Four Things to Know Before Investing in Commercial Real Estate
Investors planning to enter or expand their footholds in commercial real estate are to be congratulated for there are many good reasons to invest in real estate. The benefits include a mix of security, income, tax benefits, and potential for appreciation.
Since 2000, commercial properties in the U.S. have nearly tripled in value, according to the well-regarded Green Street Commercial Property Price Index. There was only one real decline in general commercial property values in that period, and during the Global Financial Crisis of 2007-2008—but lost ground was made up by 2012. The Pandemic Recession in 2020 resulted in a fleeting six-month dip in prices, a decline that was also made up by 2021.
While appreciation has been steady through the decades, commercial real estate also rewards investors by generating operating income, the classic term – “passive income”. In other words, property owners are “paid to wait,” so to speak, for the day they choose to sell.
Like any investment, commercial property is not immune to risks.
Broadly speaking, a benefit of investing in commercial property are the solid yields. Commercial properties typically yield 5% to 8% on the purchase price, though this will vary relative to the risk free rate of 10-year Treasury bonds, so lower during periods of very low interest rates.
In contrast, the average dividend yield on listed public companies is generally lower, often running under 2%. Similarly, in recent years sovereign government bonds have yielded in low single digits, and some have even offered negative yields.
And, of course, well-selected commercial properties generally appreciate, and more than keep up with inflation, meaning that an exit strategy will often yield multiples of the originally invested equity, building the wealth of participating investors.
In the modern era, investors can buy commercial property through real estate syndications, and especially crowdfunded real-estate transactions, or real estate investment trusts (REITs) traded on Wall Street, or publicly held companies that are primarily real-estate based.
This latest market evolution—the easy and safe availability of commercial real estate to individual investors—in many ways negates what used to be a “con” of buying commercial property: It took a large chunk of cash, time and expertise to buy a large, discrete piece of commercial real estate.
With the emergence of crowdfunding, real-estate syndications and Wall Street-listed public real estate enterprises, an investor can easily diversify and thus eliminate most of the “cons” associated with the ownership of large-sale commercial property.
First, the standard types of commercial real estate include:
“Special”or “Niche” – the remaining catch-all category that can include medical, religious, or recreational properties, parking facilities, or new property types such as data centers, telecom towers or life-science business parks.
There are pros and cons within each category, and many further nuances based on time and place. Becoming an expert within just one category can take years of professional exposure and a lifetime to perfect. Those investing directly into commercial properties are well-advised to seek counsel, on everything from tax law to the title search, to the quality of the tenants, to the best financing, to the prospects for financial returns.
Whether you’re looking to invest in commercial real estate directly or through crowdfunding/syndication, here are four things to know before doing so.
Are values for the type of prospective property in the geography of prospective property going up or down? And why?
Throughout history, some great trading cities from antiquity have disappeared, typically within Mideast empires, due to development of seagoing vessels that altered trade routes, water shortages or accumulating poor soil. To be sure, while most property markets appreciate over time in modern day America, there have been regions, typically in the Rust Belt, in which some neighborhoods have gone into long-term decline.
It’s best to have property in a city with a growing population rather than a declining population. To own a property in a growing metropolis is to have an appreciating asset because population density growth trends and property values are heavily correlated.
Looking at comparable property values (or “comps”) is also advisable and relatively easy. Many county-assessor offices have put sales and assessment values online, and many commercial services, such as Costar and other online services, track property sales and prepare automated comps.
Also, those investigating large commercial properties can peruse the regular and freely available online reports issued by such commercial property brokerages such as CBRE or Cushman & Wakefield, that assess property values and rental trends or in cities and regions.
Though it may seem simple, even reading the online classified property and rental ads, in such services as Craigslist or Zillow, can tell the investor what buildings really rent for, as opposed to the optimistic outlooks of building sellers, or syndication sponsors.
Among the many advantages readily available to today’s property investor is the supreme virtue of knowledge. Even passive investors are advised to “bone up” on a region or property type—and besides, gaining a deeper understanding of a region’s history and property markets is often a reward in itself.
As mentioned, it is possible for an urban region to decline, and for longer than any particular property investor probably wants to hold on. For example, the population of steel town Pittsburgh crested in 1950 at more than 676,000 but declined to a little more than 300,000 in the 2000s (although the larger metro area around Pittsburgh has a more-stable population). The industrial Rust Belt of the US went through a historic and not always favorable transformation after the 1980s, undercut by both the decline of manufacturing and the better weather of the Sunbelt.
Of course, most urban areas in US history—still a relatively young nation—have only grown over the decades, resulting in generally appreciating property values. However, the ebbs and flows of values, even in certain less prosperous areas or old Rust Belt cities, can present opportunities—especially if the land or property is priced right for acquisition.
The process of “gentrification” or “adaptive reuse”—that is, the refurbishment or repurposing of generally central-area properties in reviving older US cities—has become well-known and has proven profitable in many regions.
A long-running and evidently intractable dynamic of urban areas in the US, and even globally, are housing shortages. For investors, owning an asset defined by shortages is a worthy prospect.
Nor do there appear to be any solutions on the boards for housing-tight America. Property zoning is a local issue, beyond the reach of the national government in Washington, and everywhere homeowners and other groups use local zoning and regulation to define their neighborhoods. Residents in single-family detached neighborhoods are not keen on having condo high-rises with ground-floor retail as new neighbors.
Even in denser areas, property owners and tenants often resist “more traffic” or other perceived negatives that additional development would bring, or even do not want the commercial competition that new construction might bring.
This urban dynamic, for better or worse, appears likely to offer medium and long-term investment opportunities for the foreseeable future for buyers of housing in most urban areas.
