Commercial real estate investment is highly profitable. Time and again real estate investors have been eyeing the sector as an alternative to residential and single-family investments. Depending on individual goals and market trends, the commercial property asset class generates increased returns on investment. In this article, we discuss a detailed guide for new investors to invest in commercial real estate.
What is commercial real estate?
Commercial real estate encompasses any property that investors use for business operations and income generation. Furthermore, unlike residential properties, commercial properties provide a workspace and not a living space. The end goal of a commercial real estate building or land is to reap profits. The commercialization of a real estate property has implications on its financing, law applications, and tax treatments.
The four main classes of commercial real estate include office spaces, industrial, multifamily, hospitality, and retail. Malls, grocery stores, office buildings, storage facilities, hotels, etc are parts of commercial real estate.
Types of commercial real estate
1. Office properties
Commercial real estate office properties include single-tenant or multi-tenant buildings and other small professional buildings and high-rises. They are typically classified into urban and suburban properties. Urban office properties are located in metropolitan areas and include skyscrapers. On the other hand, suburban office properties, include mid-rises and are located outside the core centers of a city. Hence, they are also often grouped in office parks.
Furthermore, the office buildings are further categorized into three tiers- Class A, Class B, and Class C.
- Class A office buildings are newer properties or old properties that have been completely renovated. These are equipped with state-of-the-art infrastructure. Moreover, such properties are located in prime market areas and have exceptional accessibility. As a result, its rents are above average.
- Class B offices are hotbeds for investments as such properties guarantee maximum returns through renovations and improvement. When compared to class A offices, class B properties accommodate mediocre but adequate facilities. Moreover, class B officers are also located in less desirable locations. Hence, such properties generate average rents.
- Class C offices are significantly older with poor accessibility. Therefore, investors tend to avoid such properties. This is because they need huge capital investments for the overall renovation and infrastructure upgrade of such properties. Class C properties are typically more than 20 years old and require immediate redevelopment. Due to their sub-par office space quality, these buildings generally remain vacant and require low rents.
2. Industrial properties
Industrial spaces include warehouses, factories, plants and other large to heavy manufacturing sites. These properties are used for manufacturing and distributing purposes. Hence, they are located in suburban areas, alongside major transportation routes. These properties often have height specifications and house single tenants. In 2020, the rise of e-commerce led to a boom in the demand for industrial properties.
Industrial properties are classified into four types:
- Heavy manufacturing sites contain special machinery that is customized for producing goods. These sites are not easily transformable.
- Light assembly industrial spaces are used to assemble products and store them. Unlike heavy manufacturing sites, light assembly facilities can easily be transformed into office spaces or other commercial properties.
- Bulk warehouses are large buildings, often used as distribution centers.
- Flex industrial facilities are a blend of both industrial and office uses. Hence, these buildings are easily convertible.
Multifamily properties comprise apartment fourplexes and larger buildings. Apartment complexes, high-rise condo units, co-ops and townhomes, and smaller multi-family rental units are examples of multifamily properties.
Multifamily properties, like office spaces, are classified into Class A, B, and C tiers as well. There are broadly six types of multifamily properties, that include:
- High-rise buildings that have at least nine floors and more than 100 units. These have multiple elevators.
- Mid rises that have around 9 stories and one elevator. These buildings are usually located in urban infill spots.
- Garden apartments that have 3 to 4 stories with or elevators. They are built in a garden-like setting with surface parking. Such buildings are situated in urban, rural, or suburban areas.
- Walk-ups that have 4 to 6 stories and no elevator.
- Manufactured houses are also known as mobile homes or trailers. Manufactured housing communities are communities in which the operators lease ground sites to the owners of manufactured houses.
- Special-purpose housings that are essentially multifamily properties for specific population segments. Student housing, senior housing, and low-income housing facilities are examples of special-purpose housing.
Retail properties house retailers who sell products and services directly to the consumers. They can have single or multiple tenants or standalone buildings. There are several types of retail centers:
- Community retail centres are generally 10,000 to 30,000 square feet in area. They have a mix of full-price as well as discount retailers and multiple anchors such as grocery retailers and drug stores.
