Commercial real estate investment as an alternative investment strategy is nothing new but for many investors it is still a mystery.
- Commercial real estate (CRE) is all around us, in ways not noticed by many. The “commercial real estate” category includes apartments, offices, retail space, and other such buildings.
- Income and appreciation are the two ways to make money from commercial real estate investments. Income is created through the building’s service, often from tenants’ rent payments, while appreciation is received over time through an increase in the value of the property.
- Investing in commercial real estate usually requires more money, experience, and time than many investors have. But there are investment options that allow anyone to own a diversified portfolio of commercial real estate investments, including Fundrise.
Commercial real estate (often abbreviated as CRE) is a broad term used to describe real estate used to make a profit for its owners. Office buildings, industrial property, medical centers , hotels, malls, apartment buildings, and warehouses are examples of commercial real estate. Generally speaking, it is useful to think of commercial property — which produces cash flow — as opposed to residential property, which is usually used for personal use directly by its owner and generally consists of four units or less. Historically, investment in commercial real estate as an alternative asset has brought attractive risk-adjusted returns and diversification of portfolios to millions of investors. Yet, many investors also do not understand how commercial real estate works as a tool for investment.
We’ll explain the fundamentals of commercial real estate investments in this article, including how you can start investing yourself in this traditionally powerful asset class.
History of commercial real estate investments
Historically, commercial real estate investment has been rich in benefits, delivering competitive risk-adjusted returns for millions of investors. It also has a track record of delivering powerful portfolio diversification, as an alternative asset class. Since the success of a specific commercial real estate asset is related to local market dynamics or habits, a smart commercial real estate investment can be a great way for you to expand your investment along with the local and broader economies.
There are some main distinctions between commercial real estate investments , such as stocks and bonds, and conventional investment vehicles. Unlike high liquidity stocks and bonds, which can usually be acquired and sold fairly quickly and efficiently, commercial real estate is relatively illiquid and one of the few chosen assets is considered a hard asset – a precious resource that holds intrinsic value. Most often, stocks are purchased as a source of consistent income for their selling potential, rather than their capacity, hence the stock market heuristic “buy low, sell high.”
Public market investments, like stocks, however, also have a higher volatility potential, a side effect of the high efficiency of the public market which allows for extremely fast and easy trading. On the other hand, private markets tend to be less efficient and slower, but those qualities also mean that they are less volatile because they are less correlated with other market movements.
Various forms of consumer immovables
Commercial property types themselves may vary widely, but can be categorized into four key categories by their function: office, multifamily, retail, and industrial property.
- Office: The office property consists, as the name implies, of real estate used for office buildings. This involves skyscrapers and high-rises in urban centers, as well as office parks, and suburban midrises. Types of tenants may include a law firm or start-up company. Office space can come in a variety of different styles and sizes. Lease terms are also longer for commercial real estate, in the five to ten-year range.
- Multifamily: Multifamily properties offer residential accommodation in return for rental payments. In general, buildings with more than four units are called multifamily land. Many examples include apartment complexes or group housing, cooperatives, townhouses, and condominiums. Such properties can differ widely in size and number of units. Multifamily lease agreements are usually more time flexible. Residential leases may be short-term or long-term, but usually are no longer than one year. Some lease deals may even be month to month.
- Industrial: Industrial real estate is used for commercial operations. This can include buildings for heavy manufacturing , storage, assembly, and research and development. Some examples include oil refineries (heavy production), Amazon distribution centers (warehouses), factories for drug assembly, and facilities for research and development in pharmaceutical applications. Typically speaking, these properties are not situated in locations that would be particularly suitable for a residential or retail property and their location is regulated by zoning laws specific to their industrial operations. Lengths of lease agreements are typically for five years or more for industrial real estate.
- Retail: Retail commercial real estate involves properties that provide retail companies with the space they need to conduct business with the general public. Some examples include restaurants and clothing shops. For wide multi-tenant complexes this type of commercial real estate may be built in the form of shopping centers, strip malls, factory outlets, or other such shopping centres. It may also take the shape of a standalone single-tenant building. For its owner, the earning potential of retail real estate can be largely dependent on its specific geographic location, as it significantly impacts which retail tenants will want to set up shop there. Retail leases tend to be also mid- to long-term, often within the range of 4-5 years.
