Commercial Real Estate Investing

Commercial real estate (CRE) is an aspect of real estate that primarily involves buildings for commercial purposes such as office buildings, warehouses, industrial property, hotels, malls, medical centers, and apartment buildings. Basically, commercial real estate can be thought of as a property that generates cash flow over a given period of time compared to residential real estate.

Investing in commercial real estate has provided investors with an alternative to investing. Its risk-adjusted returns and portfolio diversification has attracted millions of investors to CRE. Commercial real estate is an investment vehicle that may not be as complicated as others but still requires good knowledge to understand how it works.

Here, we will be discussing the fundamentals of commercial real estate investment, and how you can partake of its benefits as an investor.

Understanding Commercial Real Estate Investing

Commercial real estate investing is an attractive investment vehicle that deals with the commercial aspect of real estate. There are some major differences that differentiate commercial real estate investing from other investment vehicles such as stocks and bonds. While commercial real estate has attractive benefits it is relatively illiquid, unlike stock and bonds which have high liquidity and can be typically bought and sold easily. Commercial real estate is one of the few investments considered as ‘hard asset’ (i.e. a scarce commodity or resource that holds intrinsic value).

Nonetheless, high liquidity public market investments like stocks and bonds, are more prone to high volatility which causes the market to move at a fast pace until it drops in value. On the other hand, private markets are less efficient and slower, but also less volatile and less correlated to the movement of the public market.

Types of Commercial real estate

Commercial real estate is primarily defined by the types of properties listed under it. There many types of commercial real estate, but they can be majorly divided into four main categories: multifamily, office, retail, and industrial purposes.

Multifamily: The properties in this category include residential housing that are only available for rent such as apartment buildings, condominiums, townhomes, and co-operatives. Generally, buildings with more than four units are considered as multifamily property, and the sizes of the units vary. Residential leases can either be short-term or long-term, but typically do not exceed a year. They are more flexible in terms of duration.

Office: This category includes office buildings available for rent or lease. Offices can be classified into high-rises in urban areas such as skyscrapers which come with office parks, and mid-rises in suburban areas. Office buildings range from starting up a small firm to a large company, and they come in different styles and sizes. The lease terms for office real estate are usually longer and come in the range of five to ten years.

Industrial: Industrial properties are primarily used for industrial business operations. This includes warehouses, heavy machine manufacturing, assembly, and research and development buildings. Because of the nature of the business operations, these buildings are not located close to residential areas or retail properties. Their placement is controlled by zoning regulations associated with the nature of their business operations. Lease terms for industrial buildings are typically five years or more.

Retail: Retail real estate includes buildings that provide businesses with enough space to do business on a large scale. They are mostly located within residential or commercial areas in order to effectively conduct business with the public. Common examples are restaurants, coffee shops and stores. Retail buildings can either be large single buildings like retail stores, or large multi-tenant complexes like shopping malls, factory outlets, or shopping centers. Retail leases are typically mid-to-long-term, mostly within the 4-5-year range.

Commercial Real Estate Classes

Commercial real estate typically operates in classes that communicate different levels of quality for commercial real estate property. For example, Class A includes newly constructed buildings with high-quality finishes and set up, located in high-demand areas. They attract the highest rents per square foot. Compared to Class A, classes B, C, D respectively drop in the features that make Class A more desirable.

Based on the different class requirements, tenants also differ. Therefore, different rental property management needs and lease agreements will be attended to different tenants based on their capacity.

How does commercial real estate generate returns?

The fundamental purpose of any investment is to get good returns. When it comes to commercial real estate investing, there are many ways you can earn good returns from it. You can either lease a property and charge tenants and amount in exchange for the property (rental income), over a given period of time; or you can capture property appreciation over time (appreciation and value add). There is also the option of investing in commercial real estate through crowdfunding.

Rental income: This is the most common method of generating returns through real estate. Rental income is a source of cash flow or revenue for the owner of the property. There are various factors that determine what kind of rental payment a property owner can demand from a tenant; they are typically based on the classes of the properties. In addition, commercial real estate’s ability to generate returns is determined by factors such as operating expenses and debt services.

The income generated by rental payment can be considered as passive income, depending on how the property owner decides to establish a management structure of the operations of the building. As a property owner, if it is too much trouble to manage a commercial real estate building by yourself, you can employ the services of a property manager or a property management company.

Appreciation and value add

Another way to generate income from commercial real estate is through an increase in a property’s equity value over the period of ownership. The property owner would be required to be on the look for appreciation opportunities that can increase the value of a property. If properties can gain value, they can also lose value.

Basically, if demand for a property increases due to coming scarcity, there is a good chance that the value of that property will increase and customers will be willing to pay higher amounts than the original purchase price. Generally, real estate belongs to a scarce asset class, ranging from raw land to developed buildings. Scarcity is sure in real estate and it is increased by demand, especially in major cities.

While scarcity can be a force that drives real estate appreciation, it still depends on the marketplace in question. Housing demand in urban areas with limited supply are higher compared to housing markets in rural areas which have more houses but low demand. The availability of the houses is usually not a problem in both markets, but the proximity to urban life.

Appreciation through demand is a good way to add value to a property but it isn’t the only way. Investors can also make deliberate efforts to increase the value of a property. They can do this by refurbishing a building before putting it back on the market to make it more appealing to customers. The property owner can charge higher rents for better-looking apartments compared to worn out apartments.