Commercial real estate investment properties come in all shapes, sizes, types, classes, conditions, prices, and in different locations. In addition, the method or vehicle through which to invest can vary from one transaction to another.
For individual investors who are interested in commercial real estate investing and the portfolio diversification that it brings, the choices can be overwhelming and confusing. To find an opportunity that is suitable for an individual’s return objectives, risk tolerance, and time horizon, we have found that it can be helpful to narrow the opportunities down by focusing on four specific areas: property type, asset class, investment vehicle, and investment strategy. The choices in each will help answer the question, “what kind of investor are you?”
Broadly, there are four different types of commercial real estate property. From an investment standpoint, they each have their benefits and risks so it is important to understand how their income and operating expenses work prior to making an investment decision.
An Office building is designed for the unique needs of running a business. It could be a glass and steel high-rise located in a big city like New York or a low or mid-rise property located in a suburban office park. In addition, the office space could be general, meant to cater to the business needs of companies like accounting and law firms or, it could be specialized to meet the unique needs of a doctor’s office. Office investors benefit from long term leases and generally low tenant turnover. But, those same leases may come with infrequent rental increases and expensive tenant improvements.
An Industrial property is characterized by an “industrial” purpose and may include standalone warehouses, logistics facilities, or “flex” spaces. Examples of industrial tenants include shipping and import/export companies. Industrial investors benefit from predictable cash flow, lower operational risks, low CapEx requirements, and generally favorable supply/demand characteristics. But, industrial spaces can be especially vulnerable to economic disruptions and may have high upfront costs due to their large physical footprints.
Retail properties are designed for tenants who operate consumer facing businesses like clothing or electronics stores. Classic examples of retail properties include strip malls, shopping centers and standalone bank branches. Retail investors benefit from high visibility and long term tenant leases. But, the financial strength of tenants can be impacted by changing market tastes and the interior of a retail property is often built for a specific purpose, which can make them difficult and/or expensive to re-lease without major renovations.
A commercial Multifamily apartment complex is one with five or more units. Multifamily apartment building 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.
Within each property type, there is a further subdivision based on key characteristics of the property’s condition, location, amenities, and price point. This is referred to as the property’s “Class” and there are four of them.
There are four “classes” of commercial property.
- Class A: Class A buildings are the newest and highest quality. They tend to be less than ten years old and are typically located in high visibility locations in or near the Central Business Districts and/or most desirable locations of major cities (like New York City or Los Angeles), which drives strong leasing activity. They also have luxurious finishes with the newest technology, strongest amenity packages, and don’t require any major renovations. As a result, they typically have strong in-place Net Operating Income (NOI) and are considered to be the least risky. Lenders like Class A properties for their relative safety and, as a result, Class A commercial buildings command the highest sales prices and lowest cap rates.
- Class B: Class B rental properties 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. They have average finishes, tend to be in good condition and may need light repairs or modernization. On a per unit or per square foot basis, sales prices, valuations, and capitalization rates are lower than Class A properties and returns consist of a mix of price appreciation and income.
- Class C: Class C 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. They have dated finishes that likely need to be replaced because they are either obsolete or non-functioning. 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.
- Class D: Class D properties are highly speculative and not considered investment grade. Typically, they are very dated and in need of significant repairs or a complete rebuild. They are more than 30 years old and have poor locations in areas without access to transportation networks, restaurants, grocery stores, or other amenities. Class D properties have very dated finishes that need to be replaced. On a per square foot basis, Class D properties are the most affordable because they also carry the most risk.
Once an investor has completed their own due diligence and has decided which property type and class they would like to invest in, the next major decision is how to make the investment.
Commercial Real Estate Investment Vehicles
For most individual investors, there are two options through which to invest in commercial real estate, directly or indirectly.
A direct purchase is fairly self-explanatory. It is when an individual or group of individuals forms an LLC to purchase a commercial asset directly in their preferred real estate market. Doing so provides property owners with direct control over the asset identification, financing, and management process. But, commercial properties are expensive and the best ones are only available to the most well capitalized individuals. For this reason, an indirect investment may be a better choice.
In an indirect scenario, an investor places their capital with an asset manager who oversees the property identification, financing, and management process on their behalf. This allows an investor to leverage the expertise and network of the asset manager while also providing the ability to gain passive income and fractional ownership of a professional grade asset that they would have not been able to afford otherwise. However, even within the indirect scenario, there are several choices for an investment vehicle of which we want to highlight two:
- 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, which provide access to the income and profits produced by the underlying real estate assets. In addition, as long as the REIT meets certain requirements, there are some tax advantages to this structure. REITs can be publicly traded, which allows investors to buy and sell shares like stocks, providing a high degree of liquidity. Or, they can be private, which provides less liquidity and a longer term commitment.
- Private Equity: Private Equity Real Estate firms and REITs have a similar mandate, to pool investor money and deploy it in commercial real estate deals. However, the securities offered by Private Equity Real Estate firms are not publicly traded and they are only available to “accredited” or high net worth investors.
Because they aren’t bound by the same regulations as publicly-traded REITs, private equity firms have wide latitude to invest in a variety of real estate asset classes, which may or may not include income-producing properties. In addition, the legal structure may differ significantly from a REIT and they 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.
Finally, whether deploying funds directly or indirectly, there are a number of investment strategies that an individual may choose to pursue.
An investment strategy can be characterized by what an investor does with the property once they have acquired it. There are many different options, but we want to highlight two of the most popular:
- Buy & Hold: A Buy & Hold investor has a long time horizon and the opportunity for capital appreciation is a secondary concern. They like to purchase properties (usually Class A and B) that already produce positive cash flow and hold them for a long period of time while they collect the rental income. Buy & hold investors are fairly risk averse and like properties with strong tenants and long term leases. These can include triple-net leased, single tenant properties with 10+ years remaining on their lease agreement.
- Value-Add: A value-add investor is nearly the opposite of a buy and hold investor. They are willing to accept some risk in return for the potential to make a return through both income and appreciation. In a typical value-add transaction, the property is purchased and specific programs are implemented to increase the amount of Net Operating Income that the property produces. These programs can include things like: rental increases, renovations, new tenants, lease extensions, and expense reductions. We are value-add investors of buying assets below market value and using our operational expertise to increase the value before selling at a profit.
Neither strategy is necessarily better than the other so it is important that it aligns with an investors goals and return expectations.
So, when attempting to answer the question “What type of investor are you”, it is important to consider what type of property you want to invest in, which class of that property type is preferred, the vehicle through which the investment is deployed, and the strategy that the investment is made through.
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.
In our investment programs, we tend to employ a “value-add” approach, which means that we typically seek out Class B or Class C retail properties that we can acquire at a good price. Once purchased, we implement a modernization program that includes facade renovations, fresh paint, new parking lots, and the insourcing of all property management activities. Through the combination of these activities, we are able to increase rents and/or refresh the tenant base to improve Net Operating Income and thus a property’s value.
Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our middle market retail investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.