Commercial real estate investments allow investors to diversify their investment portfolios. There are some differences that set commercial real estate (CRE) investments apart from traditional forms of investment, such as stocks and bonds. The most obvious difference is that with CRE investments, investors fund the acquisition of a property, in contrast to buying shares or claims in a specific company. Stocks are considered an investment in a company, or many companies, and those companies’ profits. An investor purchases fractional ownership interest in the company, making them part owners.
While stocks are generally passive investments CRE investments can be either passive or active, depending on how you choose to invest.. If you choose to actively invest in CRE, you may own the real estate outright and need to manage the property yourself or hire a property management company to do it for you. If you are a passive investor, you typically invest through a REIT or private equity firm. In this case, the firm is responsible for the performance of the property. Both types of investments, active and passive, have the potential to generate returns.
Commercial real estate consists of office buildings, retail, multi-family (meaning more than four units) properties, hotels, self-storage, and many other property types. CRE investors lease out and collect rent from businesses or tenants that occupy their property. Raw land may also be purchased for commercial property developments.
Commercial real estate is a property used to provide a workspace, retail space, multi-family residences, or other commercial services to tenants. Often, commercial real estate is rented to generate income.
There are a variety of properties that are considered commercial property. Commercial real estate includes:
With office space, there are Class A, B, and C properties. Class A spaces tend to be the best buildings in terms of looks, age, and quality of infrastructure. Often, they are the newest, most modern of available office spaces.
Class A offices tend to be in a desirable location, or a location with high visibility. They may be considered highly competitive and may have higher rental prices. This competitive market may also lead to high rental rates. An example of a Class A office space would be a modern high rise, such as those seen in a large downtown market or city.
Class B office space tends to be older than Class A, with visible signs of aging. The market for this class tends to be less competitive than Class A office space, but that is not always the case. Spaces in this category are fully functional, with average to above average quality in infrastructure and the interior. Class B rental spaces still have potential to command higher rental prices over Class C buildings. These types of properties can also be good prospects for restoration.
Class C properties are typically the oldest of all three classes, usually over 20 years old. They offer functional spaces, but with old or rough finishes, and basic amenities. Most properties of this class are in need of maintenance and repair. For this reason, Class C office space tends to have lower rental rates and may also be located within less desirable neighborhoods.
Retail properties can range from a single storefront to strip malls, banks, restaurants, and malls. There are two kinds of retail properties: multi and single tenant properties.
Multi-type tenant properties consist of buildings such as community shopping centers. It also includes a single large building with multiple tenants like a mall. Single-tenant properties can be any size, ranging from a small diner to a big box chain store.
These types of properties include apartment complexes, high-rise condos, mobile home parks, and smaller multi-family units. A property qualifies as a multi-family unit if it has more than one unit to rent, but it can also be considered a commercial property if it has more than four spaces. Many former residential investors get their start in commercial property investment by expanding into larger, multi-family properties.
Industrial properties typically include warehouses or large manufacturing sites. While these types of buildings are usually geared toward manufacturing industries, the properties have recently been leaning toward e-commerce and last mile distribution uses.
Industrial buildings tend to offer spaces with height specifications and the docking availability needed for these types of industries.
There are two categories within hotel and resort properties: independent and flagged. Independent hotels and resorts are typically unaffiliated, privately-operated businesses, while flagged hotels and resorts are part of a chain or group of hotels.
These properties can also be further subdivided into six categories:
There are four major types of senior care facilities: independent living, assisted living, nursing care, and memory care.Independent senior care facilities feature a minimal level of medical care compared to the other types. Assisted living facilities provide live-in care for those elderly who require ongoing medical attention or rehabilitation therapy. Usually, 24-hour onsite care is available.Nursing care facilities support residents with acute medical needs such as a stroke. Meanwhile, memory-care facilities specialize in care for Alzheimer’s and other forms of dementia.Elderly care facilities tend to be privately owned and operated, although many partner with local hospitals or medical schools. You can invest in these types of properties through a real estate investment trust (REIT), private equity group, or other means.
