Commercial real estate 101 aims to provide a detailed overview of the basics of investing in commercial real estate all investors should know.
Commercial real estate means office buildings, retail shopping malls and even hotels. When people think about the real asset class and real estate in general, residential real estate is the first thing that comes to mind. Still, the commercial real estate segment makes up a larger portion of the real estate sector’s investable universe.
Table of Contents
- How to invest in commercial real estate
- Why invest in commercial real estate
- Types of commercial real estate including alternatives sectors
- Commercial office building grades
- Commercial Real Estate Investment Strategies and Return Profile
How to Invest in Commercial Real Estate
The list below shows some of the most accessible forms for investors to invest in commercial real estate. Due to the typical value of commercial properties, which can easily reach millions of dollars, it is prohibitive for individuals to buy into the market through direct investments. But there are many different other ways where investors can buy into a fund that invests in the real estate on their behalf.
- Listed Real Estate Investment Trusts (REIT)
- Unlisted Real Estate Funds (mutual funds or real estate private equity funds)
- Purchase the real estate directly (including land for development)
The easiest way for most to invest in commercial real estate is through a REIT.
REITs can be an effective means for investors looking for a hands off passive investment approach to the area or who do not have direct property operating experience. REITs can provide immediate liquidity and portfolio diversification across multiple assets, geographies and tenant credit risk. Owning a portfolio of assets can drastically reduce the overall risks of investing in commercial real estate.
In contrast, directly owning real estate can be attractive for those looking for a hands on approach and can leverage their commercial experience. The trade off is any direct real estate assets. The highly concentrated nature of the investment means the ultimate return is subject to just a few tenants. The value of the asset can also make a disproportionate share of the investment portfolio.
Why invest in Commercial Real Estate?
Like other real assets once leased, commercial real estate provides a consistent and predictable cash flow with long-term capital appreciation. There are several advantages that commercial real estate has over residential property.
Long Term Leases
The lease terms on commercial real estate assets are usually longer than residential leases. It is common to have a 3, 5 or even 10 year lease term for offices and warehouses. Retail leases are also typically a minimum of 5 years compared to 12 month lettings in residential properties.
There can be more flexibility in lease negotiations between the tenant and landlord. Depending on market conditions, the tenant could also pay for all the building operating expenses as part of the lease. Examples of costs included in a typical commercial property operating budget include statutory rates, electricity, body corporate (strata fees), cleaning and building repair and maintenance.
The case where the tenant pays the operating expenses of the building is called a net building. In this instance, the landlord is only responsible for building capital expenditures.
As with anything, there is no such thing as a free lunch. If the landlord or tenant requires a specific clause such as the right to hand back the property, if the real estate is a long term redevelopment option and require demolition clauses in the leases, there will be associated costs or lower rent. But it can be attractive for some to have this flexibility, which is impossible in some residential markets.
Types of Commercial Real Estate Properties
We have outlined below the main types of assets covered under the commercial real estate umbrella and the ones with the greatest investment demand and liquidity from institutional real estate investors.
Office – Commercial office is the most common type of assets associated with commercial real estate. These can either be occupied by a single or multiple tenants, and typical office buildings can be valued in hundreds of millions of dollars.
Retail – Shopping Centers and strip malls are large retail, commercial properties. These would have a department store, major discount retailer and neighborhood supermarkets.
The income profile of retail assets can be quite different from office buildings due to the usual tenant mix. The anchor tenant for a mall is usually a department store like Macy’s, which will pay minimal rent. Most of the money is made from leases of the surrounding retail tenancies to specialty retailers, which trades off the foot traffic the anchor tenant brings to the center.
This model has been severely disrupted following the emergence of online shopping and the department store model’s demise. The major retail center owners have recently been shifting towards including more lifestyle and experience-based shopping to make up for the fall in foot traffic.
Industrial – Warehouses, distribution centers and light industrial factories fall within the industrial category. Usually, these are single tenant buildings that require a portfolio to get the scale to minimize the tenant credit and lease expiry risk. The advantage of industrial assets over office and retail is that lease terms are usually longer and can span from 5 to 10 years.
There is also a range of specialist asset classes that fall outside of the above. These assets are more illiquid and less natural demand from investors. The current strong market environment and the chase for yield mean that more and more investors are extending their commercial property mandate to include assets in the alternative real estate classes below.
Hospitality – Hospitality covers hotels and resorts. Hospitality is a tricky asset class because hotels are usually operated under management agreements rather than leases. Unlike most commercial real estate income, which is lease driven hotel owners, income is directly linked to hotel management’s performance.
