What is Commercial Real Estate
Commercial real estate is simply defined as a property with the potential to generate profit through capital gain or rental income. Commercial property spaces include office buildings, duplexes, restaurants, and warehouses. If you can make money by renting it out or holding it and reselling it, it is considered commercial property.
How does commercial real estate differ from residential properties?
Commercial real estate differs from residential property in four key ways:
Purpose – With the exception of residential rental properties such as apartment buildings, commercial real estate is typically used as a place of business rather than a residence. The purpose of commercial spaces is to provide income for owners and investors.
Price – Commercial properties are much more expensive than residential properties because they are typically larger buildings on large plots of land in heavily trafficked commercial areas, and are thus more likely to be owned by a group of investors rather than an individual.
Occupants – Residential properties are frequently owner-occupied, whereas commercial properties are typically occupied by business tenants who lease the property from the owner or a group of investors.
Lease Terms – Commercial real estate properties typically have longer lease terms than rental residential properties, with retail and office spaces having the longest leases, averaging 5-10 years, as opposed to typical residential apartments or homes, which are leased for six months to a year.
How does investing in commercial property differ from investing in residential property?
While commercial property typically requires a larger initial investment than residential property, the potential rate of return is often higher–but you may also face greater risk, particularly with retail or industrial tenants in an uncertain economic climate. On the plus side, as a commercial real estate owner or investor, you can benefit from triple net leases, which shift financial responsibility for costs such as real estate taxes, maintenance, and insurance to the leasing tenant.
In contrast to residential real estate, most commercial real estate investments do not allow you to live on the property. However, the advantage is that you are typically working with business owners (a B2B relationship) rather than renters (a B2C relationship). Income-producing businesses are more likely to follow lease terms and pay rent on time. Longer lease terms in commercial real estate can provide more consistent cash flow, and tenants such as government agencies and healthcare providers can provide stability even in an unstable economy.
On the downside, investing in commercial real estate can be more difficult than investing in residential properties. Most commercial investors have a background in commercial property law or have a team of commercial property experts on hand to help them navigate the red tape that comes with the commercial real estate industry.
What are the different kinds of commercial real estate?
- Office Spaces – Office buildings are generally divided into two types: urban and suburban. Urban office buildings are found in cities and include skyscrapers and high-rise properties, some of which can be as large as several million square feet. Suburban office buildings are typically smaller in size and are sometimes grouped into office parks.
Office buildings can be multi-tenanted or single-tenanted, with many being built-to-suit. They are also divided into three tiers: Class A, Class B and Class C. The Building Owners and Managers Association International (BOMA) elaborates:
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Class A – The most prestigious buildings compete for premier office users, with rents that are higher than the local average. Buildings feature high-quality standard finishes, cutting-edge systems, excellent accessibility, and a strong market presence.
Class B – Buildings compete for a diverse range of users, with office spaces renting at the area’s average rate. The building finishes are average to good for the area. The building finishes are acceptable for the area, and the systems are adequate, but it cannot compete with Class A at the same price.
Class C – Buildings competing for tenants requiring functional space at rents lower than the local average. Medical office buildings are a niche sub-sector in this market.
- Retail Spaces – Retail refers to the commercial spaces that house the retailers and restaurants we frequent. They can be multi-tenant (with an anchor, or lead tenant, who drives traffic to the leased property) or single-use, standalone structures.
The retail industry is complicated because the type of shopping centre is determined by a variety of factors, including size, concept, types and numbers of tenants, and trade area.
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Big-box centres (with a national chain such as Target, Walmart, Best Buy, or Dick’s Sporting Goods) and pad sites (single-tenant buildings within a shopping centre, often a bank, restaurant, or drugstore) are examples of single-tenant buildings.
- Industrial Spaces
Industrial buildings house industrial operations for a variety of tenants and are typically located outside of cities, particularly along major transportation corridors. Low-rise buildings can also be organised into industrial parks. The properties are divided into four categories:
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Heavy Manufacturing – These buildings are highly customised and house the machinery that manufacturers require to operate and produce goods and services.
Light Assembly – These are not as personalised and can be used for product assembly or storage.
Bulk Warehouse – These properties are typically large and serve as distribution centres.
Flex Industrial – These properties feature a mix of industrial and office spaces.
Keep in mind that industrial land use has its own set of zoning laws, such as research and development (R&D) facilities, which require a specialised type of industrial zone.
- Multifamily
Commercial real estate is defined as any residential property with five or more units owned by a single entity. The multifamily sector includes all types of residential real estate other than single-family homes, such as apartments, condos, co-ops, and townhouses. Multifamily property, like office buildings, is frequently divided into three classes: A, B, and C.