- Strip centres are smaller retail properties in local neighbourhoods. Such centres provide local residents of a neighbourhood with necessary day-to-day products like groceries, pharmaceuticals, entertainment and restaurants. These may or may not house larger retail tenants.
- Regional malls range from 400,000-2,000,000 square feet in area. They have high-end anchor tenants such as department stores and big-box retailers along with entertainment and restaurants.
- Power centres are a combination of smaller and major regional retailers. These shopping centres are usually more than 300,000 square feet in area and have excellent interstate accessibility.
- Outparcel are often standalone properties that house single tenants. These are located near large shopping centres in city cores.
A step by step guide for new investors to purchase their first commercial real estate asset
1. Set your goals
The first step to building a portfolio is to determine the purpose and financial goals before. An investor must have a clear vision of what they want to achieve from a particular investment.
Investors must know whether they want a steady flow of monthly income or long-term capital appreciation. Do they want to focus on investing in office properties? Or are industrial properties more up their sleeve? Having a clear idea of whether they want to be an active or passive investor or if their end goal is to reach financial freedom, equips them with a foolproof investment strategy. Some of the strategies include:
- Buy-and-hold strategy, where an investment property is bought and rented for monthly income
- Fix-and-flip strategy, where an investor buys a property, renovates it and sells it out for profits
- Rental property strategy, where investors rent out their single-family properties as vacation homes to generate rental income
- Wholesaling or Micro-flipping, where an investor buys an undervalued property for the market and quickly sells it to an end-buyer for easy profits
- Real estate investment trusts (REITs), where investors buy shares of companies that operate or finance real estate projects. The investors receive dividends from any income the company generates. REITs are passive investments.
Depending on the investor’s long-term and short-term goals, they must select a suitable investment strategy.
2. Determine your commercial real estate asset strategy
Commercial real estate investment is divided into four main strategies: core, core-plus, value-add, and opportunistic. These strategies depend on the risk tolerance and the return targets of the investors.
1. Core assets
Buyers consider commercial real estate investment in core assets as the safest bet. These assets are in fairly good condition in prime locations and are almost never vacant. Hence, core assets are stable assets because it generates steady income flow in the form of market rents. In core assets, investors adopt a buy-and-hold strategy as they involve little or no risks. Here, investors aim for capital preservation and reliable cash flow rather than asset appreciation. Core assets deliver around 7-10% of returns on investment.
2. Core plus assets
A Core plus asset is in similar condition as core assets, but it requires a certain degree of renovation. These offer a steady income for the investors who are willing to tolerate moderate risks to reap more returns after redevelopments. Since these properties are adequately good quality, they witness generous occupancy rates. Moreover, after renovations, investors can renew the leases of the existing tenants and even raise the rents and increase income. Core plus assets deliver around 9-12% of returns on investment.
3. Value add assets
Value add properties are higher up in the risk-returns scale as such assets require extensive renovations and repositioning. These properties are not fully occupied and witness low demand and a decent amount of vacancies. After investing in value-added assets, investors seek to not only generate income but significant value appreciation. Post renovations, investors increase rents and the net operating income of the property. As a result, the value of the property thoroughly improves. Hence, value-added assets are a combination of risks and returns. Value add assets deliver around 12-18% of the returns on investment.
4. Opportunistic assets
Opportunistic assets offer the highest risk-reward investment strategy. Such properties require massive or complete renovations. Hence, these assets are also called distressere3d assets. Moreover, they include repositioning a building from one use to another.
Furthermore, these properties are located in developing markets. As a result, opportunistic assets witness high vacancy rates notwithstanding their market potential.
In this scenario, the investors undertake the buy and flip strategy with the goal of generating maximum returns. The aim to generate immediate rental income is not the priority of investors. Here, the investors buy a distressed asset, add value to it, and wait for anywhere around t-7 years till the property reaches its desired appreciation. After the property reaches its required potential, the investors ‘flip’ or sell the property at a much higher price. Opportunistic assets generate around 15%+ returns on investment.
Passive commercial real estate investment
This strategy is an example of active commercial real estate investment. In these scenarios, the buyers need to invest their capital, time, and risk tolerance. As opposed to active investments, passive investments in commercial real estate are also gaining popularity among investors.