Service Stations – The advantage of service stations is their long leases, which provide income security.
Childcare Centers – These are assets leased to childcare operators on a long lease term. Notably, the buildings required for child care are not build to suit, and the key risk for these assets is low entry barriers. The value of the asset is largely driven by the signed lease.
Data Centers – Highly specialized asset class, and due to its specialized use, there is significant key tenant and obsolescence risk. One question is, what are the alternative uses if the tenant moves out.
Student Housing – Student housing is a relatively new asset class. One issue investors in student housing need to be aware of is the key substitute for the product is residential housing. There is a demand for student housing in strong residential markets, but in weak markets, student housing owners compete directly with residential housing investors for the same tenants.
Life Sciences– These could include long-term generic properties leased to GP, dentists or specialists to hospitals. Due to the nature of the market, it is tough to find these assets as most doctors are owner occupiers of their own practices. There is a trend away from this, but it is slow, and options are currently limited.
Commercial Office Building Grades
Commercial buildings in each category also fall into various asset grades. Still, these are subjective and commonly defined by agents or investors informally rather than a formal process that will state a building is of a particular grade.
Premium Grade Asset – These are the best assets in each category and demand the highest rents. Characteristics of premium grade include the best location in the CBD and usually come with spectacular views.
A Grade Asset – Strong and functional buildings that are relatively new, energy efficient and close to key transport networks. Ideal for tenants that want a good building in a good location but not necessarily all the best amenities and views.
B Grade Asset – Older style buildings. Although it can still command strong rents due to location but usually is the cheapest option for tenants due to its fringe or suburban locations or older style building quality.
CBD and Metro Locations
The basic tenant of real estate is always location, location and location. This applies the same to the office market, which is separated between CBD and metropolitan markets.
Financing Commercial Investments
As commercial real estate assets, once leased has a consistent cashflow stream, it is common to see high leverage levels deployed in the sector.
Senior financing re also strict, where the base loan to value is around 50%, unlike 80% seen in the residential sector. This is usually done through the use of a combination of senior and mezz loans.
Mezz can be sourced from non-bank lenders or private real estate funds, providing more flexible capital from standard senior loans.
Commercial assets offer an immediate income with a chance for long term capital appreciation. That is not to say that commercial assets are a lower return asset class. The total return on investment depends on a broader economic backdrop and local supply and demand than typical residential assets. The returns profile of commercial assets also varies depending on the investment strategy.
Commercial Real Estate Investment Strategies and Return Profile
Core Real Estate – Core real estate strategy is an income-driven strategy where the investment strategy is focused on fully leased buildings in stable markets. These are usually the best in their class, perceived to have the safest cash flow and well located.
Core assets cover mostly premium and A grade buildings due to their location and modern construction. The assets would have minor leasing risk as the current tenants have signed long leases, and due to the nature of the buildings and the prime locations, there is a low re-leasing risk as there is always tenant demand to be in great buildings in prime locations.
Core asset owners can be characterized as family offices and institutional real estate funds. These are the most sought after buildings whenever they come to the market and are priced accordingly.
Core Plus – Core plus real estate strategy is a step up from the core strategy on the risk curve covering assets that might be considered core. It is still priced at a slight discount due to either upcoming leasing risk or major capital works program required to bring the amenities and building quality up to its peers.
Due to the foreseeable risks, investors require a higher level of return in implementing strategy, but the asset is considered a core asset once the temporary transition is completed. The important distinction to these strategies below is that the underlying assets bought and sold are fundamentally sound core Premium and A grade assets in good locations.
Core funds could allocate a portion of the portfolio to core plus assets to increase overall returns.
Value Add – Value add involves taking on minor development, building reposition and leasing vacancy risk. Whilst the investment return of core assets are primarily income driven, returns from value add can be a mix of income and capital appreciation.
The business plan typically involves a period where the asset is repositioned, and a value pop transitioned to a cash generating asset on completion.
The majority of the return is realized from selling the asset after adding value to the building.
Opportunistic – Opportunistic real estate strategy is at the highest end of the real estate investment risk and returns spectrum out of all commercial real estate strategies. The opportunistic strategy usually involves funding developments or developing/permitting risk from empty land to a fully built office building to achieve the targeted return.
Examples of the opportunistic strategy include buying in counter cyclical markets or fully vacant buildings in depressed markets and aim to ride the market recovery.