Commercial Real Estate

• Commercial real estate refers to properties used specifically for business or income-generating purposes.
• The four main classes of commercial real estate include: office space; industrial; multi-family rentals; and retail.
• Commercial real estate provides rental income as well as the potential some capital appreciation for investors.
• Investing in commercial real estate usually requires more sophistication and larger amounts of capital from investors than does residential real estate.
• Publicly traded real estate investment trusts (REITs) are a feasible way for individuals to indirectly invest in commercial real estate.

The Basics of Commercial Real Estate

Commercial real estate along with residential real estate comprise the two primary categories of real estate property. Residential properties include structures reserved for human habitation and not for commercial or industrial use. As its name implies, commercial real estate is used in commerce, and multi-unit rental properties that serve as residences for tenants are classified as commercial activity for the landlord.

Commercial real estate is typically categorized into four classes, depending on function:

1. office space;
2. industrial use;
3. multi-family rental; and
4. retail.

Individual categories may also be further classified. Office space, for example, is often characterized as class A, class B or class C.

• Class A represents the best buildings in terms of aesthetics, age, quality of infrastructure, and location.
• Class B buildings are usually older and not as competitive—price-wise—as Class A buildings. Investors often target these buildings for restoration.
• Class C buildings are the oldest, usually over 20 years of age, located in less attractive areas, and need for maintenance.

Note that some zoning and licensing authorities further break out industrial properties—sites used for the manufacture and production of goods, especially heavy goods—but most consider it a subset of commercial real estate.

Commercial Leases

Some businesses own the buildings they occupy. However, the more typical case is that the commercial property is leased. Usually, an investor or group of investors owns the building and collects rent from each business that operates there. Commercial lease rates—the price to occupy a space over a stated period—is customarily quoted in annual rental dollars per square foot. Conversely, residential real estate rates quote as an annual sum or a monthly rent.

Commercial leases will typically run from one year to 10 years or more, with office and retail space typically averaging between five and 10-year leases. This can be contrasted with more short-term yearly or month-to-month residential leases.

In a 2017 study conducted by real estate market analyst firm CBRE Group, Inc., analyst Alex Krasikov found that the term—length—of a lease was proportional to the size of the space being leased. Further, the data showed that tenants would enter long leases to lock in prices in a rising market environment. But that is not their only driving factor. Some tenants with requirements for large spaces will enter long leases due to the limited availability of property that matches their needs.

There are four primary types of commercial property leases, each requiring different levels of responsibility from the landlord and the tenant.

• A single-net lease makes the tenant responsible for paying property taxes.
• A double-net (NN) lease makes the tenant responsible for paying property taxes and insurance.
• A triple-net (NNN) lease makes the tenant responsible for paying property taxes, insurance, and maintenance.
• Under a gross lease, the tenant pays only rent, and the landlord pays for the building’s property taxes, insurance, and maintenance.

Managing Commercial Real Estate

Owning and maintaining leased commercial real estate requires full and ongoing management by the owner. Property owners may wish to employ a commercial real estate management firm to help them find, manage, and retain tenants, oversee leases and financing options, and coordinate property upkeep and marketability. The specialized knowledge of a commercial real estate management company is helpful as the rules and regulations governing such property vary by state, county, municipality and industry, and size.

Often the landlord must strike a balance between maximizing rents and minimizing vacancies and tenant turnover. Turnover can be costly for CRE owners because space must be adapted to meet the specific needs of different tenants—say if a restaurant is moving into a property once occupied by a yoga studio.

Investing in Commercial Real Estate

Investing in commercial real estate can be lucrative and serve as a hedge against the volatility of the stock market. Investors can make money through property appreciation when they sell, but most returns come from tenant rents.

Direct Investment

Investors can use direct investments where they become landlords through the ownership of the physical property. People best suited for direct investment in commercial real estate are those who either have a considerable amount of knowledge about the industry or who can employ firms who do. Commercial properties are a high-risk, high-reward real estate investment. Such an investor is likely to be a high-net-worth individual since CRE investing requires a considerable amount of capital.

The ideal property is in an area with low CRE supply and high demand which will give favorable rental rates. The strength of the area’s local economy also affects the value of the CRE purchase.

