Commercial real estate (CRE) is different than the stock market. The appeal of commercial real estate is its potential to generate higher investment returns, potential consistent returns, passive income, tax benefits, and appreciation. It is important to understand that not all commercial investments are equal, so you need to learn what is considered a commercial real estate investment and the different kinds of CRE.
CRE involves the purchase or development of multi-family units, such as apartments, properties leased out for business or retail purposes, or specialty use buildings, among other types. Raw land for development also qualifies as CRE if it is intended for commercial development.
There are many kinds of commercial real estate. Some of those include:
To learn more about the different kinds read our article on “What is a Commercial Real Estate Investment”.
There are a wide variety of investment opportunities to accommodate for the broad range of investor needs. These can be generally sorted into active and passive investments.
In an active commercial real estate investment, one or more investors come together to purchase property directly for their portfolio. The investor or investors control the property identification, selection, financing, and property management. This approach may yield favorable results, but it can be time consuming and benefits from experience and expertise at every step.
Active investors must also find and assess their commercial real estate properties themselves. This can be a time-consuming step in the process that includes items such as analyzing financial statements, making projections, reviewing existing lease terms, and negotiating purchase prices, as well as understanding market conditions and trends.
Once a property is found, the next step is to purchase the property. As an active investor, you must either arrange financing or pay for the property in cash. Arranging for financing includes activities such as presenting deals to potential lenders, negotiating the required down payment and interest rates, gathering documents the lender requests, and responding to lender questions and concerns. This step is also time-consuming.
An active investor must also develop steady cash flows on their own. Once the property is purchased, the work of property management begins. This is an ongoing activity. Property management may include activities such as collecting rent, routine repairs and maintenance, and managing leasing activity, which includes keeping vacancy rates to a minimum. Some investors outsource this to a third-party property manager.
A passive commercial real estate investment is a suitable alternative for those who do not want to or do not have the time to have to deal with the day to day management of their investment, or cannot buy the properties outright. It includes the same steps as active investment, except these steps are done by someone else. A passive investment provides all the benefits of active CRE investments without the hassle of managing it.
There are two common paths investors can take to gain CRE assets. These are:
Their primary advantages are tax benefits, including depreciation, and cash flow. For example, REIT investments are not taxed at the corporate level so there are no corporate taxes. The property cash flow is instead distributed to investors. Depreciation allows investors to deduct the cost of acquiring an asset over a period of time.
Private equity firms are similar to REITs because both deploy investor capital into commercial real estate assets. However, they are structured differently.
Private equity investments come in two different types: funds and individual offerings. Under the fund structure, investors contribute capital for the general purpose of investing in commercial real estate. Each fund specifies what type of commercial real estate they invest in, like an REIT. The fund also decides how the capital will be deployed within the guidelines of the private placement memorandum.
Private placement memorandums (PPMs) detail the agreement between the investor and the private equity offering, including the terms of the offering, the risks of the investment, how the investor’s money will be invested, and how the investor will receive potential profits, among other things. Simply put, it describes the investment.
Under the individual offering structure, capital is raised to purchase a specific property. Investors know exactly which property their money is going toward.
Private equity offerings share similar tax benefits with REITs but focus on funding investments as needed, unless it is a fund. REITs are typically ongoing, so when you invest, it is a continuous process of buying and selling properties. With private equity offerings, investors can choose whether to participate in an investment or not, allowing them a chance to assess the risk. REITs may also offer this benefit.
Crowdfunding is one place you can find private equity commercial real estate offerings. Websites, such as CrowdStreet or RealCrowd, act as marketplaces where investors can look for investing opportunities and join in at their discretion.
For CRE investment beginners, the primary benefit of working with either REITs or private equity firms is not having to fund the purchase of the entire property. Both passive investment vehicles also provide you with the ability to access and use the knowledge, experience, expertise, and connections in pursuit of a high rate of return, as well as portfolio diversification.
When choosing a REIT, private equity firm, or crowdfunding venture, it is a good idea not to jump in with the first company you find. Take the time to research each company or group, including their past offerings, realized returns, and testimonials from others who have invested with them. You can also ask what their due diligence process is like for choosing which investments to buy.
During your research, also consider assessing the group’s trustworthiness by doing research in areas like:
You should also understand that not all property types are the same. There are a variety of asset classes within commercial real estate. The supply and demand, yield, and overall potential profitability of each sector may vary greatly.
Income from commercial real estate investments is also dependent on the type of property, its location, condition, the tenants it is trying to attract, how well it is managed, the retention rate, and the cost put into the property. The tenant type also matters. For example, tenants looking to rent corporate offices will be different than those looking to rent a multi-family unit.
Active investors will have to do this research themselves, including which properties they want to invest in and how to invest in them. This approach takes time, especially if you do your due diligence.
Meanwhile passive investors leave the research to the REIT or private equity firm. These companies look for which properties to invest in, do the research on the property’s location and other important factors that determine potential profitability, and often have a type of CRE asset they specialize in.
Before you begin investing, outline a clear picture of your finances. You should consider how much money you have available for investments, and whether you are purchasing in cash or through a loan if you are an active investor.
Active investors often handle their own finances, including the acquisition of the loan or paying for the property outright. This also means they must handle the legalities of purchasing the property.