Classes and leases in commercial real estate
Classes of immovable property often differ, from Class A to Class D. Each class indicates a degree of quality for a commercial property. Class A, at the top, reflects newly developed properties with high-quality finishes, generating the highest rents per square foot in on demand areas. Each subsequent class corresponds to increasingly older and generally less desirable assets, from Class B to Class D.
Tenants differ across all types of properties investing in commercial real estate. Various arrangements, rental property management requirements and lease agreements come with different tenants.
In some instances, a property will employ a net lease, which is an agreement in which the tenant not only pays for the right to occupy the commercial real estate, but also agrees to pay some or all of the operating costs of the property. The typically available expenses to be included in a net lease agreement are taxes, maintenance costs and insurance fees. A tenant can pay one or all of these categories depending on whether they have a net lease agreement that is single, double or triple. For obvious purposes, net leases may be very lucrative for the property owner, and less desirable for tenants.
How to generate returns on commercial real estate investments
An investment strategy often begins with the purchase of a property in order to make money in two ways: first, by leasing the property and charging tenants to rent in exchange for the use of the property; and, second, by capturing the property’s appreciation over time.
Let’s look at each of these ways in which opportunities for commercial real estate investment can potentially generate returns.
One way that commercial real estate will thrive is by generating rental income from a tenant or multiple tenants as an investment. In turn, rental income becomes cash flow or income for the property’s equity proprietor. This cash flow / sales / rental income also enters investors’ hands in the form of dividend payments for commercial real estate that operates through a fund (as with Fundrise).
The ability of commercial real estate to generate cash flow depends on a number of other factors, for example operating expenses and debt service. Property landlord duties may include maintenance and repairs, loan interest payments, rent collection, evictions, finding tenants, and ensuring that property is at all times in compliance with all applicable legislation.
If the work is too difficult, or if you lack the financial , legal, and real estate skills required to manage a property and tenants, you may consider hiring a property manager — or a whole property management company —. A property manager charges a fixed earnings fee or percentage fee, which relieves property management responsibilities but also reduces the owner’s monthly earning potential for you.
Maintaining a balance of vacancies versus occupancy is a vital aspect of effectively producing rental income — with the smallest possible vacancy. Each unit that is unoccupied represents potentially lost earnings. Ideally, a rental property with high occupancy should deliver a stable cash flow and consistent return. Most owners are aiming for an occupancy rate of 90 per cent or higher. It is important to take a close look at vacancy rates and occupancy rates for the areas you are considering investments in.
The income generated by rental payments is often considered passive income for the owner, depending on how they have chosen to establish their operations management at the building. While some real estate investors like to be fairly hands-on, others prefer to delegate property managers operational responsibilities. In cases like these, it can be said that with the tradeoff of an additional cost, the cash flow provided by the rent truly is passive income. However, Fundrise is a truly hands-off investment option for real estate that offers passive income potential while not placing property-level management responsibilities on your shoulders and maintaining a low-fee model.
Value & Appreciation
The second chance of returns and profitability of a commercial real estate investment comes from any rise in the asset value – or appreciation – of the property during the ownership period. Properties can also lose value, and even the most disciplined, proven investment strategies can not guarantee gains, owing to the fact that the value of a real estate investment can be influenced by outside economic forces. All forms of property have the potential to increase the value of assets and productivity, from the raw land to the site home to the already built extensive apartment housing.
On the whole, real estate is a special and limited class of properties. More raw land can not simply be “created.” As many renters experience in major cities, this scarcity is augmented by demand. When the demand for your property rises, or in the area close to your house, there is a fair possibility that tenants will be willing to pay higher rents, and potential buyers will be willing to pay a higher price than you initially paid to purchase it.
Furthermore, scarcity often depends on the particular marketplace at issue. A supply-constrained housing market in an urban center will place greater value on a new apartment building than on a rural area with a marketplace in which housing is plentiful. The scarcity of a hard asset and the corresponding values of a property can vary greatly from one zip code to another.
Various markets are also called primary , secondary, or tertiary markets. In general, a primary market refers to the center of a major metropolitan region, where populations are dense with high economic activity. Usually, primary markets are where some of the most costly real estate in the world lies. Secondary markets in terms of population are smaller than primary markets, and are often the areas surrounding a primary market, such as a suburb of a major city. Finally, a tertiary market is still smaller than a secondary market, and is even further away from a major urban hub. Similarly, the real estate of a tertiary sector in the other two groups is usually much cheaper and in less demand than the real estate, primarily due to a lower total population. Nonetheless, many secondary or tertiary markets can present good investment opportunities for commercial real estate, depending on factors such as demographic trends or growth in local employment.
