Commercial real estate investing as an alternative investment strategy is nothing new, but it’s still a mystery to many investors.
- Commercial real estate (CRE) is all around us, in ways that many people may not notice. The category of “commercial property” includes apartments, offices, retail space, and other such buildings.
- Income and appreciation are the two ways that commercial real estate investments can earn money. Income is produced through the operation of the building, often from rental payments from tenants, while appreciation is earned through an increase in the property’s value over time.
- Commercial real estate investing normally requires more capital, expertise, and time than many investors have. But there are investment options, including Fundrise, that make it possible for anyone to own a diversified portfolio of commercial real estate investments.
Commercial real estate (often abbreviated as CRE) is a broad term describing real property used to generate a profit for its owner. Examples of commercial real estate include office buildings, industrial property, medical centers, hotels, malls, apartment buildings, and warehouses. In general, it’s helpful to think of commercial property — which generates cash flow — in contrast with residential real estate, which is typically used directly by its owner for personal use and typically consists of four units or less. Historically, investing in commercial real estate as an alternative asset has provided millions of investors with attractive risk-adjusted returns and portfolio diversification. But, many investors still don’t understand how commercial real estate works as an investment vehicle.
In this article, we’ll explain the fundamentals of commercial real estate investments, including how you can start investing in this traditionally powerful asset class yourself.
- A background on commercial real estate investing
- Different types of commercial real estate
- How commercial real estate investments can generate returns
- Methods to evaluate commercial real estate investing return potential
- Commercial real estate investing strategies
- Real world commercial real estate investing examples
- The bottom line
A background on commercial real estate investing
Historically, commercial real estate investing has been rich with benefits, providing millions of investors with attractive risk-adjusted returns. As an alternative asset class, it also has a track record of providing powerful portfolio diversification. Because the success of a particular commercial real estate asset is tied to the trends or behaviors of its surrounding local market, a smart commercial real estate investment can be a great way for you to grow your investment along with the local and broader economies.
There are some key differences between commercial real estate investments and traditional investment vehicles, such as stocks and bonds. Unlike stocks and bonds, which have high liquidity and can typically be bought and sold relatively quickly and easily, commercial real estate is relatively illiquid and one of the select few investments considered a hard asset – a scarce resource that holds intrinsic value. Most often, stocks are purchased for their selling potential rather than their capacity as a source of consistent income, hence the “buy low, sell high” heuristic of the stock market.
However, public market investments, like stocks, also have a higher potential for volatility, a side effect of the public market’s high efficiency, which allows extremely fast and easy trading. Private markets, on the other hand, tend to be less efficient and slower, but those qualities also mean they’re less volatile, as they’re more less correlated to the movements of other markets.
Different types of commercial real estate
Commercial real estate property types themselves can vary widely, but can be divided by their function into four main categories: office, multifamily, retail, and industrial properties.
- Office: As the name suggests, office property consists of real estate used for office buildings. This includes skyscrapers and high-rises in urban areas, along with office parks and mid-rises in suburban areas. Example tenants could include a law firm or start-up company. Office space can come in a range of styles and sizes. Lease terms for commercial real estate are often longer, in the five-year to ten-year range.
- Multifamily: Multifamily properties offer residential housing in exchange for rental payments. Buildings with more than four units are generally considered multifamily property. Some examples include apartment buildings or apartment communities, co-operatives, townhomes, and condominiums. The size and number of units of these properties can vary widely. Multifamily lease agreements are usually more flexible in terms of duration. Residential leases can be short-term or long-term but are typically not longer than a year. Some lease agreements can even be month to month.
- Industrial: Industrial real estate is used for industrial business operations. This can include heavy manufacturing, warehouses, assembly, and research and development buildings. Some examples include oil refineries (heavy manufacturing), Amazon distribution centers (warehouses), product assembly factories, and pharmaceutical research and development facilities. These properties aren’t generally located in areas that would be very desirable for a residential or retail property, and their placement is guided by zoning regulations that apply to their industrial business operations. Lease agreement lengths for industrial real estate are typically for five years or more.
- Retail: Retail commercial real estate includes properties that provide the spaces required for retail businesses to conduct business with the public in general. Some examples include clothing shops and restaurants. This kind of commercial real estate can be developed in large multi-tenant complexes in the form of shopping malls, strip malls, factory outlets, or other such shopping centers. It can also take the form of a single-tenanted standalone building. The earning potential of retail real estate for its owner can depend largely on its specific geographic location, because it significantly impacts which retail tenants will want to set up shop there. Retail leases also tend to be mid- to long-term, often in the 4-5 year range.