Flexible, or flex, properties are typically a hybrid of office and industrial spaces. Office units are usually offered in one portion of the unit with storage or warehouse are offered in the back. For example, in a single tenant flex property, a contractor may have offices at the front of the unit while using the warehouse space in the back of the building to store needed tools and supplies.
Medical properties are developed specifically for tenants in the medical field to consult with patients and perform medical procedures such as surgeries.
Flex properties tend to attract companies such as construction, manufacturing, e-commerce, medical, logistical distribution, technology, call center, or companies in need of retail and office showroom spaces, among many other industries.
With this property type, tenants do not reside on the property. Units are usually rented out on a monthly or yearly basis and are used to store a customer’s material items.
These types of properties do not fall under the previously mentioned categories. They are usually created for a specialized purpose, such as amusement parks, churches, music and concert halls, sporting stadiums or arenas, and parking garages.
Investing in CRE has potential financial benefits. Commercial properties potentially provide tax benefits, including depreciation, cash flow, appreciation, investment portfolio diversification, inflation protection, in addition to having a tangible asset.
Depreciation can be used to reduce a property’s tax liability, which reduces the tax burden. It allows you to deduct the cost of acquiring an asset over a period of time. There are also other kinds of depreciation that may benefit you.
In addition to depreciation, capital gains taxes realized upon the sale of an asset can be deferred through the 1031 exchange program if the sale proceeds are reinvested into another like kind real estate property .
CRE investments offer potential steady income that can be higher than typical yields on stocks and bonds. This income can potentially provide protection and diversification against the more traditional and volatile financial markets, among other benefits. Part of this income can be categorized under cash flow.
Cash flow is defined as the money that goes in and out of a business or investor’s portfolio. It is produced through the operation of the commercial property, such as through monthly rental payments that comes from the tenant or multiple tenants. Often, this potential profit reaches investors through dividend distributions if they invest through a REIT, private equity firm, or other investment vehicle.
A property’s ability to generate cash flow depends on several factors, such as operating expenses, debt service and property management. Landlord, or property management, duties can include maintenance and repairs, loan interest payments, rent collection, evictions, finding tenants, and ensuring the property is compliant with all applicable laws at all times.
Maintaining balance between vacancy and occupancy is also part of the management process. The objective is to balance operations in order to maximize income.
Appreciation refers to the increase in a property’s value over a period of time. All types of properties have potential for appreciation in asset value, from raw land to an office building and apartment complexes.
Generally, real estate is a scarce asset since more raw land cannot be “created.” This scarcity increases as the availability decreases because more properties are bought, thus removing them from the market and leaving fewer options available for purchase.
Scarcity often depends on the specific market as well. A supply-constrained housing market in an urban center will value a new apartment building more highly than a rural area would value this building due to high demand, for example.
There are also different markets to consider: primary, secondary, and tertiary markets. Generally, a primary market refers to the center of a major metropolitan zone, where the population is dense and economic activity is high. Examples of primary markets include Los Angeles, New York, San Francisco, Phoenix and Chicago. Typically, real estate is the most expensive in these areas.
Secondary markets are smaller in population than primary markets. Examples of secondary markets include Tampa, Houston, Portland, Seattle, and Miami.
The final type of market, tertiary, is smaller than secondary markets. Examples of tertiary markets include Greenville (NC), Tallahassee, and Colorado Springs. Real estate here tends to be cheaper and less in demand due to a lower population.
Keep in mind, however, that properties can lose value and even the most well-planned investment strategies can’t guarantee gains through appreciation.
Real estate tends to gain value over time. Thus, if you have your investments spread over a mix of CRE asset classes, your overall investment could remain secure and growing. Not only that, but there are several commercial real estate options to choose from. You can choose to invest in a mall, for example, or an office building, or keep your investment smaller by investing in just one condo community. There is a lot of flexibility in what you can invest in and where you can do it.