Apartment rental buildings, in particular, are classified into several property types. Freddie Mac has divided them into six distinct buckets:
High Rise – A building with at least nine floors and one lift.
Mid Rise – A multistory building with an elevator, usually in an urban setting.
Garden-Style – A one-, two-, or three-story apartment development constructed in a garden-like setting in a suburban, rural, or urban location; buildings may or may not have elevators.
Walk-Up – A four to six-story building with no elevator.
Manufactured Housing Community – A community in which the operator rents out ground sites to owners of manufactured homes.
Special Purpose housing – A multifamily property of any style that caters to a specific population segment, such as student housing, senior housing, and subsidized (low income or special needs) housing.
- Hotel
The hotel industry includes establishments that provide lodging, meals, and other services to travellers and tourists. The hotels can be independent (boutique) or flagged, which means they’re part of a major hotel chain like Marriott or Sheraton. Real Capital Analytics divides them into six different categories:
Limited Service – There is no room service, restaurant, or concierge on site.
Full Service – Includes room service and an on-site restaurant.
Boutique – Located in an urban or resort setting, offers full-service amenities, is not a member of a national chain, and has fewer rooms.
Casino – Includes a gaming component, such as video poker or slot machines.
Extended-Stay – Limited service, with fully equipped kitchens in guest rooms and larger rooms for extended stays.
Resort – Full-service, on a large plot of land in a typical resort setting (such as Hawaii or Orlando), with an attached golf course, water park, or amusement facility.
- Special Purpose
Commercial real estate investors may own special purpose real estate, but it does not fall into any of the previously mentioned sectors. Special-purpose facilities include open land for fairs, amusement parks, churches, self-storage, and bowling alleys.
What is the best way to get into the commercial real estate industry?
If you want to diversify your portfolio by investing in commercial real estate, you should first understand the various types of investment options.
Direct Investment – Direct investment is the most straightforward way to invest in commercial real estate, assuming you have a lot of money and knowledge. With a direct investment, you will work with a real estate agent or broker to find a property to buy, after which you will have the option of leasing it out and managing it yourself as the landlord or hiring a property manager.
In-Direct Investment – If you don’t have a lot of money and don’t know much about commercial real estate, you can still invest in it indirectly. REITs, crowdfunding, and exchange-traded funds (ETFs) all allow you to invest without taking full responsibility for the leased property. Rather than buying a property, you can invest in a company that buys, sells, and leases commercial properties. As a limited partner, you will receive a portion of the investment returns without being involved in day-to-day commercial property operations or decisions.
Types of Indirect Commercial Real Estate Investment
Real Estate Investment Trust (REIT) – REITs are companies that purchase commercial real estate properties and lease them to tenants. REITs issue shares to qualified investors (such as mutual fund managers and other professional investors) and then pay out 90% of profits as dividends to shareholders. REIT investment is a more liquid form of property ownership because its shares can be easily bought and sold.
Crowdfunding – Commercial real estate crowdfunding, like traditional crowdfunding, allows a group of people to pool their resources to fund a large project, such as the purchase of a commercial property. Crowdfunding requires a lower initial investment than other types of CRE investing, but it is not strictly regulated, so investors must be accredited by the Securities and Exchange Commission.
Exchange Traded Funds (ETFs) – An REIT ETF operates similarly to a mutual fund, but because it is publicly traded in the stock market, its value fluctuates more frequently than a mutual fund. An REIT ETF typically consists of a collection of REIT securities rather than stocks and has lower overhead fees because the securities are not traded individually.
Commercial real estate investment benefits and drawbacks
Weighing the benefits and drawbacks of investing in commercial real estate can help you decide if it’s the best option for you.
Traditionally offers a strong return on investment, especially in areas with high demand and low inventory.
Longer lease terms than residential real estate provide greater cash flow stability.
Can offer both short-term cash flow from leasing and long-term returns from capital gains over time.
Provides a more diversified portfolio and may give you greater control over ROI.
During an economic downturn, sectors such as government and healthcare can provide greater stability.
Cons of Investing in Commercial Real Estate:
Buying and selling are long processes, making it less liquid than other investment vehicles.
Buying a property outside of a partnership or publicly traded REIT may necessitate a larger initial investment.
Can be highly susceptible to economic downturns, especially in retail and small businesses.
Because different commercial tenants have different space layout needs, tenant turnover can be time-consuming and expensive.
Direct investing necessitates an understanding of commercial real estate laws, regulations, and best practices.
Conclusion
Commercial real estate provides a diverse range of profitable opportunities for owners, investors, and tenants, but it is not for everyone, Learning more about the CRE industry can help you better understand its intricacies and open up new opportunities for diversifying your portfolio or expanding your business.
Stay up to date on what’s going on in the commercial real estate world by reading the latest CRE news on the FloorTap.