Commercial real estate classes and leases
Classes of real estate vary too, spanning from Class A to Class D. Each class communicates a level of quality for a commercial real estate property. Class A, at the top, represents newly constructed assets with high quality finishes, in in-demand areas, attracting the highest rents per square foot. Each subsequent class, from Class B to Class D, corresponds to increasingly older and generally less desirable assets.
Tenants differ across all types of commercial real estate investment properties. With different tenants comes different arrangements, rental property management needs, and lease agreements.
In some cases, a property will employ a net lease, which is an agreement wherein the tenant not only pays for the right to occupy the commercial real estate property, but also agrees to pay some or all of the property’s operating costs. The expenses typically available for inclusion 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 single, double or triple net lease agreement. Net leases can be very attractive to the property owner and less desirable for tenants, for obvious reasons.
How commercial real estate investments can generate returns
An investment strategy often begins with purchasing a property, with the aim of making money in two possible ways: first, by leasing the property and charging tenants rent in exchange for use of the property; and, second, by capturing appreciation of the property over time.
Let’s examine each of these ways that commercial real estate investment opportunities can potentially generate returns.
One way commercial real estate can succeed as an investment is by producing rental income from a tenant or multiple tenants. Rental income, in turn, becomes cash flow or revenue for the equity owner of the property. For commercial real estate that functions through a fund (as with Fundrise), this cash flow / revenue / rental income often reaches the hands of investors in the form of dividend distributions.
Commercial real estate’s ability to generate cash flow depends on a number of other factors, such as operating expenses and debt service. Property landlord duties can include maintenance and repairs, loan interest payments, rent collection, evictions, finding tenants, and ensuring that property is compliant with all applicable laws at all times.
You might consider hiring a property manager — or an entire property management company — if the job becomes too demanding, or if you lack the necessary financial, legal, and real estate knowledge needed to manage a property and tenants. A property manager charges a fixed fee or percentage fee of earnings, which alleviates property management responsibilities, but also reduces monthly earning potential for you, the owner.
Maintaining a balance of vacancy versus occupancy is a key part of successfully generating rental income — with as little vacancy as possible. Each unit that is unoccupied represents lost earning potential. Ideally, a highly occupied rental property will produce a steady cash flow and consistent returns. Many owners aim for a 90% occupancy rate or higher. It’s important to closely consider vacancy rates and occupancy rates for the areas in which you’re considering investments.
The income produced by rental payments is often considered passive income for the owner, depending on how they’ve decided to establish their management of operations at the building. While some real estate investors like to be fairly hands-on, others prefer to delegate operational responsibilities to property managers. In cases like those, it can be said that the cash flow provided by rent truly is passive income with the tradeoff of an additional cost. Fundrise, however, is a truly hands-off real estate investment option offering passive income potential while putting no property-level management responsibilities on your shoulders and maintaining a low-fee model.
Appreciation and value add
The second opportunity for returns and profitability of a commercial real estate investment comes from any increase in the property’s equity value – or appreciation – over the period of ownership. Properties can also lose value, and even the most disciplined, proven investment strategies can’t guarantee gains, due to the fact that outside economic forces can impact a real estate investment’s value. All types of property have the potential for appreciation in asset value and profitability, from raw land to a site home to an extensive apartment housing already developed.
In general, real estate is a unique and scarce asset class. More raw land can’t simply be “created.” This scarcity is increased by demand as many renters experience in major cities. If demand increases for your property, or in the area near your property, there’s a good chance that tenants will be willing to pay higher rents, and prospective buyers will be willing to pay a higher price than you paid originally to buy it from you.
In addition, scarcity often depends on the particular marketplace in question. A supply-constrained housing market in an urban center will value a new apartment building more highly than a rural area with a marketplace where housing is plentiful. The scarcity of a hard asset and corresponding property values can vary massively from one zip code to another.
Different markets are often referred to as primary, secondary, or tertiary. A primary market generally refers to the center of a major metropolitan zone, where populations are dense and economic activity is high. Primary markets are typically where some of the country’s most expensive real estate is located. Secondary markets are smaller than primary markets in terms of population, and are often the areas surrounding a primary market, like a suburb of a major city. Finally, a tertiary market is smaller still than a secondary market and located even further from a major urban hub. Similarly, a tertiary market’s real estate is typically even cheaper and in less demand than real estate in the other two categories, generally due to lower population overall. Still, many secondary or tertiary markets can present good commercial real estate investing opportunities, depending on factors like demographic trends or local job growth.
