Asset Focus: Commercial Real Estate
From apartment buildings to warehouses, commercial real estate has long been a staple part of institutional investment portfolios. Today, more relaxed financial regulations have opened the door for smaller investors too!
In this latest instalment of our series focussing on investments that pay monthly income, You’ll find several ways to add the income and capital appreciation potential of commercial real estate to your investment portfolio in 2021.
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The information in this article won’t transform you into a commercial real estate investing whizz-kid. But I think it is a great place to start if you want to understand how this complex and potentially very profitable asset class might make a suitable addition to your own portfolio or retirement account.
What is Commercial Real Estate?
The term commercial real estate (CRE) pretty much covers any type of property owned to produce income, excluding residential property with less than 4 units, So, basically most types of real estate apart from single family homes, mobile homes, condos, duplexes, triplexes and quadplexes.
CRE is all around us. It is the mall you shop at, the office you work at, the restaurant you eat at, the medical centre where you have your check up, your self-storage unit, and the senior living accommodation where you visit Grandpa on Sundays. It is also the 300-unit apartment block your sister lives in. Even the farmland that grew the grain for your burger bun, that’s commercial real estate too!
While there is no real official classification system, here are the 8 main categories of commercial real estate that most people agree on:
- Multifamily Apartments
- Mixed Use
- Special Use
It’s worth noting that each category in CRE has an almost endless list of sub-categories. For example, there are many different types of land, such as farmland, or development land. There are then sub-categories of farmland itself, including arable land, grazing land, and permanent cropland (such as an apple orchard).
As you can imagine, there are also many different types of industrial, retail, hospitality and all other categories of CRE. Here is a little deeper explanation of each of the 8 broad categories of commercial real estate.
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A very popular category of commercial real estate with investors right now, when one refers to multifamily real estate, one is essentially making reference to apartment blocks. This could mean one single building with 5 or more residential units, or several such buildings in a larger complex.
Multifamily assets are classed A through C (sometimes through D), with A being newer, top class, well-located properties, and D being older buildings in need of a lot of work – and probably not very well-located. Many investors look for C or D-class properties located in (or close to) A or B Class areas, with the aim of improving the property with renovation and increasing rents.
Because multifamily buildings tend to be large and therefore expensive to purchase and operate, the opportunity to invest in all but the smallest of these assets has historically been reserved for wealthy investors, including investment funds, large asset managers, REITs, and other institutional investors.
Today, financial regulations have been eased making it possible for all types of investors to participate directly in the ownership of multifamily real estate. For the most part, smaller investors can access multifamily real estate investments via pooled investment schemes such as syndications and crowdfunding.
While there are still some restrictions on who can invest in certain types of investment structure, I’ll cover exactly how you can invest in multifamily real estate later in this article.
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Much as it sounds, office real estate is simply office buildings. That could be anything from a single office, to huge skyscrapers with hundreds of units, and could include anything from just one large corporate tenant, to hundreds of smaller businesses utilizing flexi-office space or co-working space.
Again, much like multifamily real estate, because office blocks tend to be large and expensive, investing in them has been a luxury reserved for investors with a lot of capital to spend, and/or access to huge piles of credit.
Typically, office real estate is categorized as A, B or C Class, with Class A being the best quality assets, and Class B buildings perhaps not as well-located, a little older. Class C assets are usually the oldest – over 20 years old – not in great locations, and possibly requiring some renovation.
Investors tend to buy Class A office real estate as a safe-bet income generator. Class B and C assets are typically acquired with a value-add strategy, with investors seeking to increase the value and rents by improving the buildings.
Industrial Real Estate includes most buildings and land that are purposed for industrial business activities such as manufacturing, warehouses, storage, and logistics, among others. Most cities have specific zoning for industrial real estate so that the industrial activities (noise, waste, traffic, pollution, etc.) do not disrupt or disturb other businesses or residents.
As with all other types of commercial real estate, industrial properties are classed A through C, with A being prime, and B & C properties more of a value-add proposition. This is an important consideration for investor because the class of the real estate will determine what type of investing strategy, and what level of risk and return is involved.
As more and more of the economy moves online, well-located industrial real estate such as logistics and warehousing could be a great long-term investment for both capital growth and income.
