Understanding commercial real estate and commercial real estate investing can help investors earn high returns.
Commercial real estate is a large market, estimated at $3.6 trillion in the US as of 2020. There’s great investment potential, so let’s take a look.
What is Commercial Real Estate?
One characteristic of commercial real estate is that it is diverse. Many people without a more detailed understanding of this real estate sector usually think of commercial real estate as retail locations — physical brick-and-mortar stores set up to sell tangible goods of some kind. Customers walk in, buy, and walk out. This covers restaurants, food service businesses, as well as convenience stores, department stores, big-box stores, and boutique retail merchants.
However, it by no means covers the entire sector of commercial real estate.
Other types of commercial real estate may be oriented toward industrial manufacturing and production. Maybe no customers visit the site, but it's a building where products are created. There is also another set of commercial real estate for wholesale, warehousing, and inventory purposes.
Commercial real estate also includes multi-family rentals as well as commercial offices and healthcare facilities.
All of this combines to form a market estimated at $3.6 trillion!
Let's take a detailed look at commercial real estate and what it represents in the overall real estate market.
Four Types of Commercial Real Estate
Experts often identify four (or possibly more) particular categories of commercial real estate in local markets.
Multi-family rental
One form of commercial real estate is multi-family real estate. This consists of apartments, townhouses, detached or semi-detached units (although these may be otherwise classified), and other types of housing on a single development footprint.
Retail
Another form of commercial real estate is retail. Brick-and-mortar stores are giving way to the phenomenon of online e-commerce, but there's still demand for retail space in a given municipality or neighborhood.
Office space
Office real estate is another type of commercial real estate. It is sometimes referred to as corporate real estate holdings.
Industrial use
Lastly, there's industrial real estate, oriented towards industrial manufacturing and production.
Some experts also add other kinds of specialized real estate, including hospitality real estate and mixed-use projects.
Three Classes of Commercial Real Estate
Commercial real estate also falls into three classes or grades that help agents and others represent property values and individual holdings to stakeholders.
Class A Commercial Real Estate
Class A real estate represents the best buildings in terms of:
Age of the building
Involved infrastructure
Building aesthetic
Location
New buildings are often regarded as class A commercial real estate. They've been specially designed according to modern code and outfitted with all that modern retail or commercial tenants might need. These buildings look good, need little maintenance, and with proper development guidance, they are well located for commercial use.
Class B Commercial Real Estate
Class B commercial real estate properties are not as attractive as Class A properties but are generally more attractive than class C properties.
A typical class B commercial real estate property has some age but is generally in decent condition. Some may call these "legacy properties" because they have been operational for some time, have normal wear with age, and have a design and construction that is perhaps a little obsolete compared to a class A property.
Class C Commercial Real Estate
Class C commercial properties may be in poor locations for business use and may need quite a bit of maintenance. These are buildings that buyers may see as fixer-uppers and are not as attractive for move-in-ready commercial tenants.
One way to compare class B and C properties is that class B properties may generally look okay without being considered prime commercial real estate. Class C properties will often have evident maintenance needs.
Class C properties are also often located away from prime commercial real estate areas.
Whether they are in cities, towns, or other areas of the country, many municipalities have developed master plans or comprehensive plans that drive business development. These plans often reference key business zones that are more conducive to commercial uses.
Class C properties are generally away from these prime areas, and therefore are less valuable for business use.
To further understand comparative classes in commercial real estate, it might help to look at the infrastructure example a little closer.
For instance, class C properties may not have elevators or lifts. They may not be air-conditioned or climate controlled. These factors can make a big difference in their commercial or business use and financial attractiveness.
Just as class A properties are often built to modern code, they will also have an array of working features and accessories that make them attractive.
These three primary classes of commercial real estate help agents, buyers, and others, value individual properties for commercial operations and leasing or purchase.
Another example is the location of commercial buildings near transportation access like freeway exits or rail lines. Again, new construction often represents class A in that it is placed near new highway infrastructure or other access to transportation hubs. In contrast, class C buildings may be stuck away in areas without much transportation access.
Why do people invest in commercial real estate?
There are several reasons to invest in commercial real estate. Let's look at some of the common motivations for commercial real estate investment.
Portfolio diversification
All sorts of investment experts underline the need for a diversified portfolio. As they explain, portfolio diversification protects investors against volatility and big market changes.
The simple way to explain diversification is that it helps you avoid putting all of your eggs in one basket. Looking at it from a market perspective, you could say that investing all of your money in single equity exposes you to significant potential loss if that single equity's value drops quickly.
While certain asset classes of investment allow investors to diversify further.
For instance, take a money manager or investor with 20% or 30% of their entire holdings in equities and 20% or 30% in bonds. That account is diversified against massive fluctuations in the stock market exchange where the equities are held. But real estate is its own additional diversification because the underlying assets have their own value that's not connected to the stock market.
Along with new kinds of alternatives like cryptocurrencies and different technology-related funds, real estate is its own unique component of a diversified investment portfolio.
Earning returns
Another reason to invest in commercial real estate is that multiple types of gains can be earned from your investment capital.
There are two fundamental types of gains in the commercial real estate world. Operational gains or money that comes in through leases or rent payments from tenants. The other type of gain is the money (capital appreciation) that commercial real estate investors can make through resale.