Indirect Investment

Alternatively, investors may invest in the commercial market indirectly through the ownership of various market securities such as Real Estate Investment Trusts (REITs), exchange-traded funds (ETFs) that invest in commercial property-related stocks, or by investing in companies that cater to the commercial real estate market, such as banks and realtors.

Advantages of Commercial Real Estate

One of the biggest advantages of commercial real estate is attractive leasing rates. In areas where the amount of new construction is either limited by land or law, commercial real estate can have impressive returns and considerable monthly cash flows. Industrial buildings generally rent at a lower rate, though they also have lower overhead costs compared to an office tower.

Commercial real estate also benefits from comparably longer lease contracts with tenants than residential real estate. This long lease length gives the commercial real estate holder a considerable amount of cash flow stability, as long as long-term tenants occupy the building.

In addition to offering a stable, rich source of income, commercial real estate offers the potential for capital appreciation, as long as the property is well-maintained and kept up to date. And, like all forms of real estate, it is a distinct asset class that can provide an effective diversification option to a balanced portfolio.

Disadvantages of Commercial Real Estate

Rules and regulations are the primary deterrents for most people wanting to invest in commercial real estate directly. The taxes, mechanics of purchasing, and maintenance responsibilities for commercial properties are buried in layers of legalese. These requirements shift according to state, county, industry, size, zoning, and many other designations. Most investors in commercial real estate either have specialized knowledge or a payroll of people who do.

Another hurdle is the increased risk brought with tenant turnover, especially relevant in an economy where unexpected retail closures leave properties vacant with little advance notice.

With residences, the facilities requirements of one tenant usually mirror those of previous or future tenants. However, with a commercial property, each tenant may have very different needs that require costly refurbishing. The building owner then has to adapt the space to accommodate each tenant’s specialized trade. A commercial property with a low vacancy but high tenant turnover may still lose money due to the cost of renovations for incoming tenants.

For those looking to invest directly, buying a commercial property is a much more costly proposition than a residential property. Moreover, while real estate, in general, is among the more illiquid of asset classes, transactions for commercial buildings tend to move especially slowly.

Pros

• Hedge against stock market
• High-yielding source of income
• Stable cash flows from long-term tenants
• Capital appreciation potential

Cons

• More capital required to directly invest
• Greater regulation
• Higher renovation costs
• Illiquid asset

Commercial Real Estate Outlook and Forecasts

The U.S. commercial property market took a big hit during the 2008-2009 recession, but it has experienced annual gains since 2010. These gains have helped recover nearly all recession-era losses.

The “2019 U.S. Real Estate Market Outlook,” an annual report issued by CBRE, believes:

Although it is late in the economic cycle, the outlook remains very good for all four major commercial real estate asset types. There will be minimal appreciation in values, but income returns should remain healthy.

However, other indicators suggest the commercial property market has peaked in the post-recession growth cycle. According to California real estate firm, Ten-X Growth, commercial property pricing ended 2018 up just 1% from 2017.

A Ten-X report noted that the 2018 final total for commercial properties confirms their view of the late economic cycle pricing. The firm’s research found that vacancies are rising, rent growth is slowing, and market interest rates are on the rise

As reported by Forbes, the retail sector, in particular, has proved a pain point in the broader commercial property market, as widespread store closures intensified in 2017 and continued into 2018. For example, popular mall REIT Westfield Corporation saw their stock price shed about 30% between mid-2016 and late 2017 before reversing some losses through January 2018. Unibail-Rodamco SE acquired Westfield for US$15.8 billion, creating Unibail-Rodamco-Westfield (URW).

Most firms, however, maintain that the property market remains healthy overall. J.P. Morgan, in its “2019 Commerical Real Estate Outlook,” largely echoed CBRE’s view stating that 2018 was the ninth year of increases in commercial property rents and valuations. Morgan predicts this pace will slow but continue and do not see a downturn until after 2019.

Note that the COVID-19 pandemic, so far, has not really caused real estate value to drop substantially, and property values have remained steady or even have risen, much like the stock market through the Fall of 2020. This is a key difference between the economic fallout occurring in 2020 and what happened a decade earlier.