Overall, diversifying your investments may help you manage risk and may reduce the volatility of assets in your portfolio.
Inflation protection is another potential benefit of CRE investments. Commercial real estate generally takes more time to respond to sudden changes in economic activity, though this isn’t always true. CRE potentially can protect from inflation. Shorter term leases, such as those for multi-family units, are able to provide this protection by increasing rents every year allowing investors to keep inflation risks at bay. Another example of inflation protection are hotels, which can adjust their pricing daily to account for inflation.
For some investors, commercial real estate is attractive because it is a tangible asset. Put simply, an investor can see and touch their asset. Active investors can visit a property before investing in it to learn about its size, condition, location, and other factors that may affect its value and earnings, which can be a reassuring step for some investors. However, this does not offset some of the risks that come with real estate. For example, unoccupied properties may cost an investor money over time. Passive investors entrust the firm or REIT to assess the property beforehand but may still find reassurance in visiting the property themselves.
Regardless of whether you are an active or passive investor, you may also experience pride of ownership. There is joy in knowing you own or funded an income producing property.
No investment is free of risk, even commercial real estate. Past performance of an asset cannot be a predictor of future successes.
Commercial properties may be more expensive than residential ones, meaning they require larger upfront investments if you are an active investor. The number of options that allow investors to pool their money, such as REITs and private equity firms, mitigate the risk
associated with investing in a property by lowering the amount of money investors need to fund the purchase of a commercial asset.
If you are actively investing in a property, rather than through a REIT or private equity firm, you will be responsible for managing the property. Due to size and complexity, some commercial properties require more management oversight than residential types. However, this can be mitigated through hiring third-party managers or management companies.
If you are passively investing in a property, the responsibility of the investment is handled by the REIT or private equity firm. A REIT or private equity firm may hire a third-party management company to maintain the asset. The same risks that affect active investors may also affect passive investors, but it may be through indirect means.
Each commercial property carries a credit risk, which is the risk of a tenant unable or unwilling to pay their contractually obligated rent. In order to mitigate this risk, it’s critical to perform due diligence on the financial condition of each existing and potential tenant. This only applies, however, if you are actively investing in the property. For passive investors the REIT or private equity firm will manage tenant and lease negotiations and contracts.
Real estate markets are dynamic and ever-changing based on broader macro- and micro- economic conditions. Commercial properties may be somewhat protected from these changes due to longer leases, but that is not always the case. For example, a long-term trend has been the shifting of manufacturing jobs from expensive markets in the United States to less expensive markets in China and other countries. As a result, markets that had a strong manufacturing base, such as Michigan, and their associated real estate assets have been heavily impacted in comparison to states without a strong manufacturing base, such as Florida.
Real estate is a highly illiquid asset class. If you are actively investing in a property, this affects you the most, since you are using your own money to fund your investment, while the liquidity of any passive investments depends on its terms.
There are limited buyers and sellers, as well, and if a property cannot sell quickly at market price, the owner faces liquidity risk.
The net operating income, or NOI, represents the income generated by a property after operating expenses. In order to calculate it, you take the amount of income brought in from rent over a given time period and subtract the fees and costs spent on maintaining and owning the property.
Investors use NOI to measure a property’s profitability. Generally, you would want to see a profit, meaning the income generated is greater than the expenses.
This refers to the net amount of money in your pocket after all expenses and any debt, capital improvements, and other necessary costs are paid. Another way to put it is the difference between company cash inflows and outflows over a given time period.
Like NOI, the goal is to see a profit rather than a loss. The amount of cash coming in should be greater than the cash flowing out.
The internal rate of return is used to evaluate the profitability of an investment property over its lifetime. It is commonly represented as an average annual return percentage and can be used to measure the performance of an investment over a period of time.