3. What Type of Property to Own?
What type of property to invest in is always an intriguing question, and for many of the same considerations that attend to all investing: If an asset is widely regarded as attractive, the relatively high price reflects the consensus. Out of favor assets can be acquired at a lower price—but there are usually solid reasons why assets fall out of favor or cost less than the alternatives.
As mentioned before, the seven types of property are 1) residential, 2) office, 3) industrial, 4) hospitality, 5) retail, 6) agricultural and 7) the “special” category that can include medical, religious, or recreational properties, parking facilities, or new property types such as data centers, wind- or solar-farms, telecom towers or advanced life-science business parks.
For some investors, the choice of what type of property to buy may come down to a personal decision based on one’s own life history. An investor who has worked in retailing may be inclined to look for value in that type and may have a leg up on spotting undervalued assets.
For investors seeking security and stability above other factors, tech-related assets and in many markets, housing, may offer the most security against the loss of capital. To state the obvious, the demand for eCommerce continues to grow and with it so do the facilities required to service this industry, while housing is chronically undersupplied in the US, due to various building restrictions. Even in the long-term, housing promises to remain tight in many regions of the nation.
For investors who like to “time the market” the hospitality sector might be attractive at the tail-end of any economic downturn. In general, the hospitality industry has a “high beta,” meaning that in good times business is great and in bad times, business seriously flags. It is easy to see why—lodgers are business travelers and vacationers, and both segments are highly discretionary, and likely to be trimmed when belt-tightening times come. Like many investments, timing is likely the key to selecting an entry point in the lodging business.
Other property types, like office, offer many opportunities and challenges, presently and through history. The central business district is relatively new, with office districts barely a century old, though now iconic of many urban skylines. Just as technology—steel construction and mass transit—helped create office districts and sky-rises, so technology will challenge office markets in the future and should be harnessed to ensure relevancy in competitive markets.
One reassuring aspect of property in dense and growing regions is that even if a use becomes obsolete, a centrally located structure can retain value. Old office buildings can be repurposed into housing, and unused warehouses into creative office space. The business of upgrading property is another way to invest in real estate.
The “special” category is another interesting segment to prospect. The businesses of data centers or telecom towers promise to have legs, as do life science or high-tech business-industrial parks. As the world of commerce evolves, so will the uses of property.
4. Have an exit strategy
As a practical matter, short-term investing is rarely an option in commercial property markets, but some investors may develop medium- or long-term outlooks.
In general, the medium-term in commercial real estate investing is defined as three to seven years. Most crowdfunded and other real estate syndications present a liquidation event or exit strategy within that time frame.
Thus, investing in real estate does present some issues regarding what economists call “opportunity costs.” The property buyer’s capital will be tied up, or not liquid for the duration of the investment.
There are some workarounds to illiquid property assets. The direct property investor can choose to refinance the original mortgage, to return equity to investors from an appreciating asset, which can be reinvested as a down payment on a new property, building wealth for all.
That said, as a long-term asset, or even multigenerational investment, property is a fine alternative, especially if farmland or located in growing cities. Many families operate farmland or commercial properties on which the mortgage has been paid off, thus becoming permanent cash cows.
In any event, property nearly always rewards the patient investor.
Before the 1960s, the prospects for most to invest in commercial property were somewhat limited, and usually required the direct purchase of real estate.
What is sometimes called “fractional ownership”, or real estate syndications did not really take off until the postwar era, especially in the 1950s. Many of the old-school real estate syndications were worthy but did require heavy upfront fees to organize.
The year 1960 was a banner year in that enabling legislation passed the US Congress allowing real estate investment trusts (REITs), which brought the benefits of commercial property to nearly all retail investors and high net-worth individuals. The foundation for the modern REIT was expanded with the Tax Reform Act of 1986, when the trusts were given the right to operate and manage property, rather than simply owning or financing it.
Perhaps the most exciting and third level of fractional real estate ownership opened in 2012, with the passage of the Jumpstart Our Business Startups Act, or the “JOBS Act,” a law intended to encourage funding of small businesses by easing certain securities-industry rules and equity-raising rules.
The short story is that the JOBS Act paved the way for property syndicators to legally solicit both large and small investors broadly, and very efficiently online and by advertising—and thus “crowdfunded real estate” was born.
Investors can peruse investment opportunities, view property photographs, and even invest, once logged into a system and properly accredited. This is the democratization of real estate opportunities.
It hardly needs to be said that with the advent of publicly traded REITs and crowdfunding, diversifying a property portfolio has become a task immeasurably eased.
There are different ways to diversify property, from regional or geographic, to selecting a mix of property types, such as warehouse and residential.
Another option for investors is to mix it up by the date of the property liquidation event or exit strategy—so that one is garnering profits from sold properties on a regular basis for application into new properties.
Many homeowners may wish to consider that in terms of their own portfolio, they are already deep into residential property in their own city. Another property type in a different region would add balance.
Investing in real estate has never been easier. From anywhere and at any time of day or night, investors can choose to own commercial real estate, of any flavor, in nearly all regions of the country. By the click of a mouse, investing online through crowdfunded syndications is doable, and became a mainstream way of investing in real estate in just the first few years since legalization in 2012.
In choosing to do so, the investor is almost invariably signing up with expert management, and, in the case of syndications, management that is co-invested alongside them.
To be sure, due diligence before any investment is necessary, and every investment has risks. Additionally, syndicated property investing is a pastime for the patient, with usual minimum three-year holds in syndications.
Given the mix of income, security and appreciation, property investing is an endeavor that has stood the test of time. Businesses within a city come and go, but the property remains, delivering rewards for owners through the generations.
That permanent value is the fundamental reason why owning real estate is often a smart decision.