Commercial real estate (CRE) is defined as a class of real estate assets that are purchased with the intent to generate a profit through rental income, capital gains or both. Broadly speaking, there are four widely recognized commercial property types:
- Office: Office space is designed for the unique needs of running a business. The office building layout could be general, meant to cater to the basic business needs of traditional companies like accounting and law firms. Or, it could be specifically designed to meet the unique needs of a specialized tenant such as a doctor’s office or medical imaging center.
- Industrial: An industrial property is characterized by properties with an “industrial” purpose and may include standalone warehouses, logistics facilities, or “flex” spaces. Examples of industrial tenants include shipping companies such as UPS or Amazon, as well as light manufacturers.
- Retail: Retail properties are designed for tenants who operate direct-to-consumer (DTC) businesses like clothing or electronics stores. Classic examples of retail properties include strip malls, shopping centers and standalone bank branches.
- Multifamily: A commercial multifamily property is an apartment building with five or more residential dwelling units.
Although the general purpose of each property type is the same—to generate positive cash flow—they each have slightly different operational quirks and risk profiles that should be carefully considered before choosing which one to invest in. For example, multifamily properties require a significant amount of day-to-day management, but generally tend to fare better than other asset classes in an economic contraction. Alternatively, industrial properties are preferred for their long term leases, but tend to have large physical footprints and can be particularly vulnerable to economic downturns. Still, regardless of the asset class chosen, there are a variety of benefits associated with a commercial real estate investment in general.
Benefits of a Commercial Real Estate Investment
When committing capital to a commercial property, real estate investors may realize some or all of the following benefits:
- 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 payments. If the property is purchased at an attractive price, income alone may 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 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 (NOI) that they produce. Because Net Operating Income is calculated as the property’s income less expenses, the owner has the ability to control the formula by implementing strategies designed to increase income, reduce expenses or both. By increasing NOI, the property owner is able to “force” the property to appreciate, regardless of market conditions.
- 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 overall tax liability. Further, capital gains taxes realized upon sale can be deferred indefinitely through the “1031 Exchange” program, as long as sale proceeds are continually reinvested into another real estate property of “like kind.”
- 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 commercial real estate can provide another level of diversification to an investment portfolio, which can be helpful in an economic downturn.
- Inflation Protection: Because commercial real estate is a physical, “tangible” asset, it tends to be a good hedge against inflation. This is due to the fact that real estate developers generally 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, which drives higher property valuations. These value increases tend to keep pace with inflation, and so commercial real estate can be a good hedge.
Given the benefits, we believe that commercial real estate deserves an allocation within a broadly diversified portfolio of risk assets.
Commercial Real Estate Risks
Although the benefits of commercial real estate investment can be significant, it isn’t without risk. Below are the primary 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, 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.
- 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. Mitigating this requires performing 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 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 may be 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 on a daily basis. This raises the risk that someone may have a car accident in the parking lot, say, or they may slip and fall on an icy sidewalk. Beyond these examples, there may 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 pertinent to the specific commercial real estate property.
There is no such thing as a risk-free investment, but experience, expertise, and active risk mitigation strategies can reduce overall risk exposure.
Commercial Real Estate Investment Options
For those convinced that a commercial real estate is a good investment based on 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 and use it to purchase a commercial investment property asset 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 overseeing all property management activities. 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 have all three and may be better off with 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. 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 means 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. They provide the passive income of real estate ownership without the time commitment or hassle needed to manage a property or properties on a day-to-day basis. Generally, there are four types of REITs that investors can choose from:
- Equity REITs: Equity REITs are publicly traded companies (the shares of which 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 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, an investor 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 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 private equity investments 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 investment options, products, and strategies. Individuals should take care to research and ensure that the chosen investment is a good fit for their own needs and objectives.
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.