Investing in Commercial Real Estate: Risks and Rewards
By Percy Nikora, Owner, Co-Founder
Investors looking to diversify their portfolios often consider investing in alternative asset classes. Commercial real estate is one prime example. While it’s considered an “alternative” asset class, there’s no question that it has become more mainstream over the past decade. Nowadays, it’s not uncommon to see large institutional investors, including hedge funds and pension funds from all over the world, vying for prominently located commercial real estate.
There are many reasons for this trend. Namely, investors have come to realize that commercial real estate has significant benefits, from generous tax benefits to strong cash flow and appreciation potential. Commercial real estate also has a low correlation with the rest of the market: given its illiquid nature, commercial real estate is an asset class that does not experience the dramatic fluctuations that stocks, bonds, and other securities tend to witness. Indeed, the broader economy can soften, and commercial real estate can still provide generous returns. As such, investors of all kinds are increasingly adding commercial real estate to their portfolios.
In this article, we look at the basics of investing in commercial real estate, including the many risks and rewards associated with such. Read on to learn more.
Commercial Real Estate Defined
Commercial real estate can generally be defined as any income-producing property. These are properties that can be rented and stand in start contrast to residential real estate, such as apartments, condos and single-family homes.
Commercial real estate is a complex, diverse asset class. At the most basic level, it includes six or so general property types: office, multifamily housing, retail, industrial, hospitality and land development. There are other, specialty product types, such as student or seniors housing, which often get lumped into the multifamily housing category above.
Each property type can be further classified by its property classification: Class A, Class B, or Class C real estate. Class A properties tend to be very well located (e.g., think Manhattan office tower), are in excellent physical condition, have robust amenities, are professionally maintained and have credit-worthy tenants. Institutional investors are usually most interested in investing in stabilized, Class A assets. Class B properties are a bit less attractive. They tend to have higher vacancy rates with less credit-worthy tenants, fewer amenities, and may be older buildings located in secondary markets. Class C properties fall at the other end of the spectrum. Class C buildings are usually in fringe locations, under-occupied with less desirable tenants, and are often in need of wholesale upgrades or renovations. Class B and C properties can still be highly lucrative investments for those interested in improving the properties (what’s known as “value-add”), especially when there’s an opportunity to bring the property into Class A condition.
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Risks of Investing in Commercial Real Estate
There are tremendous benefits to investing in commercial real estate, many of which we’ll get into below. That is not to say, however, that commercial real estate is foolproof. There are a few risks that all investors should certainly be aware of, including:
Most commercial real estate relies on professional, third-party property management. Depending on the type of building, management costs can easily be 10% or more of monthly cash flow. Older properties, particularly those with failing building systems, are usually the most management intensive. Properties that have short-term or less credit-worthy tenants also tend to be management intensive, with property managers having to routinely fill vacancy and/or track down overdue rent payments. Managing commercial real estate certainly isn’t for the faint of heart, especially as calls can come in at all hours of the day.
A common misconception is that commercial real estate is the easiest way to generate passive income. Simply invest and then sit back and relax while the cash flow rolls in. Unfortunately, that’s not quite how CRE investing works. There is, in fact, a great deal of time commitment needed. This includes finding and underwriting various deals. Many investors will look at dozens, if not hundreds, of properties before investing in one. Then there’s a due diligence phase: depending on the type of deal, there may be inspections, environmental testing and more that’s needed prior to closing on the property. After closing, properties need to be marketed, leased, and professionally managed.
Many of these duties can be outsourced to third parties, but that does not mean there is no time commitment needed by the investor. The larger a real estate portfolio grows, the more time is needed to oversee those managing the deals on your behalf.
Aside from those buying one-off or smaller (e.g., 1-4 unit multifamily) rental properties, most commercial real estate investors will need to rely on professional assistance. This includes brokers, lawyers, property managers, contractors and more. Hiring each of third parties has costs associated with it. There’s also the added risk that you’re entrusting major decisions to these people, so it’s important to vet each thoroughly to ensure they are highly capable.
Contact Penn Capital Today for more information on investing in commercial real estate
Benefits of Investing in Commercial Real Estate
One of the primary reasons investors choose to add commercial real estate to their portfolios is because the asset class, generally speaking, tends to appreciate over time. There is no guarantee that this will happen, and will largely depend on the investor’s holding period and time horizon. However, commercial real estate usually increases in value over prolonged periods of time.
Moreover, as rents come in, those payments are applied to the mortgage to help pay down any loans utilized to purchase the property. This combination—paying down debt plus appreciation—can help investors accumulate significant equity in their properties. Investors can then leverage this equity, by refinancing or taking out a line of credit, to make property improvements or to grow their portfolios.
Limited Management Hours
To be sure, commercial real estate investing does require some time commitment. However, the direct management hours are limited, particularly for CRE investors who have substantial portfolios that are managed by third-party property management companies. Properties, especially those that have been newly renovated and are fully stabilized, require direct management on behalf of investors. Moreover, investors who invest in a fund or otherwise in a “limited partner” capacity can take a much more hands-off approach to management. Limited partners are able to defer to the project sponsor (or the “general partner”) to oversee all real estate activities on the investors’ behalf.