Passive investment is a strategy where the investors generate passive incomes through commercial real estate. Some of the modes of passive investments include Real estate investment trusts (REITs) and crowdfunding.
Crowdfunding in commercial real estate is a way of accumulating small sums of money from multiple investors to fund large commercial real estate projects. In exchange for financing a big-budget commercial project, each investor receives great returns. Furthermore, crowdfunding enables investors to diversify their portfolios and make several short-term investments.
Read more about Lilypads’ article on REITs here.
3. Build a reliable partnership
Investing in commercial real estate for the first time can be daunting. So it is ideal to partner with experts and seasoned professionals to secure the investment and get maximum returns.
Collaborating with a reputed commercial real estate sponsor mitigates potential issues in the investment. This is because the right sponsor makes smart decisions. They have experience in relevant niches and know how to operate a property, build its value and maximize ROI. Based on the specific investment parameters, institutional sponsors and private equity real estate sponsors, as well as real estate investment platforms, are particularly helpful. Such platforms identify the end goals and risk tolerance of the investors and determine appropriate exit strategies for them.
However, it is wise to conduct extensive research on the partners before entering into a partnership with them. Investors should look for a few things before associating with them:
- Look for an investment sponsor’s or a platform’s online and offline presence. This will provide an insight into their investment portfolio.
- Investors must also learn about the sponsor’s investment strategy and track records.
- Research about the sponsor’s credibility, experience and personnel. Investors must inquire about their charges and references.
- It also helps in taking the advice of a third-party professional, like an attorney or a financial advisor before partnering with such platforms.
4. Run the numbers that matter
It is important to underwrite a commercial real estate investment to evaluate the deal. Crunching the metrics helps investors to understand how a potential investment will perform in the future and determine the areas of improvement. Some of the important metrics for a commercial real estate deal include:
1. Internal Rate of return (IRR)
IRR measures a project’s profitability. It is the annual rate of return on investment. This metric takes into account initial investment costs, cash flow, and property sale proceeds. A property’s internal rate of return estimates the value of the property in the holding period. Hence, a property projecting a higher IRR is more profitable for investment. IRR is expressed as a percentage.
2. Equity Multiple
Equity multiple measures the ratio of total cash returns to the paid-in capital over the entire time span of an investment.
For instance, an investor puts $200,000 into a property and receives $400,000 from distribution and sale proceeds over the total hold period. Here, the investor will receive a 2x equity multiple. This is because the returns of $400,000 divided by the invested amount of $200,000 equal 2.0.
Equity multiple is also referred to as return on equity or multiple on invested capital.
3. Cash on cash return
The cash on cash return denotes the ratio of annual pre-tax operating net cash flow to the total amount of cash (equity) invested in the deal. The annual pre-tax cash flow is divided by total cash investment to get cash on cash returns of a property for that year. It is also represented as a percentage.
Cash on cash returns helps investors to understand how a potential investment will perform in the current as well as a future market scenario. It also helps investors to determine the future income profitability against their initial investment.
4. Net operating income (NOI)
NOI in a commercial real estate investment is the total income a property generates, minus the total amount spent on its capital expenditures. A commercial property produces income from various sources including potential rental income, vending machines, parking fees, and so on. On the contrary, the property incurs operating expenses in the form of vacancies, utilities and maintenance charges, property taxes, etc.
Read our article to know more about the net operating income (NOI) of a commercial real estate asset.
5. Never underestimate the power of due diligence
Before acquiring commercial real estate, investors need to conduct intensive due diligence. Such an intricate background check helps in unearthing details about the property that are not readily available. This information helps in determining the value of the property. Furthermore, with due diligence, investors uncover financial demerits of a property that can make an investment a costly mistake.
Prospective buyers must carefully scrutinize the fundamentals of the property. These include the financials, compliance obligations, risk assessments, and other liabilities. For this reason, it is beneficial to partner with an experienced real estate sponsor. Their expertise in studying the resources to evaluate the value of a property or a portfolio limits the emergence of post-purchase risks.
Purchasing one’s first commercial real estate is certainly profitable and a great way to diversify one’s portfolio. However, identifying one’s investment goals and strategy, and partnering with experts and extensive due diligence will lead the way to the best ROI vehicle.