If an individual has excess capital that he or she would like to deploy into an investment of any sort, there are several popular options from which to choose. One could choose to invest in the stock market, in which case it’s possible to achieve high returns—but this option could also face significant price volatility. One could seek the relative safety of the bond markets where returns are more stable, but have limited upside. Or, an individual could consider a commercial real estate (CRE) investment property, which sits between the two options in terms of its risk/return profile.
We believe that there is room for all three strategies in a broadly diversified portfolio of risk assets. But to understand the benefits of allocating capital to commercial real estate, it is first necessary to understand exactly what constitutes commercial real estate in the first place.
What is Commercial Real Estate?
The term “Commercial Real Estate” is used to describe a broad class of real estate assets that are purchased with the intent to earn a profit through income, price appreciation, or both. Typically, the space in a commercial property is leased to other businesses (as opposed to individuals—with the exception of Multifamily), and these businesses use it to operate their companies. For those interested in commercial real estate investing, there are four major types of properties, each of which has its own risks, benefits, 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 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 due to the fact that it can be difficult and expensive to move a business. However, these 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 buildings are designed for tenants who operate direct-to-consumer businesses like clothing or electronics stores. Classic examples include strip malls, shopping centers and standalone bank branches. Retail property owners benefit from high visibility and long-term leasing activity. But changing market tastes can impact the financial strength of tenants, and since the interior of a retail property is often built for a specific purpose, it can be difficult and expensive to re-lease them without major renovations.
- Multifamily: A commercial multifamily property is an apartment building with five or more units (as opposed to a residential property, which has fewer than five 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.
Benefits of Commercial Real Estate Investment
For those who choose to invest in commercial real estate assets, there are 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 spaces 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 on 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 these investors 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 income stream 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 lease term. 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: There are two major tax benefits to a CRE investment. 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 Net Operating Income and property values 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, this strategy is not without risk.
Commercial Real Estate Risks
There are a number of risks and challenges that potential commercial real estate investors should consider before committing capital to a deal:
- 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 property management issues like rent collection and common area 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 his or her 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 someone may slip and fall on an icy sidewalk. Generally, 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.
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.