Commercial real estate leases are generally much more flexible than residential leases. Residential leases, for example, tend to use a standard form regardless of property specifics. Sometimes these forms are issued at the state or regional level, and are then coopted by individual property owners. But across the board, residential leases tend to be highly governed by local, state, and federal housing regulations.
Commercial Leases are Much More Flexible
Commercial leases can be highly nuanced and uniquely tailored to individual properties and tenanting situations. For example, an office lease might include provisions for the landlord’s fit-out of the space. A retail or restaurant lease, meanwhile, might be structured to have a base rent payment plus a percentage of gross sales above a certain threshold. Investors in CRE can structure their leases in a way most favorable to their needs.
Triple Net Leases
Commercial real estate investors can also take advantage of what’s known as a “triple net” or NNN lease. The NNN lease is the gold standard of commercial real estate. This lease structure makes the tenant responsible for their base rent AND a majority of operating costs, including property taxes, insurance, utilities and maintenance. This even includes standard property repairs associated with the commercial space being occupied. For example, if the HVAC system dies, the tenant in a NNN lease is responsible for its repair. This structure inherently means the base rent, on a per square foot basis, is lower than what it might be in a single- or double-net lease, but it at least takes the ownness out of the landlord’s hands to be responsible for those ongoing costs.
Straightforward Price Evaluations
Another benefit of commercial real estate is that price evaluations, more commonly known as appraisals, are relatively straightforward. Unlike residential appraisals, which rely on a wide array of variables, commercial real estate is priced based on its income-generating potential.
Although there are technically a few ways to appraise a commercial property, most appraisers use what’s known as the “income capitalization” approach. Using this approach, appraisers divide the net operating income of the property by its current market value. This results in a “cap rate” that investors can use to evaluate the merits of a deal. The higher the cap rate, the more lucrative the investment may be. Lower cap rates may be less lucrative in the short-term (in terms of cash flow) but are generally considered “safer” investments.
As indicated above, commercial real estate tends to appreciate over time – especially for those who plan to hold assets for a significant (5+ year) period of time. There will naturally be ebbs and flows in the overall market, but buy-and-hold investors can generally expect to see their properties appreciate in value.
Investors may have heard of “depreciation” as being another benefit to owning commercial property. Interestingly, properties can both appreciate and depreciate in value at the same time. Properties may appreciate in value (i.e. their market value) while simultaneously depreciating, a term that has significant tax implications. Commercial real estate is considered to depreciate over a 39-year time horizon. Investors can “write off” this depreciation proportionally each year, thereby sheltering a significant portion of their positive cash flows.
Investing in commercial real estate is a great way for investors to diversify their portfolios. Most people are taught at an early age to invest in stocks, bonds, and other securities. Few consider investing in alternative asset classes, such as commercial real estate. However, adding CRE to your portfolio is a good way to provide stability, as commercial property is less subject to market fluctuations – at least not to the same extent as traditional securities, which can experience dramatic daily swings. Commercial real estate, because it cannot be purchased or sold with the click of a button, tends to be a more stable asset class relative to other investment alternatives.
Is Commercial Real Estate Right for you?
Despite its many benefits, many people still wonder whether investing in commercial real estate is best for them. There are several things to take into consideration when making this decision.
- How much time do you have? Real estate investing can be time consuming, so factor this into the equation. If you’re looking to be a more passive investor, it’s worth investing alongside others (in a fund or otherwise), thereby taking a limited partner position where you’re at least one step removed from day-to-day decision making.
- What level of risk are you willing to accept? If you’re going to invest in commercial real estate, decide what level of risk you’re willing to take. Those with a higher risk tolerance might steer toward certain property types (e.g. hotel or retail), of certain property classifications (Class A vs. B or C) and in certain locations (primary vs. secondary markets).
- What are the current market conditions? While we’ve noted that commercial real estate tends to appreciate over time, how much it appreciates depends largely on when you purchase. Real estate cycles generally last for about 10-15 years, on average. Investing at the peak may equate to less appreciation over time compared to investing at the trough, with better “deals” to be had during the latter. It is important to consider where we are in any given real estate cycle when deciding whether to invest in commercial real estate. Those with a longer investment horizon will be best positioned to weather the ebbs and flows of multiple real estate cycles.
Interested in Commercial real estate? Contact Penn Capital Today
Commercial real estate is attractive to investors of all kinds. There are opportunities to invest in small properties, such as 10-unit apartment buildings or 5,000 square foot office buildings. There are also ways to invest alongside others in larger deals, such as investing $50,000 of your own money into a fund that is then leveraged to purchase Class A office buildings. Then there are opportunities that run the gamut in between. Ultimately, the goal of commercial real estate is the same across the board: to generate consistent, positive cash flow while building equity in the real estate itself.
If you’re considering investing in commercial real estate, consult with your financial advisor. They’ll be able to provide guidance as to how to create a diverse portfolio that allows for at least some allocation toward commercial real estate.
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