These two types of gains provide both ongoing near-term incomes, and as well as longer-term capital/equity appreciation.
Potential Tax Benefits
In some cases, investors may purchase commercial real estate for passive investment reasons.
One way to explain this is that commercial real estate holders can get certain tax advantages by estimating and reporting property depreciation. So, in that sense, the motivation is less related to collecting money on the value of the purchase than it is to be used as a tax strategy.
A Passive long-term investment
Others who talk about commercial real estate investment may refer to them as passive long-term gains from real estate value in a particular area.
This type of capital gain is, again, unique in that it's related to the underlying value of the property itself. Properties gain value differently than other discrete and tangible asset classes do.
Hedges against recessions
Along with diversification, commercial real estate can offer a form of a hedge against recession.
This can be explained by the essential nature of many commercial properties and practices. In other words, if there is a recession and the equity market tanks or commodities are less valuable than they were before, commercial real estate retains its value because people still need to work and shop for goods and services.
Direct and Indirect Commercial Real Estate Investment
There's also a major strategic difference between the two fundamental kinds of commercial real estate investment. Investors may choose direct or indirect real estate investment based on factors such as:
Their cash position
Their desired exposure to property management responsibility
The volatility of a real estate market
This decision affects the outcomes of an investment play.
Direct real estate investment
In terms of commercial real estate investment, direct investment is the type of real estate investment that most people are familiar with.
Someone who consults an agent or buys a commercial real estate property outright participates in direct commercial real estate investment.
In a direct real estate investment, the buyer controls the underlying holdings in some manner. Landlords are direct real estate investors, and so are the companies that purchase individual properties to hold or flip.
Indirect real estate investment
Indirect commercial real estate investment is different and often much more sophisticated.
The indirect commercial real estate investment strategy involves getting access to holdings related to real estate value in more subtle ways than buying a property outright.
One example is the emergence of an instrument called a real estate investment trust or REIT. These real estate funds enable investors to buy into an investment basket containing holdings representing a small portion of some real estate property.
For a more concrete example, we can look at what some sovereign wealth funds do worldwide. A sovereign wealth fund in an Arab Gulf state like Qatar or UAE, for example, might purchase a REIT that makes them a partial owner of a U.S. real estate landmark like the Empire State Building.
That party did not purchase the property outright and is not the only owner. They only have partial ownership through the equity or holding represented in the real estate investment trust or another fund.
Today's modern real estate investment market offers investors many opportunities to obtain these kinds of indirect and usually "weighted" real estate investments.
Pros
Hedge against the market – the diversification mentioned is a key part of the benefit of buying commercial real estate, either directly or indirectly. When equities fall, the real estate holdings are less likely to devalue at the same time.
High-yield investment – as mentioned, the combination of operational income and long-term projected income from resale can offer investors attractive gains on many commercial investment properties. Commercial real estate investors can often obtain ongoing stable income from long-term real estate tenants. In other words, businesses are more likely to stay in a lease for a longer period of time than customers in the residential rental market.
Capital appreciation over time – then there's also the building's appreciation and the property's gain in value over time.
Cons
Capital-intensive investment – commercial real estate requires quite a bit of upfront money to invest, especially if you're going to invest directly. Equities or bonds may be more attractive options to those investors with smaller amounts of cash to apply to investment strategies. However, buying into REITs or Real Estate ETFs represent lower cost commercial real estate investment options.
More regulation – some investors will also find that there's more regulatory scrutiny on their real estate holdings than there may be with other investments.
Longer term locked-up capital – real estate investment money is often seen as illiquid and locked in for a certain longer period of time. The fix-and-flip strategy can be an exception, but only in certain cases.
Building maintenance and management costs – equities and other types of asset classes have zero building maintenance and management costs. This is not the case for a property. Commercial real estate requires ongoing investment in building systems, including:
Plumbing and electrical systems
Access and weatherization features
Interior infrastructure
All of this requires investors to think carefully about the pros and cons of this type of commercial real estate investment.
Commercial Real Estate Forecast for 2022
Analysts are projecting an "active 2022" for this year's commercial real estate market. Top firm CBRE predicts "a record year of investment activity, with intense investor competition, powered by abundant capital and liquid debt markets, driving up values—even as interest rates rise as monetary policy tightens."
Conclusion
Commercial real estate can be a great way to earn passive income, diversify your portfolio, and hedge against recession. Remember to do your research and know what you’re getting into no matter what asset class you choose to invest in either directly or indirectly.
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*Disclaimer: EquityBrix is not an investment adviser. This information is for educational purposes only and does not constitute investment or tax advice. It’s important to be informed and to make your own investment decisions or do so in consultation with a professional financial advisor. Under no circumstances should this material be used or considered as an offer to sell or a solicitation of any offer to buy an interest in any investment. Any such offer or solicitation will be made only by means of a written online prospectus relating to the particular investment.
FAQs
How do I get into commercial real estate?
Investors should have some upfront capital to invest in the commercial real estate in question. It helps to have a good idea of what's happening in a particular neighborhood market and project whether tenants will be available for a particular building.
How do I invest in commercial real estate?
There are choices to invest either directly or indirectly. Indirect real estate investment is an attractive solution for those with less available cash.
What is a good cap rate for commercial real estate?
A good cap rate for commercial real estate is generally thought to be between 3% and 20%.