Retail real estate is a unique category with the commercial real estate World. This interesting subsector includes properties such as retail shops, and increasingly, entertainment facilities. This could be anything from huge shopping malls, to small, boutique clothing outlets, hairdressers, florists and any other retail premises you can think of.
Much like all the other types of commercial real estate mentioned in this article, retail properties tend to be large and expensive, although it is of course possible to buy single shops or strip malls and the like. You can invest in retail real estate through syndicates, funds, REITs and other polled investments.
The retail sector has some unique characteristics that better suit certain investment strategies. For example, retail leases tend to last for around 5 years, much longer than the annual renewals common in the multifamily sector. Retail properties tend also to be lower maintenance than buildings with people living in them, and retail tenants typically pay for all utilities and maintenance
Retail properties also come with their own unique challenges, including increased sensitivity to economic cycles. A great example of this is what happened in 2020 with Covid-19 related shutdowns of much of the retail sector.
Hotels & Hospitality
Hotel and hospitality properties are unique in the real estate sector as they are both real estate assets and operating businesses that generate revenue. As such, these kinds of properties can a useful tool to generate monthly income and long-term capital appreciation.
There are effectively three types of hotel real estate; economy, mid-scale (including upper mid-scale), and luxury. Converse to some types of commercial and residential real estate, the higher end of the market luxury hotel sector – whilst the most profitable during a growth economy – is the most risky due to losing significant business in a downturn. Economy hotels also suffer during a recession as households tighten their travel budgets. It is the middle market hotels that tend to do best at surviving mixed market cycles.
Unlike multifamily properties, retail, and industrial real estate, hotels are able to adjust to the market demand very quickly by changing their room rates on a daily basis. This flexibility to manifest higher demand in higher revenue, as well as be more competitive during tough times, makes the hotel sector unique.
Much like retail, the Covid-19 global pandemic in 2020 hit hotel and hospitality real estate very hard. As tourists and business travel was effectively cancelled, many hotel and hospitality businesses went bust. Some of these hotels defaulted on their mortgage loans and are now up for sale for knock-down prices.
Another diverse subsector of commercial real estate, there are many, many different types of land. Most land starts out as agricultural in one form or another. Then, as urban areas expand, land is rezoned for the development of various kinds of real estate, including both commercial and residential.
From an investors perspective, specifically an investor seeking to build a reliable stream of monthly income, there are various ways to make land investing work. Farmland can be rented to farmers in returns for regular monthly, quarterly, or annual income. Or, you could farm it yourself, establishing permanent crops such as fruits that are relatively low maintenance but with high potential for income.
Pre-development land with or without planning permission to build can also produce income. In many cases, investors will buy raw land and sell to real estate developers on a lease option creating a regular source of income. This can be done with both residential development land and commercial development land, although actually achieving rezoning for development, or detailed planning permission to build, is very complex and time consuming.
There are also some very niche land investment strategies to consider such as timberland and forestry investments. These types of assets require a lot of knowledge and experience to manage effectively to create reliable income, but there are also many ways to invest in such things passively including specialist forestry investments funds and REITs.
Mixed Use Commercial Real Estate
Real estate for the modern age, mixed use real estate contains both a commercial and residential element, often aiming to create a convenient, harmonized living space with access to office, retail, and/or leisure facilities for residents. For example, a multi-storey apartment block with shops, offices, and cafes on the ground floor would be considered mixed use real estate.
This type of development has become a fundamental part of modern day urban planning. In many cities around the United States, developers are encouraged to put forward plans that combine residential with commercial, cultural, and entertainment space. Sometimes, mixed use will include standalone residential buildings developed on the same site as commercial assets. As such, mixed use developments can take up huge amounts of space.
There are all sorts of mixed use developments happening all the time, some new-build, and some innovative redevelopments and repurposing of existing buildings. For example, main street mixed use real estate typically refers to 2- or 3-storey town-centre buildings with commercial units on the ground floor and residential on the 2nd and or 3rd levels. Live and work space on the other hand might include residents living in the building in which they also run their small business. An example of this might be an apartment situated over, adjacent to, or behind a creative studio.
When it comes to repurposing existing properties, developers might convert parts of less busy shopping malls into residential units. Many downtown and city centre areas are also seeing somewhat of a renaissance. Years of decline have suppressed real estate values, creating opportunities for developers to buy up assets cheap and convert them to mixed use residential/commercial spaces.
