Whether it’s renting a room out to a tenant or house flipping, the prevailing understanding of real estate investment is centered on housing.
But there’s so much more to real estate investment than we think.
There are all sorts of real estate types:
- Residential
- Special use
- Raw land
- Industrial
- Commercial
Because commercial real estate (or CRE) seems so inaccessible, investors neglect its investment potential. But real estate assets in the commercial sector could significantly affect an investment portfolio’s diversification and performance.
Let’s explore commercial real estate, how it works, and how good an investment it is to enterprising commercial real estate investors.
What is Commercial Real Estate?
Commercial real estate describes properties that are utilized for the purposes of business-centered ventures, usually customer-facing. Basically, commercial real estate properties house the income-earning spaces for a given business.
Commercial real estate is the most common type of property in the market next to residential real estate.
As opposed to industrial real estate, commercial real estate is a location businesses use for buying and selling their product to customers.
Industrial real estate properties might manufacture or house the goods a business creates, but commercial real estate properties contain the shelves on which those goods are stocked.
Because this term can relate to such a wide degree of properties, there’s a diverse range of commercial real estate types.
Everything from restaurants, malls, hotels, office buildings, retail storefronts, or grocery stores falls under commercial real estate designation.
How Does Commercial Real Estate Make A Return?
The rent paid to the asset owner constitutes the return on their investment.
“How” a commercial real estate asset generates a return for the investor isn’t all that different from how landlords earn capital from renting a living space.
Most businesses don’t have the resources to build their own commercial space. Starting a business comes with enough operating expenses as is; the added cost of developing real estate to conduct that business is an expense few businesses can afford.
That being the case, the vast majority of commercial spaces are leased to businesses. The property owners collect rent from the commercial tenant, in this case, the business leasing the space.
What Are The Benefits of Commercial Real Estate?
- High income potential
- Fewer interruptions to earnings
- Businesses are reliable tenants
- Have a clear value
- Hedge against inflation
- Triple net leases
Residential and commercial properties are similar in that their income is earned through the rent collected from the tenant.
However, some key differences make commercial real estate particularly beneficial investment assets in a portfolio.
Let’s look at a few ways commercial real estate makes for a unique asset class.
High Income Potential
Commercial spaces have high annual returns. Investors can generally count on an annual return between 6% and 12% based on the property’s purchasing price. Considering how expensive commercial real estate can get, that can be a substantial return for the investor.
Compared to the income potential of residential real estate, commercial real estate tends to be higher for a number of reasons. For one, commercial spaces can be much larger than housing spaces. This translates to higher rental payments from the tenants, which means more income earned from the real estate property.
Furthermore, commercial spaces are places of business. That means they are operating with more capital than residential space. The higher cash flow in commercial spaces translates into a higher range of income earned for the property manager.
Fewer Interruptions to Earnings
One of the most precarious parts about renting out a property is finding a tenant that can reliably pay their rent on time.
Residential properties, like apartment buildings or single-family homes, have a higher degree of tenant reliability than commercial spaces. Breaches of contract over the livability of the space mean that residential property owners can be taken to civil court for many reasons.
Renters may be unable to pay their rent. It’s perfectly common than residential tenants simply want to move to another space, leaving the landlord in a scramble to find new tenants.
When it comes to property rental, investors want as few interruptions to their income stream as possible. The property wants to generate a return if the rent doesn’t come in.
These interruptions to income earned through rent are far less common in commercial spaces because businesses are often reliable, steady clients.
Businesses Are Reliable Tenants
A business is less likely to move on a whim because it is far more costly to move a business than a place of residence. The business would have to advertise their new location, move their goods, and reconnect with distributors—it’s in a business’s best interest to stick to one place.
The commercial office space is the heart of the business owner’s income. The business owner’s strategies align with that of the property owner. The business wants to make a profit with their goods or services. The property owner wants the rental income paid by the tenant.
This dynamic makes a business an ideal tenant and commercial real estate assets a reliable source of income for real estate investors.
Commercial Properties Have A Clearer Value
One of the murkier parts of acquiring real estate assets is getting the optimal price for your investment. The value of residential properties is a little more opaque in their value compared to commercial investment properties, removing the time and concern over determining the most reasonable price for an asset.