Request appreciation isn’t the only way a property’s value increases. Many buyers are taking an aggressive “value-add” approach to commercial real estate, increasing the property in order to improve its intrinsic value and purchase price, or its potential to gain income during the holding era. Another example of this will be the upgrading of structural items, like flooring or countertops, or multi-family apartment building appliances. Such updates can involve a lot of expenses, but they can also enable the owner to charge higher rent for nicer apartments. Any money spent on real estate upgrades would theoretically raise the building’s sales price in the future.
A property may be empty during the renovation time and therefore not receive rental income. Consideration of the necessary debt service is important, and ensuring that you can continue making payments for any borrowing during the holding period, even if the property does not produce rental income.
Certain methods of gaining gratitude in addition to physically upgrading a building may include rezoning an adjacent parcel of land (for example, from residential to multi-family), so that more apartments can be constructed. Changing a piece of land’s entitlements and permits can have a significant impact on the selling price of that land.
Tools for evaluating commercial real estate with future returns
Besides recognizing how the rental income generation and appreciation work, there are many ways to measure and evaluate the actual or expected return potential of a house. Here are some of the main concepts you should be familiar with in order to understand the proper calculation of returns on commercial real estate investments:
- Net operating income (NOI): the net operating income, or NOI, in real estate represents the annual income (or income) generated by an investment property after annual operating expenses. It is simply, in simple cases, the cash flow created from rent for a given period of time, minus any fees or costs associated with owning the land.
- Capitalization rate (cap): The capitalization rate, or cap rate, is the most common form of valuation used in real estate investment. This is based on unlevered yield (rate of return) of a property. In other words, a cap rate estimates the normal rate of return of a property for a single year without taking into account any interest on the asset, making it possible to compare the relative value of one property with another. In general, a cap rate is expressed as a percentage value.
- Internal Return Rate (IRR): The internal rate of return ( IRR) is a metric used to assess an investment’s profitability over its lifetime and is represented as the average percentage of annual returns. An investment’s IRR can be calculated forward-looking to estimate potential future returns or backward-looking for measuring a completed investment’s performance. Technically, the IRR is the growth rate necessary for today’s value of the asset to be equal to its future projected value.
- Debt service: Debt service refers to the amount of payments a loan requires. The amount of payment will vary according to several factors, including the ratio of loan-to – value (LTV). One important indicator of inherent risk in the investment is the ability of a property’s cash flow (either existing or future) to servicing debt. In general terms, the higher the amount of debt (i.e. the higher the leverage) the more risky the investment.
There are other useful concepts to master, such as risk-adjusted returns (which refers to a way of thinking about how much an investment generates in balance with its relative amount of risk it carries), or how investors often evaluate a property’s value by weighing its value against its total square feet. These general thumb rules can give you a head start in your analysis of an investment opportunity. For example, by knowing how much dollars you cost per square foot, you can decide if you are getting a decent value for the amount of space you’ve bought, based on the price per square foot of other properties in a similar market.
Finally, of course, all investors have a legal obligation to understand the tax implications and processes for filing tax documents, regardless of whether it is a passive or active investment, for the total returns they earn on their investment.
Investment approaches in commercial real estate
The central strategy for commercial real estate investment is simple: you must recognize inherent real estate demand in a given region and then buy a property when supply is still scarce. Yet real estate itself can be a complex and expensive asset class. And it’s easy to make costly investment errors without due diligence. It is imperative for you to understand both the specific variables surrounding that property, plus the general strategies that apply to that investment when buying a property for commercial investment. Some of the investing strategies most common include:
- Industrial land for redevelopment: You can realize that in the coming years a fairly depressed community has potential for an economic revival. You could acquire an industrial property for the short term, and find a commercial tenant. Long term, you might later try to get the property rezoned into retail or residential real estate for construction, until demand booms in the rest of the city. You could then sell the property and collect any appreciation gained, or continue to own the property while receiving income from its tenants’ monthly rental payments.
- Renovation apartment building: When you see an area with a good economy and steady population growth, you might be searching for an opportunity to purchase an apartment building and improve its earning potential by renovating it. By enhancing the living conditions for tenants, you can raise rental prices, gain more short-term cash flow, while still potentially increasing the asset ‘s overall appreciation.