Special Use Commercial Real Estate
This is a very interesting category of commercial real estate. Special use buildings can be broadly described as a piece of real estate that is appropriate for a single (or very limited) purpose in its current form without significant capital investment.
There are elements of special use real estate within the other categories of CRE that I have mentioned already in this article. For example, assisted living facilities might be considered as part of the hotels and hospitality sector, as well as fulfilling the definition of special use.
Other examples of special use real estate include hospitals, cemeteries, cold storage facilities, marinas, oil wells, quarries, mines, and golf courses. The list goes on.
There are plenty of opportunities to invest in special use real estate. Often, due to the very niche nature of the subject property, they will require industry-experienced management and/or operating businesses. As such, you will find that there are specialist funds and asset managers that focus on very specific real estate sectors such as leisure and entertainment properties, or assisted living facilities.
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How To Invest In Commercial Real Estate for Monthly Income
As I mentioned at the very start of this article, there are now many ways for investors of all shapes and sizes to participate in commercial real estate investments. Indeed, CRE can be a great tool to add alternative sources of income to a well-diversified portfolio.
Because CRE assets are typically large, expensive buildings, it usually requires a significant amount of capital (usually both equity and debt) to acquire, renovate and also operate and/or manage them effectively. This means that, for the most part, these types of buildings can only be purchased by the super-wealthy, or by pooling many investors funds together.
This means that, historically at least, the only way to hold commercial real estate as a smaller, private investor, has been to buy small commercial buildings, or invest in a REIT (or, be super rich). But that all changed in 2012 with the introduction of the JOBS Act. This new piece of financial legislation relaxed securities laws and allowed for smaller investors to participate in the kind of pooled collective investment schemes that had previously only been accessible to accredited investors.
Here are some of the best ways to add various types of commercial real estate to your own investment portfolio in 2021 and beyond.
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Let’s start with the obvious – buying your own commercial real estate. If you don’t have millions (or billions) of dollars in spare cash lying around, then your options are limited, but by no means non-existent. Of course, anyone can purchase any commercial building provided you can find one within your budget.
For example, you could buy a retail shop, a garage, a self-storage facility, or a small office building. You could also look into smaller multifamily properties with between 5 and 20 units. These smaller assets are often overlooked by institutional investors and syndicators who typically want larger properties.
As with any type of real estate, there are a ton of ways to buy CRE. For best value, you should look for distressed assets with a strong value-add element, or motivated sellers willing to offload their property at a discount in exchanged for a quick sale, or accept seller financing as a purchase option. Preferably, you want a combination of these things to make up a great deal.
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Syndications can be a great way to invest in commercial real estate with a smaller amount of capital and expertise than is usually required to acquire whole buildings outright.
A syndication in real estate is essentially a partnership between different investors. Each party brings something to the table, ultimately combining their expertise, resources and capital to acquire, develop, and manage a large commercial building that they could not afford on their own.
Commercial real estate syndications usually comprise a syndicator – sometimes called a sponsor – and investors. Each party has a different role to play.
The syndicator is responsible for sourcing suitable properties to purchase, due diligence, project planning, arranging senior and mezzanine debt, sourcing equity investors for the syndicate, and managing the development, property management and sale or refinance of the property. For this work, the syndicator will earn a fee of around 1% of the deal value.
The sponsor will also invest some of their own money in the deal – usually between 5% and 10% of the total equity required. They will also earn a percentage of the total property income once other syndicate investors have been paid their “preferred return”.
Other investors in the syndicate are more often than not passive. They will simply put up the money and collect income on their investment throughout the term of ownership.
There are many different corporate and contractual structures to consider when approaching commercial real estate syndication, including many ways of dividing the income and risk attached to the investment. You should take independent legal advice on the paperwork, and seek references and details of previous successful (or otherwise) investments from the sponsor.
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Whilst still quite new, this method of grouping a number of smaller investors funds together via an online platform to purchase more expensive real estate assets has become increasingly popular in recent years. This is mostly due to the low entry levels, and the fact that these platforms offer everyday investors the chance to invest in institutional scale assets. It should be noted however that access to some crowdfunding platforms is restricted to accredited investors only.
Crowdfunding is mostly a passive investment, generating income from rents and leases, and potential exposure capital gains from development and price appreciation.