Passive investors allow the passive investment vehicle, whether a REIT or private equity firm, to handle the purchasing and managing of the property. There’s also more flexibility with how much you choose to invest, especially since there are often multiple investors funding the
investment in this property. If you are not under the fund structure, you can even choose which property to invest in.
Both active and passive investors should consider which markets they wish to invest in. They also need to consider what types of properties they are looking to purchase Sometimes, this requires guidance. Active investors are responsible for determining whether they need expert guidance as they learn the market.
Financial research and analysis is a necessary step. Every type of property is different. When choosing a property, active investors keep in mind that it’s an investment in a specific geographic area with its own unique supply and demand. While some properties may seem to do well on a macro-level, but there may be an oversupply of that property in the area an investor was considering. Comparable properties, referred to as “comps,” are also a part of this process. This refers to analyzing the prices paid for recently sold properties that are similar in location, size, and asset class.
Active investors must also understand market cycles. Analyzing and understanding the market cycles helps avoid buying when the market is high, which may force investors to sell later when the market is low. Knowing specific indicators of the various market cycles will also help determine what opportunities for investing are available at that time.
Passive investors still benefit from an understanding of the type of property or area they are investing in, as it can help them feel like they are investing in a good property or fund. Private equity firms source the property first, which may allow investors time to do their own research if they choose.
The due diligence period is the time in which a prospective buyer can conduct thorough research on an investment opportunity per the purchase and sale agreement. This can include reviewing their historic property financials, reviewing leases, market research, determining financing options, conducting property inspections, speaking with tenants, getting a property condition report, appraisal, and environmental study, as well as a feasibility study, or any other necessary research needed to ensure the property is a good investment.
Active investors have to perform or coordinate this research themselves. It can be a time- consuming task, especially if investors want to ensure they are being as thorough as possible. Too often, new investors are so excited about purchasing their first CRE investment, they miss something in their due diligence. This is why active investors may benefit from having a firm understanding of what needs to be investigated, carefully analyzed, and inspected before making a purchase.
It’s recommended that investors do not rush into a deal. It is better to lose out on the deal than to enter one they are not prepared to handle. Mistakes can be avoided by having a due diligence checklist for the specific CRE property type you are interested in. This can decrease the chances that nothing goes unaddressed and allows the investor to learn as much as they can about the property.
For passive investors investing through REITs or private equity firms, the due diligence required includes thoroughly vetting the company or person handling their investment. The REIT or private equity firm then handles the due diligence regarding the property or properties, which investors may ask to see. Investors often want to see this due diligence to better understand their investment. For passive investors, there is still a good amount of due diligence needed from the sponsor to the offering documents of the properties themselves.
It is a good idea to look for an expert in the market regardless of whether you are still browsing possibilities and considering the types of investments you want to make. Even if you you already have a clear direction in mind, consulting with an expert is encouraged.
For active investors, this could look like hiring a broker or working with a financial advisor. As an investor, however, you are still responsible for all the previous steps before this point.
Passive investors trust the expertise of the firm. With the PPM, investors know the terms of the offering, where their money is being invested, how they will receive potential profits generated by cash flow, and other important information about the investment.
The right success metrics include, but are not limited to, projected occupancy and rental rates, projected net operating income (NOI), projected cash available for distribution, and projected sale price.
For example, net operating income provides investors with an estimate of how much they may potentially make or potential have made on an investment, subtracting all the necessary operating expenses.
There is always some uncertainty with an investment. One way to potentially account for the unexpected or unknown factors is to consider cost contingencies. These are additional funds set aside as part of your initial acquisition costs to help with unexpected expenses that may arise. This can also be used to help cover your debt service until the property is stabilized.
Another best practice is to create a capital reserve or replacement reserves fund. This is an account with money set aside for long-term improvements.
Because active investors are more than likely involved with their investments, they need to consider a contingency fund to manage the property, including unexpected repairs, maintenance projects, and improvements made to the property.
Passive investors allow the REIT or private equity firm to manage the property, so that they, as the investor, have a fixed level of investment. With private equity firms and REITs, your investment is the only cost you have to worry about regarding the property because you typically only lose what you invest, in comparison to active investors who may take on a larger risk. The fund is generally responsible for ensuring all real estate activities, including acquisition, financing, redevelopment, and ongoing property management are conducted as agreed upon. These deals also tend to have reserve funds set aside or lines of credit available if needed.
There can be uncertainties with timelines. Investors may set unrealistic timelines to build, renovate, fully lease, or reach market rents for their investment. New construction, renovation, increasing rents, changing management, and other property management activities take time and are not guaranteed to stick to the schedule.
An active investor directly deals with these setbacks, especially if they are managing their own property. Other potential setbacks may include the time needed to negotiate leases, build tenant relationships, and research zoning and permits prior to any potential renovations. Passive investors, while not necessarily active in managing the property, are also directly affected by these obstacles because their potential returns may be slowed if things go longer than initially planned.
It is a good idea for both active and passive investors to try and identify any potential obstacles during their due diligence period, so that they may prepare for them as part of their contingency costs or with a plan of action should delays occur.
If you are a passive investor investing through REITs or private equity firms, make sure to be flexible in your return expectations and timelines. Property performances can fluctuate due to economic factors, market cycles, or challenges that happened after the acquisition.