- Land for entitlement: Sometimes you can identify an area with virtually no population- and economic growth-ripe development in the near future. In that case, you may aim to acquire raw land and then obtain all the building permits at that site, adding new value to the property. Then you can sell the entitled property to someone else who wants to build the land, instead of doing the building yourself.
Because commercial real estate has traditionally been very expensive , requiring investors to attach large sums of money over long periods of time to a single property, very few investors could afford to invest. Particularly those who could always rely on a commercial investment strategy for real estate that involved borrowing with borrowed money, such as a fixed interest loan through a lending bank.
But today, options such as Fundrise have enabled anyone to add commercial real estate to their portfolios with a significantly lower capital requirement, far less personal risk, and more robust diversification of assets. Fundrise also provides the potential for truly sustainable income as well as long-term appreciation, as all management of real estate funds and assets is handled by the own professional in-house real estate team from Fundrise.
Types of real world industrial real estate investing
Doug’s hands-on apartment building
Let’s look at an investment in commercial real estate in action to better understand the efficiency of that type of asset. Doug is purchasing an ancient, $5 million, 40-unit apartment house. After all his expenses (otherwise known as his net operating income) he earns a rental income of $500,000 per year one. Some tenants leave each year, as with all the properties. Doug renovates vacant apartments before having them re-leased to new tenants at higher rates. Doug’s improvements increase the rental income of the property by $50,000 each year for five years, so the property earns $750,000 per annum by the end of year five.
Doug then opts to sell the $16 million apartment building. For two reasons, the buyer was willing to pay a higher price than Doug 5 years ago: First, Doug renovated the apartments and added value to the property. These renovations, in turn, enabled Doug to raise the unit rent prices, and they now earn him 50 percent more income than they did when he purchased the building. Second, as new tenants and entertainment centers moved into the area, economic development in Doug ‘s town increased property prices. Tasty work, Doug!
Jason approaching hands-off
Doug ‘s cousin, Jason, has heard from his relative that real estate can be a pretty lucrative asset class, and that he is also interested in investing — but he has no time, desire, knowledge, or just as much capital to commit to the ongoing management of one or more properties. He also doesn’t want to take on the responsibility of an extra loan and mortgage on top of the one he already has for the home of his children.
After a bit of research, Jason learns that there are a number of alternative investment options for real estate, which allow investors to add high-quality commercial properties to their portfolios. Many streamline the process by removing all responsibility for management from the investors’ shoulders themselves. In certain cases, investment options include purchasing shares in a real estate-focused fund, such as a real estate investment trust ( REIT), which offers investors direct access through a single investment to a wide variety of assets.
Jason also explores Fundrise as a way to quickly access non-traded REITs (many REITs are traded publicly and thus fail to provide greater diversification benefits), relying on the hands-off, low-cost structure and low risk minimum ownership options it provides. Jason is prepared to allow his investment to mature for five years or longer, in keeping with the investment horizons of Fundrise. Many of Jason’s portfolio properties are well placed to expand in similar ways to Doug’s apartment building, and Jason’s ownership share in those properties would reflect that future growth. In addition, Jason’s Fundrise portfolio also contains several other forms and strategies of assets.
Jason receives some paid dividends, as the assets in his portfolio produce cash flow from tenants or interest payments. During the meantime, when the land prices themselves shift, so will the Jason’s shares prices. Jason gains many benefits from real estate investments as the in-house real estate department of Fundrise manages for him the assets found in his portfolio.
The starting line is
- Unlike publicly traded stocks, direct investment in commercial real estate can provide stable cash flow in the form of rental income, often without the volatility of government investment. Adding real estate to an investment portfolio will bring benefits from a new cash flow, plus long-term growth opportunities as well as diversification of portfolios.
- Commercial real estate is a hard commodity, and a precious resource as well. It retains inherent value, and over time it typically appreciates value. Access to this asset class has traditionally been limited to large institutional investors because of its expense, but modern investment platforms like Fundrise have made it easier for anyone to access commercial real estate investment than ever before.
Historically, the average investor and their investments have been out of scope of direct commercial real estate investment. This is because investments in commercial real estate are typically dominated by institutional investors since projects require millions of dollars in capital and a profound reservoir of expertise to improve and operate a property. Fundrise allows you to invest directly in a diversified portfolio of private-market commercial real estate for low fees, low minimums and high return potential.