Another great benefit of crowdfunding is the ability to invest in multiple projects, which can be a great way to reduce the overall risk profile of your portfolio.
There are many crowdfunding sites to choose from. Some specialize in residential property, others in commercial assets, and yet more in specific niches such as multifamily, or hotel and hospitality properties.
As the real estate syndications explained in the section above in this article, crowdfunding projects will have a project sponsor and passive investors. While the sponsor finds and plans a suitable project, passive investors simply stump up the cash and collect their income distributions.
Whilst investment returns vary wildly from one project to another, it is fairly reasonable to assume an overall annualized return on investment of between 11% and 15%. Remember though, investment returns are your reward for risking your capital, they are not guaranteed, and crowdfunding – like most investments – carries a significant amount of risk.
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Real Estate Investment Trusts (REITs) have been the go-to real estate investment for many years. According to industry body NAREIT;
REITs, or real estate investment trusts, are companies that own or finance income-producing real estate across a range of property sectors. These real estate companies have to meet a number of requirements to qualify as REITs. Most REITs trade on major stock exchanges, and they offer a number of benefits to investors.
There are all sorts of REITs listed on pretty much every stock exchange globally. Most have some sort of niche such as the type of real estate they own (multifamily, offices or care homes, etc.), or perhaps their overall business model. As such, buying shares in a REIT can be a very accessible way for smaller investors to invest in a particular real estate sector or area.
REITs generally collect operating income from tenants in the buildings they own, and distribute dividends to their shareholders. In order to legally qualify as a REIT, they must distribute at least 90% of their net income to shareholders. These dividends are paid out pre-tax, and individual shareholders then pay tax on the income they receive.
Some REITs – known as mortgage REITs or mREITs – invest in debt rather than physical property. They loan money to property owners in the form of mortgages, or buy pre-existing mortgage debt and collect the interest income to distribute to their shareholders in the same way as a property-owning REIT does.
One of the risks of investing in a REIT is that the shares are publicly listed. As such, share prices can be subject to negative news and general market movements regardless of the value of the underlying real estate assets.
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Real Estate Notes, Trust Deeds and Private Lending
If you don’t particularly want to own physical real estate, another fantastic way to invest is to buy real estate mortgage notes, or participate in private lending. Note investing and private lending allows investors to collect monthly income in the form of interest, making this investing modality a useful addition to any portfolio or retirement account.
Broadly speaking, there are two types of mortgage notes; performing and non-performing. A real estate note is considered performing if the borrower is up to date on payments. Performing notes are great for investors that want a reliable source of monthly investment income.
A non-performing note occurs when the borrower is in default and is no longer making payments. These notes can be good investments as they trade for a significant discount to face value, but can take a lot of time, effort and resources to turn into a profit.
Every note investment comprises a promissory note and a mortgage deed or deed of trust. The note is a contract between borrower and lender, and the deed secures the investment against a piece of real estate which can ultimately be sold of the borrower defaults on the terms of the note.
There are both 1st position mortgages, and 2nd position mortgages. In the case of a foreclosure, 1st position loans are paid out first, and 2nd position loans are paid out only if there are any funds left. This means 2nd position note investments carry more risk, and therefore also often a higher rate if interest.
Real estate notes are freely traded within a large secondary market, and there are plenty of ways to buy notes, including direct from banks and other primary lenders, note brokers and hedge funds, and other note investors either directly or via online exchanges.
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Investment Returns and Risk in Commercial Real Estate
Investment returns for commercial real estate investments vary wildly from one type of property and investment strategy to another. How an investment is structured will also have some bearing on the net returns received by an investor.
For example, a crowdfunded investment in an individual care home is likely to carry significantly different risks and returns than an investment in an office REIT. The sector, property, management, strategy, location and market all play a part in overall investment performance in commercial real estate.
As with any investment, you should do your homework. Try to figure out what your own investing goals are first, along with the level of risk you are prepared to take. This will give you a solid foundation to go out and source a commercial real estate investment that best suits your needs.
Remember, all investment carry risk. There is no golden bullet or investment sweet spot. Things can and do go wrong with even the best opportunity, planning and management. Try to spread your risk over multiple investments, and never invest in one single project what you cannot afford to lose.
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To find out more about commercial real estate and the role it could play in your investment portfolio, read these resources: