Commercial real estate describes property used to generate a profit, like industrial property, office buildings, apartments and hotels.
Traditionally, investing in commercial real estate is an alternative asset – a type of asset that’s not considered part of an investment portfolio. It’s provided countless investors with portfolio diversification and attractive risk adjusted returns. But some investors may not understand how investing in commercial real estate works.
There are key differences in investing in alternative assets and traditional investments, like stocks and bonds. Traditional investments are traded on a secondary market, while commercial real estate is considered a scarce resource with intrinsic value as a hard asset. Investors often purchase stocks for their upside potential rather than as a source of income. Another key difference between real estate and traditional investments is the concept of liquidity. Liquidity refers to the ease with which an investment can be converted into cash. Stocks and bonds would be considered highly liquid assets, whereas real estate has relatively low liquidity. Some investors choose to purchase shares of real estate investment trusts, or REITS, which allow for the financial benefits of property returns with the liquidity benefit of stocks or bonds. Additionally, real estate can offer tax benefits that other investment types may not.
With commercial real estate, investors use property as a source of income in two ways. Cash flow is created through effectively leasing the property at rates that will cover the costs of ownership as well as generate additional revenue on a monthly basis that the owner can access. Real estate can also produce a return through the appreciation in the property’s value over time, resulting in a gain to the owner when the property is sold for more than the owner’s purchase price. In some cases, if properly managed, the property can produce both types of income.
Cash Flow/Rental Income
Tenants differ across the spectrum of commercial real estate investment properties. Lease agreements, property management agreements, and the level of maintenance and involvement in the property all vary widely in a number of ways.
For instance, apartment properties typically have individuals or families as tenants, and leases are guaranteed by an individual who may cosign the lease. Leases differ both in terms and in length. Owners may have many tenants and many payments to manage each month. With commercial properties, businesses lease space and are responsible for the payment of rents, and leases can be guaranteed through personal guaranty by the owner of the business, larger security deposits, corporate guaranty, letters of credit, etc. Leases will again differ in both term and length, and rates can differ widely even in the same property based on additional factors such as the initial investment made to prepare the space for the tenant’s occupancy, commission costs, owner concessions, etc. All of these items are negotiated during the process of securing a commercial tenant, and are reflected in the tenant’s lease.
Regardless of the property type, it is important for owners to closely evaluate the true value creation of leasing a space to ensure that cash flow goals and objectives are met. The cost of leasing space must be factored in during this evaluation to ensure that accurate financial projections can be achieved.
Potential returns from a commercial real estate investment also come from an increase in the property’s value over time. Due to a variety of factors, properties might also lose value. These factors can be macro or microeconomic, including things like the overall economic state of a country, a state, and a particular city/market, how a property’s rental incomes compare to the rest of the market, the occupancy level of a property and how this compares to the rest of the market, the physical condition of the property and how well it is managed.
Most investors also take a “value-add” approach to their properties, making improvements to commercial real estate to increase its intrinsic value and ability to earn income, negotiating rent escalations in leases, etc. Money spent to update a building might boost the selling price down the road, and a property that can produce higher revenue each year while maintaining a low churn cost will also be worth more. “Value-add” can also refer to a scenario where an investor buys a property that has low occupancy, is in disrepair, and is therefore offered at a lower than market price. This type of investor will have a plan of improvements and leasing that will be executed after purchasing the property, and a level of investment that will be made in addition to the purchase price that will ultimately result in a target gain at the time the property is sold. This type of scenario may not necessarily produce cash flow during the period the investment is held, but should produce a larger return at the time the property is sold.
Supply and Demand
Generally, real estate is considered a scarce resource. That is, more land can’t simply be “created”. As properties are built in and around a particular market, the available land is consumed, if you will, and becomes even scarcer. But as more buildings are built, the inventory of space available for tenants to lease increases. Demand for space is driven largely by the economic health of a particular segment of the economy and/or commercial tenant, such as office, retail, industrial, or medical businesses. When the inventory, or supply, of space available for lease increases, and demand decreases or remains the same, tenants have more choices and are able to negotiate more aggressively in their favor, meaning lower rental rates and more landlord concessions. Occupancy rates may also decrease overall as a result of this, potentially leading to the lowering of rental rates in order to entice tenants to enter into a lease. When the supply of space available for lease increases but demand also increases, this may not be the case and these variables keep pace with each other. When supply decreases and demand increases or remains the same, landlords may have the upper hand in the negotiations to attract tenants, as there is less space for tenants to choose from. This will result in higher rental rates and fewer concessions from landlords. Supply can increase or decrease based on new properties being developed in a market, property demolition or destruction, large employers relinquishing leased space due to company consolidations or closures, large employers choosing to purchase property rather than lease or vice versa, etc.
The Bottom Line
Commercial real estate can be a very profitable investment, capable of producing significant revenue streams in different ways. As with any investment, research and guidance are an important part of ensuring the desired returns are met. A commercial real estate expert is an important part of this process, and will help his or her client analyze opportunities and manage the investment properly. This allows the investor to have the tools and knowledge needed to make the best decisions for a successful outcome.
Contact DRK and Company at 614-540-2404 with any questions you have about commercial real estate. We’ve been serving Columbus for 45+ years, and our experienced commercial real estate team can guide you through the process of selecting, purchasing, managing, and selling your commercial property.