management of grocery store anchored retail centers. To learn more about our current investment commercial real estate opportunities, click here.
Commercial Real Estate Explained
As described above, the distinguishing characteristic of commercial real estate and what defines it is that it is leased to businesses with the intent of making a profit. But, just as there are many different types of businesses, there are many different types of commercial real estate to accommodate them. Below, the eight types of commercial real estate are described.
The Eight Types of Commercial Real Estate
Type #1: Retail
A retail property is one that contains space that is leased to businesses who sell their goods/services directly to consumers through a storefront. Investors like retail properties because they are highly visible and tenants tend to sign long term leases. But, their traffic levels are also closely tied to macroeconomic factors and consumer discretionary income levels.
Within the retail category, there are three property subtypes that real estate investors should be aware of.
General Purpose Shopping Centers
A general purpose shopping center is one where a shopper can go to purchase general items like food, clothing, and electronics.
A power center is one that is 250,000 to 600,000 square feet in size, has three or more anchor tenants and serves a trade area of 5 to 10 miles. Typical tenants include “category killers” like home improvement and warehouse club stores.
Community Retail Centers
A community retail center is one that is smaller than a power center and designed to serve the needs of their local community. Typically, they are 125,000 to 400,000 square feet in size and laid out in a strip mall format, “L,” or “U” shape. The tenants tend to be focused on general merchandise or convenience-type offerings.
Type #2: Multifamily
A multifamily property is the exception to the rule that commercial real estate spaces are leased to businesses. Multifamily properties contain 2 or more residential dwellings that are contained within the same building or group of buildings. There are three subtypes of multifamily properties.
A duplex contains two rental units, a triplex contains three, and a quadplex contains four. These are commonly found in suburban areas and are a good starting point for multifamily investors. For lending purposes, these are considered residential properties (instead of commercial) so they may qualify for residential lending programs.
A “garden” style multifamily property is one that contains more than four units and has considerable access to garden space or a lawn. Garden style apartments may be housed in one building or many and are usually one to three stories tall and located in suburban or rural areas.
Mid-Rise & High Rise Apartments
Mid-rise apartment buildings are those that have five to 12 stories within the same building and high-rise apartments are 12 stories or higher. Because of their height, they usually have elevators and are located in dense urban areas like New York City, Los Angeles, or Miami.
Type #3: Office
The third type of commercial real estate is offices. Office buildings contain spaces that are leased to companies who use it to operate their businesses. The space may be a general office like an accounting firm or investment advisor. Or, they may have specialized uses like a dentist’s office or research lab.
Office Building Classes
Office buildings (and other commercial real estate types) come in four classes, each of which have a letter grade from A to D. Class A spaces are the newest, most luxurious, and have the best locations. They also command the highest rental rates. Class D properties are in poor condition and may need a complete overhaul or demolition. Class B and Class C are in between.
Central Business Districts
Often, office buildings are clustered around the central business district of cities. In larger cities, like Chicago, there could be clusters of skyscrapers because there is high demand for space and the most efficient use of space is to build up. Or, in smaller cities, offices could be clustered around a “main street” which has the same concept but smaller buildings.
While central business districts are certainly convenient and useful given their proximity to shops, restaurants, and services, they can also be very expensive. As a result, it is also common to see large companies build sprawling suburban office complexes that have one or more buildings and amenities like a garden or courtyard. For a large company, this can be a much more cost effective way to accommodate many employees.
Type #4: Industrial
As the name suggests, industrial real estate is a classification of properties that have an “industrial” purpose. Generally, this means that they are used as manufacturing, distribution, and/or logistics facilities. Industrial properties fall into three categories.
Light assembly properties tend to be smaller in size and their best use is as a storage space or final product assembly plant. For example, a light assembly space could be used to receive all of the inputs for a product that are then assembled onsite and shipped to customers.
By definition, “flex spaces” are designed to be flexible and contain some combination of warehouse and office space. For example, imagine an import company who imports goods to be stored in their warehouse, but it also includes some small amount of office space or display area where they can bring customers to show their products.
These are very large spaces, usually 50,000 – 1,000,000 SF, that are used as a centralized distribution point for large companies. For example, imagine a company like WalMart who has a nationwide presence. They may have a bulk warehouse in Central Florida that is used as a distribution point for all of their Florida stores.
Type #5: Hotels / Hospitality
A hotel is a type of commercial real estate that rents space to individuals by the night. There are three hotel types that investors should be aware of.
A full service hotel is one that provides a full suite of services to guests. These typically include onsite restaurants, fitness centers, a spa, room service, etc. For example, the Ritz Carlton brand is a well known full service hotel brand that caters to business travelers and vacationers looking for luxury.