Appreciation through demand isn’t the only way the value of a property increases. Many investors take an active “value-add” approach to commercial real estate, making improvements to the property to increase its intrinsic value and purchase price, or its ability to earn income during the holding period. One example of this would be updating cosmetic details, such as flooring or countertops, or appliances of a multi-family apartment building. Updates such as these can involve many expenses, but they can also allow the owner to charge higher rent for nicer apartments. Any money spent on property renovations can potentially boost the selling price of the building in the future.
During the period when renovations are underway, a property may be empty and therefore not earning rental income. It’s crucial to consider any required debt service, and to ensure that you can continue to make payments for any financing during the holding period, even if the property is not generating rental income.
Other methods to achieve appreciation besides improving a structure physically might include rezoning an adjacent parcel of land (for example, from residential to multi-family), so that more apartments can be built. Changing the entitlements and permits available to a piece of land can have a considerable impact on that land’s sale price.
Methods to evaluate commercial real estate investing return potential
On top of understanding how the generation of rental income and appreciation work, there are several ways to calculate and assess a property’s current or projected return potential. Here are some of the major concepts that you should be familiar with in order to properly understand the calculation of commercial real estate investment returns:
- Net operating income (NOI): In real estate, the net operating income, or NOI, represents the annual revenue (or income) generated by an investment property after annual operating expenses. In simple cases, this is essentially the cash flow generated from rent over a given time period, minus any fees or costs associated with owning the property.
- Capitalization rate (Cap rate):The capitalization rate, or cap rate, is the most common valuation method used in real estate investing. It’s based on a property’s unlevered yield (rate of return). In other words, a cap rate measures a property’s natural rate of return for a single year without taking into account any debt on the asset, making it easy to compare the relative value of one property to another. A cap rate is usually expressed as a percentage value.
- Internal rate of return (IRR): The internal rate of return (IRR) is a metric used to evaluate the profitability of an investment over its lifetime and is represented as the average annual return percentage. The IRR of an investment can be calculated forward-looking to estimate potential future returns or backward-looking to measure the performance of a completed investment. Technically, the IRR is the rate of growth necessary for the value of the asset today to equal its projected value in the future.
- Debt service: Debt service refers to the amount of payments required under a loan. The payment amount will vary depending on several factors, including loan-to-value (LTV) ratio. The ability of a property’s cash flow (either existing or future) to service debt is one important indicator of inherent risk in the investment. Generally speaking, the greater the amount of debt (i.e. the more leverage) the riskier the investment.
There are other useful concepts to master, such as risk-adjusted returns (which refers to a way to think about how much an investment generates in balance with its relative amount of risk that it carries), or how investors frequently assess the value of a property by weighing its value against its total number of square feet. These general rules of thumb can give you a head start in analyzing an investment opportunity. For example, by knowing how many dollars you’re paying per square foot, you can determine whether you’re getting a good deal for the amount of space you’ve purchased, 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 for the total returns they earn on their investment, regardless of whether it’s a passive or active investment.
Commercial real estate investing strategies
The core strategy for commercial real estate investing is simple: you identify inherent demand for real estate in a given area and then you purchase a property while supply is still scarce. However, real estate itself can be a complicated and expensive asset class. And without due diligence, it’s possible to commit expensive investing mistakes. It’s imperative for you to understand both the specific variables surrounding that property, plus the general strategies that apply to that investment when buying a commercial investment property. Some of the most common investment strategies include:
- Industrial property for redevelopment: You might recognize that a relatively distressed neighborhood has potential for an economic resurgence in the coming years. You could acquire an industrial property and find a commercial tenant for the short-term. For the long term, you could later seek to have the property rezoned for redevelopment into retail or residential real estate, once demand in the rest of the area booms. You could then sell the property and capture any earned appreciation or continue to own the property while earning income from monthly rental payments from its tenants.
- Apartment building for renovation: If you see an area with a strong economy and steady population growth, you might look for an opportunity to buy an apartment building and increase its earning potential through renovation. By improving living spaces for tenants, you can increase rental rates, earning more cash flow in the short-term, while also potentially driving the overall appreciation of the asset.