Commercial properties have an advantage over other types of real estate in this regard because an investor can inquire about the current owner’s income statement. An income statement will tell the prospective investor all sorts of pertinent information about the value and earning potential of the property.
Whether it’s a retail space, restaurant, office, or hospital, commercial real estate properties have capitalization rates (cap rates) that indicate the performance potential of a given property type in an area.
With clear visibility of a commercial property’s value and earning potential, investors can get a clear look at an asset before they leap in with their investment.
Commercial Real Estate Can Be A Hedge Against Inflation
Inflation can depend on an investor’s savings or securities-based assets in the stock market. As prices increase in the post-pandemic economy, the purchasing power of their liquid capital becomes weaker, retirement savings dwindle and markets slow down with fewer people making investments through the exchange.
The commercial real estate market has historically been a safe place to keep investments when inflation increases prices.
For one, rent prices tend to keep pace with rising prices in the economy. As ownership costs increase, these price increases become factored into the rent. The landlord needs to make a profit on the property to keep it running, so these increased costs determine the rent paid by the tenant. As prices increase, the income generated by rental payments remains the same or grows.
What’s more, already developed commercial properties will operate under lower interest rates than the ones instituted by inflation. The Federal Reserve increases interest rates to curb rising inflation. However, in the case of properties that are already locked in with their interest rates, they remain unaffected while rising prices increase their overall value.
Triple Net Leases
Unlike residential properties, commercial properties have contractual options that allow the property owner to be exempt from paying additional upkeep expenses on the property. Under a triple net lease, the tenant pays for real estate taxes, building insurance, and maintenance fees.
Triple net commercial leases spare the owner significant expenses, so their return is more distilled on their asset. Without these added expenses, commercial property investors no longer need to subtract them from the tenant’s rental payment income.
By signing a triple net lease, they take on these additional expenses so that they can make the alterations they deem necessary to abide by their brand’s image.
Commercial properties don’t have the same level of regulations determining how contracts are written. Residential properties have a high degree of standards they must maintain to ensure a decent living space for their tenants.
Commercial real estate, on the other hand, houses businesses that may have differing views about how they want to care for the property. Lease standards are more relaxed for commercial properties to accommodate different viewpoints on optimizing the property for a given business.
How to Invest in Commercial Real Estate
Clear benefits make commercial real estate assets a lucrative addition to any portfolio. So how can an investor buy into commercial real estate?
Commercial real estate is extremely expensive — the price of commercial property is calculated by the square footage, which adds up quickly. Whereas some investors may be able to acquire residential properties like condos or multi-family homes as individual landlords, commercial properties are far less accessible for solo investors.
Not only are they pricier, but they also require a much larger investment of your time. One property can hold several businesses, each requiring the owner’s due diligence and care.
The best way to buy in is through a more significant financial group.
REITs
Real estate investment trusts allow everyday investors to get involved in commercial real estate investment for passive income.
These trusts act similarly to companies traded on the stock exchange. Instead of generating an income from creating a good or service, these trusts earn an income through the financing, ownership, and sales of real estate assets, often consisting primarily of commercial estate options.
You Can Publicly Trade REITs
Investors can buy shares of a REIT through the exchange like they were any other tradable security. In doing so, investors can buy into commercial property-driven REITs and gain access to the investment opportunities this type of real estate provides.
Private Equity Real Estate Funds
Private equity funds are similar to REITs with a few advantages.
They aren’t publicly traded, so they are more immune to market fluctuations—these funds are managed by professionals using capital derived from a selective pool of investors.
With the backing of accredited investors, private equity funds provide investors a premium investment opportunity on real estate opportunities that REITs miss—and with better returns on their investment.
Invest With The Best
Christina has thrived in one of the country’s hottest real estate markets for over four decades.
We’ve dialed in an effective strategy over years of experience in the Westside region of Los Angeles. In some of the most exclusive neighborhoods in the city—Santa Monica, Malibu, Beverly Hills—we’ve found a niche market that continues to generate returns.
Get started with Christina today if you’re interested in tapping into these real estate gold mines.
Sources:
Pros and Cons of Investing in Commercial Real Estate | NOLO
Cap Rate: Defined and Explained | Rocket Mortgage
Triple Net Lease (NNN) | Investopedia
The Impact of Inflation on Commercial Real Estate | PB Mares