Limited Service Hotel
As the name suggests, a limited service hotel is one that has a limited number of services. For example, instead of a sit down restaurant, they may have a grab and go market. Or, instead of a full fitness center, they may have a scaled back fitness room with just a few pieces of equipment. Courtyard by Marriott is an example of a limited service hotel that caters to travelers on a budget.
Most hotel stays are in the 3-7 night range, but there is a certain segment of travelers who need to stay longer. Extended stay hotels are designed for them in the sense that rooms might include some amenities that make it feel more like home. For example, they may include small refrigerators, kitchenettes, and maybe even a small stove or cooktop. Residence Inn by Marriott is an example of an extended stay hotel.
Type #6: Land
All commercial real estate properties come with land, but sometimes it is vacant with no building on top of it. This is an asset class in and of itself and there are three subtypes that investors should be aware of.
Agricultural land is vacant land that is used for agricultural purposes such as farming or pasture. It is often found in rural areas because it is relatively inexpensive and usually comes with significant tax benefits.
Infill land is vacant land that is located in an urban area where nearby properties have already been developed. For example, an infill lot could be located in the central business district of an urban city and its best use is to build up, like a high rise apartment building or office.
Brownfield land is the name used to describe land that has some sort of environmental impairment. For example, the groundwater could have known contaminants. In such a case, the land may be available for a good price because it can be very costly to remediate the environmental issues.
Type #7: Mixed Use
All of the real estate types above have a dedicated, single-use, which is very common. But, there is an entirely different type of property that has a mixed-use, which means that it includes two or more property types. For example, a mixed use property could include a multifamily apartment building on top of a retail shipping center. These are very common in suburban areas that cater to individuals who want to live/work/shop all in the same place.
Type #8: Special-Purpose
Again, as the name implies, a special purpose commercial building is one that is built for a very specific purpose that may not fit into the other categories described above. For example, sports stadiums, amusement parks, self-storage, student housing, bowling alleys, movie theaters, or zoos are all special purpose commercial properties.
Advantages of Investing in Commercial Real Estate (CRE)
Despite the differences in the types of commercial real estate above, there are a number of advantages of investing in commercial real estate that are the same for all. They include:
1. Cash Flow
Because these properties are rented, they can produce a certain amount of cash flow that is distributed to investors on a regular basis.
Over a long period of time, real estate tends to appreciate in value due to scarcity and market driven factors. When price appreciation is combined with regular cash flow, the returns can be significant.
3. Tax Benefits
Operating expenses can be deducted from rental income, which lowers a property’s tax burden. In addition, real estate investors can defer capital gains taxes upon sale as long as they reinvest their money into another property of like kind. This process can be repeated over and over, deferring capital gains taxes indefinitely.
Commercial real estate price movements tend to have a low level of correlation with other asset classes like stocks and bonds. As such, including it in a portfolio can provide another layer of diversification, which also reduces risk.
Risks to Consider with CRE Investing
While the advantages can be significant, commercial real estate investment is not without risk. Specifically, market rental rates can change, the property can suffer from high levels of vacancy, or an unexpected storm could cause damage that requires expensive renovations to repair.
Getting Started in Commercial Real Estate Investing
There are a number of ways to gain access to commercial real estate investments.
For beginners, perhaps the easiest and most accessible way to do so is through the purchase of shares in a publicly traded real estate investment trust (REIT). These are companies who own, operate, or finance commercial real estate and they specialize in the rental property types described above. For example, National Retail Properties (Ticker: NNN) is a publicly traded REIT that specializes in single tenant, triple net leased retail space (they own other property types, but this is their focus). Or, Prologis is a REIT that specializes in industrial buildings and logistics facilities.
The benefit of this real estate approach is that investors can get started with a relatively small minimum investment, the management fees are low, and they have liquidity because the shares can be bought and sold on public exchanges. While this strategy is perfectly acceptable, there is another approach that many investors also like.
Investing Through Private Equity Real Estate
Private equity firms invest in the privately held equity of other firms, including those that own real estate. Private investments are only available to accredited investors who meet certain income and net worth requirements so they are slightly less accessible, but private equity firms bring a significant amount of experience, expertise, and resources to a real estate transaction. As such, individual investors – who are accredited – have an opportunity to gain access to deals that they would not be able to find and/or purchase on their own.
For individuals interested in partnering with a private equity firm, they should perform their own due diligence to ensure that the firm’s strategy aligns with their own individual risk tolerance, real estate investment objectives, and time horizon.
Summary & Conclusion
Commercial real estate is a type of asset that is purchased and leased to business tenants with the intent to earn a return through rental income and/or price appreciation.
There are eight types of commercial real estate, each of which include their own operational quirks and risk profile. They include: hotel, retail, industrial, mixed-use, office, multifamily, special purpose, and vacant land.
For many investors, the easiest way to gain access to commercial real estate assets is through the publicly traded shares of a real estate investment trust. For accredited investors, partnership with a private equity firm is also a viable option.
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 commercial real estate investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.