- Land for entitlement: Sometimes you can identify an area with virtually no development that is ripe for population and economic growth in the near future. In that case, you might aim to acquire raw land and then obtain all the permits necessary for construction at that site, adding new value to the property. Then, instead of carrying out the construction yourself, you can sell the entitled property at a profit to someone else who wants to develop the land.
Because commercial real estate has traditionally been very expensive, requiring investors to tie up large sums of money in a single property for long periods of time, very few investors could afford to invest. Even those who could were frequently reliant on a commercial real estate investment strategy that involved leverage with borrowed capital, such as a fixed interest loan through a lending bank.
Today, however, options like Fundrise have made it possible for anyone to add commercial real estate to their portfolios with a significantly lower capital requirement, far less personal risk, and more robust asset diversification. Fundrise also offers the opportunity for truly passive income as well as long-term appreciation, as all management of the real estate funds and properties are carried out by Fundrise’s own experienced in-house real estate team.
Real world commercial real estate investing examples
Doug’s hands-on apartment building
Let’s look at a commercial real estate investment in action to better understand the performance of this asset type. Doug buys an old, 40-unit apartment building for $5 million. He earns a rental income of $500,000 in year one after all of his expenses (otherwise known as his net operating income). As with all properties, some tenants leave each year. Doug renovates vacant apartments before re-leasing them at higher rates to new tenants. Doug’s improvements increase the property’s rental income by $50,000 each year for five years, so by the end of year five the property earns $750,000 per year.
Doug then decides to sell the apartment building for $16 million. The buyer was willing to pay a higher price than Doug did 5 years ago for two reasons: Firstly, Doug renovated the apartments, which added value to the property. In turn, these renovations enabled Doug to raise the rental prices for the units, and they now earn him 50% more income than they did when he bought the building. Secondly, economic growth in Doug’s city increased property values as new renters and entertainment venues moved into the neighborhood. Nice job, Doug!
Jason’s hands-off approach
Doug’s cousin, Jason, has heard from his relative that real estate can be a pretty lucrative asset class, and he’s also interested in investing — but he doesn’t have the time, desire, knowledge, or quite as much capital to commit to the ongoing management of one or multiple properties. He also doesn’t want to take on the burden of an additional loan and mortgage on top of the one he already has for his family’s home.
After a little bit of research, Jason learns that there are a number of alternative real estate investing options, which allow investors to add high quality commercial real estate properties to their portfolios. Some streamline the process by removing all management responsibilities from the shoulders of the investors themselves. In many cases, investment options involve buying shares of a real estate-focused fund, like a real estate investment trust (REIT), which gives investors immediate exposure to a broad range of properties through a single investment.
Jason also discovers Fundrise as a way to easily access non-traded REITs (many REITs are publicly traded and therefore fail to offer deeper diversification benefits), and he’s drawn to the hands-off, low-fee structure, low investment minimum investment options that it offers. Jason is prepared to let his investment mature for five years or longer, which is in line with Fundrise’s investment horizons. Many of the properties in Jason’s portfolio are well positioned to grow in similar ways as Doug’s apartment building, and Jason’s share of ownership in those properties will reflect that potential growth. On top of that, Jason’s Fundrise portfolio includes properties of many other types and strategies too.
As the properties in his portfolio generate cash flow from tenants or interest payments, Jason collects any distributed dividends. Meanwhile, as the values of the properties themselves change, so do the values of Jason’s shares. Jason enjoys many benefits of the real estate investments while Fundrise’s in-house real estate team manages the properties contained within his portfolio for him.
- Unlike publicly-traded stocks, direct commercial real estate investing can provide stable cash flow in the form of rental income, often without the volatility of public investments. Adding real estate to an investment portfolio can offer the benefits of a new cash flow, plus long-term appreciation potential, as well as portfolio diversification.
- Commercial real estate is a hard asset that is also a scarce resource. It holds intrinsic value, and usually appreciates in value over time. Because of its cost, access to this asset class has historically been limited to large institutional investors, but new investment platforms like Fundrise have made it easier than ever before for anyone to access commercial real estate investing.
Historically, direct commercial real estate investing has been out of reach for the everyday investor and their portfolios. This is because investments in commercial real estate are typically dominated by institutional investors as projects require millions of dollars in capital and a deep reservoir of expertise for improving and operating a property. Fundrise makes it possible for you to invest directly in a diversified portfolio of private market commercial real estate for low fees, low minimums, and the potential for strong returns.