Real estate can offer diverse opportunities to build wealth. The US commercial real estate market size in 2020 is $1.1 trillion and has grown by 2% annually on average. Regardless of the type of real estate, it’s either financed by debt, equity, or a hybrid of these two methods.
Both investment types carry their own risk and rewards. With debt financing, investors and institutions loan money with the expectation that they’ll receive their original investment with a fixed rate of interest. They also generally expect some collateral to secure the loan and reduce the risk. Equity financing is similar to investing in company stock, as investors have higher upside, but also higher risk as there is generally no collateral securing the investment.
Residential and commercial real estate can be broken into many subcategories. The two main categories of residential real estate are single and multi-family homes. These consist of 1 unit and 2+ units, respectively. Commercial real estate has more niches like retail (i.e shopping malls), office, mixed-use, and industrial. There are several sub-niches such as office space for healthcare companies.
This guide will walk you through the fundamentals of investing in commercial real estate, including its pros and cons.
Four Risk Profiles of Commercial Real Estate Investing
Regardless of what you invest in, there will always be a risk-reward payoff. Higher risk usually means a higher potential reward and vice versa. In traditional investing, common stock has higher risk and potential reward than more conservative investments like AAA-rated bonds. Investing in commercial real estate has a similar risk-reward payoff, which can be divided into four main categories: core, core-plus, value add, and opportunistic.
Core investments are considered the “bonds” of the commercial real estate market, as they are the least risky when investing in commercial real estate. They are generally stable and provide steady cash flow.
Most core investments are Class A buildings that are well-maintained, leased to high-quality tenants, and have long leases. They require little to no improvements when purchased, which also caps the upside potential for investor returns in exchange for stability.
These investments tend to generate predictable cash flows. Investors that select this investment class think long-term and seek capital preservation over high growth.
These types of properties are also usually found in strong markets and have creditworthy sponsors that make it easier to obtain financing.
While commercial real estate is illiquid compared to stocks or bonds, this investment class is the most liquid of the four risk categories.
Core-plus investments are relatively stable, as they’re located in areas that attract financially stronger and responsible tenants. Vacancy is relatively low. These investments therefore tend to access financing more easily.
The main difference between core and core-plus is that core-plus properties have slightly more risk. For instance, a 20-year old apartment building that needs slight repair would fall under the core-plus category.
Other core-plus properties might have a pending lease rollover or have parking lots that need to be refurbished. These minor value-add opportunities can help investors see higher returns and risk, but this investment class still offers some stability.
Value add investments are properties that have some existing cash flow but might benefit from more significant improvements. Some examples include making physical improvements to justify higher rents, expanding marketing campaigns to sign on more tenants, and implementing ways to lower operating expenses.
These add-ons provide more upside potential than core or core-plus properties. Yet, the upside is uncertain and requires active management which makes this commercial real estate investing class riskier than the former two. The add-ons, for example, could take more time to complete, cost more money to complete, or not achieve the desired results.
Value-add investments are also riskier since they usually use higher leverage (i.e debt) ratio compared to core and core-plus.
Opportunistic investments offer the highest growth potential, but carry the most risk when investing in commercial real estate. These can be compared to “fixer-upper” homes as they usually need significant renovation. They may also have high tenant vacancy rates. Land investments that require a new development are also considered opportunistic investments.
These are usually financed with relatively high leverage that come with relatively high-interest rates and potentially strict loan covenants.
Pros & Cons of Commercial Real Estate Investing
- Cash Flow and Appreciation
You can earn cash flow (i.e monthly rents or dividends) and/or capital appreciation by investing in commercial real estate. Commercial real estate income is typically higher than the average dividend-paying stock.
- No Property Management Obligations
Many real estate investors are intimidated at the thought of managing property. Regardless of the commercial real estate investment; property managers can be hired to take care of the maintenance tasks on your behalf.
Real estate can be a viable asset class for many investors as it provides diversification from paper assets like stocks and bonds. Real estate is often viewed as being inversely correlated, which means that it can provide a higher ROI when assets like bonds depreciate and inflation is high.
- Financial Barriers
Unlike buying US stocks online with commission-free trades, direct investments in real estate properties isn’t as accessible to the average person. There are many costs, like agent commission, title fees, and mortgage fees when investing in commercial real estate. It also has a longer investment cycle, is not considered a liquid investment, and many of these opportunities are only open to accredited investors.
- Tenant Vacancies
One of the main factors that negatively impact any real estate investment is the tenant vacancy rate. Vacancies can lead to substantial losses as there are no tenants paying rent, but expenses still continue. There are also costs, including marketing expenses and leasing commissions, that are incurred when finding new tenants.
- Economic Trends
Commercial real estate can be cyclical. It’s important to pay attention to the ups and downs of specific property types to understand the right opportunities.
Develop Your Risk Tolerance and Time Horizon
There are many categories and sub-niches within commercial real estate. Before investing in commercial real estate, know your investment time horizon, and understand your risk tolerance.
If you’re looking for stability and capital appreciation over the long-term, then core or core-plus investments could be a good fit. Value-Add and opportunistic investments could be more suitable if you’re looking for higher returns and can handle the risk.
Other types of commercial real estate investing like REIT ETFs or investing small amounts with online commercial real estate crowdfunding can allow you to diversify within the asset class with smaller minimum investments.
Real estate can be an important asset class within a diversified portfolio. However, even within the category, there are many different types of real estate and many different factors to consider in an investment.
Consult a financial planner or tax professional before investing in commercial real estate, especially physical properties. It’s very important to consider the local real estate market, the needs of each property, how value can be captured, and the tax consequences of each investment.
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