Commercial Real Estate Investing: The Basics
Real estate investing involves the purchase, ownership and management of buildings and land with the intent to make a profit. There are two major categories of real estate: residential, and commercial. Both are great entryways to build wealth. Commercial real estate investing, in particular, is known to provide some of the highest return on investment (ROI). For those looking to diversify or move away from solely investing in stocks, bonds and other alternative investments, this guide will outline everything you need to know to confidently invest in commercial real estate.
What properties are considered commercial real estate?
Commercial real estate properties serve a broad range of businesses and it is important to understand the major groups.
• Office • Retail • Multifamily • Industrial • Special purpose
1. The Office
Office space is the most common commercial real estate and can range from a single tenant medical office to a high-rise building. They are divided into three classes: A, B and C.
Class A commercial real estate properties are located in the most desirable areas. They are typically newly built or recently renovated with highly desired amenities. These properties are managed by professional real estate management companies.
Class B commercial real estate properties are generally older properties that require some type of capital investment. These properties are well maintained and managed, and in good locations. They often require minor repairs and maintenance. This property type is a popular investment target for commercial real estate investors.
Class C commercial real estate properties are located in undesirable locations. They require massive amounts of capital investments. These properties have high vacancies, and turnover of tenants compared to Class A and Class B properties. Class C properties in good locations are usually targeted for redevelopment opportunities.
Retail properties are quite popular with commercial real estate investors. They range from small strip malls (consisting of smaller mom and pop businesses), community retail centers (developments anchored by a large grocery store, for example), banks, restaurants, and malls. They are often located in high traffic urban areas with high visibility. The size of these properties can range from 2,500 square feet to 500,000 square feet and beyond.
Multifamily buildings are designed for housing that contain multiple units, such as apartment complexes. The moniker stems from the multiple rentable living spaces in each building.
Investors in this category should keep in mind that residential tenants usually have shorter lease terms than office and retail, and thus tenant turnover is higher. Even with higher turnover rates, multifamily is one of the most stable commercial real estate investments. Lastly, this category tends to provide lower yields even though it is considered a safer asset class.
Industrial property is used for industrial purposes. While that may sound simple, industrial properties come in all shapes, sizes, and purposes. And they can cover a range of business types. Industrial buildings are broken down into three sizes: small, medium and large.
Small industrial sites can be one story or two story buildings zoned for industrial use. These often have a mix of warehouse, office and flexible interior space. Small businesses such as mechanics, research laboratories, and startups all use smaller buildings with flex spaces.
Medium industrial properties are generally used for warehouses and factories that are designed to manufacture and store goods. This group includes distribution companies and third party logistics companies.
Large industrial properties are designed as big box industrial spaces. These enormous industrial spaces are used as logistics and distribution centers. As in, these buildings can hold and distribute finished goods to stores and or directly to customers. An Amazon warehouse is a good example of a large industrial property.
5. Special Purpose
Special purpose real estate is designed for a specific use. So much so, that it would be difficult to repurpose the use of that property for another business. The hospitality and leisure industry (hotels, sports stadiums, amusement parks, etc.), car washes, self-storage, and churches represent a big segment of the special purpose classification.
Mixed use development, which is any combination of retail, multifamily and hospitality together, is another segment of special purpose real estate. An example of a mixed use complex is retail businesses on the first floor and apartment units on the second floor. Mixed use developments have become quite popular in recent years because there is more public demand for these trendy developments.
Finally, across these groups is another category of commercial real estate: Owner Occupied Real Estate.
Owner occupied real estate is when investors purchase real estate property with the intent of utilizing the building for their own purpose or business. Occupying real estate as an owner can be of great benefit in terms of building wealth, and equity. There are also several tax benefits in this strategy. This category can be applied to any of the classifications mentioned above.
Why should you diversify your portfolio with Commercial Real Estate?
While public market investments (stocks, bonds, REITs, ETFs and mutual funds) are more liquid, investors pay a premium for this flexibility and don’t achieve steady pay outs like they can when commercial real estate income and valuation increases. Public market investments are tied to geopolitical events and the news cycle. Private real estate is not subjected to the same daily market dynamics. Investing in commercial real estate can be highly rewarding personally and financially when done with the right strategy. It is a historically great way to build future wealth and income. It is also an avenue to reap tax benefits and achieve investment and income diversification.
How do you profit from commercial real estate investments?
Cash Flow: Commercial real estate can provide a steady stream of income due to longer lease terms. Usually, they range from 3 to 5 years. Longer lease terms provide opportunities to negotiate rent based on factors such as inflation and anticipated increasing operating expenses. There are many lease types but the one of the most popular is the triple net lease where the tenant pays for property taxes, insurance, and maintenance costs. Which relieves the owner of these costs leading to an increase in owner benefit.
Tax Benefits: Owning commercial real estate also has tax benefits such as depreciation expense. Depreciation expense is a non-cash expense that can be deducted by the owner from the net operating income. That expense can reduce the taxable income of the owner significantly and can also be used against other passive income streams.
Competition: Commercial real estate is driven by data (leasing activity, market absorption, etc) and market dynamics. These factors are tracked and impact investment decisions and enable owners to enter the market at opportune times. There is also a level of difficulty in investing and developing commercial real estate and so this space tends to be less saturated compared to the single family residential sector. Less competition and the ability to make informed strategic moves increases investor payouts.
Lease terms: Longer lease terms, as mentioned before, is one of the biggest perks to investors in commercial real estate. Most tenants are locked into leases for a minimum of 3 to 5 years. This leads to longer and higher cash flows when compared to any other investment sector. Lease lengths and resulting cash flows enables owners to project out incomes and expenses.
Investors who understand the components, dynamics and profitability of the market can make educated investment decisions. Commercial real estate will not only diversify a portfolio but add to its ROI. Commercial real estate generates cash returns, is stable and builds equity unlike other investment sectors.