Commercial Real Estate

5 Things to Consider Before Investing in Commercial Property

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apartment building room living area, vintage tone

Investing in commercial real estate (CRE) has proven itself time and again to be a smart strategy for high-net-worth investors interested in diversifying their portfolios.

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CRE compares favorably to many other forms of investment, including highly volatile stocks and bonds, in terms of predictable risk, stability, wealth creation, and current cash flow.

While investing in commercial property has many upsides, investors should consider the following fundamentals of the asset class that will help inform their approach to the category.

5 Things to Know Before Investing in Commercial Real Estate

  1. CRE is cyclical.

Just like the general economy, CRE is subject to “up” and “down” cycles. In fact, those cycles tend to mirror those of the overall economy. Asset valuations rise and fall, sellers’ markets and buyers’ markets alternate, and some property sectors do better than others at different points in the cycle.

For example, in the current cycle, the multifamily (apartment) and industrial sectors are faring quite well, while the retail and hotel sectors are struggling to find their place in a challenging and changing business environment.

Understanding how cycles have progressed in the past, as well as the drivers for certain types of CRE in specific geographic markets, is helpful before completing any transactions. As we are enjoying the longest period of historical economic recovery, thinking about holding CRE assets in the long-term can prevent sleepless nights from worrying about highs or lows in the cycle.

In addition, direct real estate investments tend to be less volatile than their public counterparts. REITS tend to move in lockstep with the stock and bond markets, making them extremely susceptible to market fluctuations. While direct real estate investment may be cyclical, it is less volatile than REIT investment.

strip mall with clothing storefront in view

  1. Capitalization matters.

The amount of debt incurred in completing a CRE transaction directly correlates to the amount of risk investors take on for that deal.

While leverage can amplify the potential returns of your investment, it comes at a price: interest. And while interest rates are currently quite low and look to remain so for a while, borrowers must cover the mortgage costs regardless of whether the property purchased is generating adequate income to cover the debt if vacancies or other property impairments occur.

In addition, the capital stack—how the investment is financed from both equity (cash) and debt (mortgage)—should be considered. Once the mortgage and operating expenses are paid, the remainder typically goes to the investor.

Related: The Ultimate Guide to Analyzing Commercial Real Estate

The capitalization structure must be factored into every CRE transaction in advance of signing on the dotted line. Careful financial analysis of the optimal mix of investor equity and mortgage debt will allow investors to maximize their returns while taking on an appropriate amount of risk.

  1. Alternative categories exist.

Office, industrial, retail, and multifamily properties are considered the four main "food groups" of CRE investment. As mentioned above, fundamentals for each group change with each cycle, creating an ideal environment for investing in some groups and a less-than-ideal environment for investing in others.

However, there are more than just four primary categories in which to invest, including senior housing, student housing, data centers, call centers, self-storage, and many others. While these are less often talked about in mainstream investment circles, some investors focus exclusively in these more esoteric categories as a means to further diversify their holdings.

Investing in such alternative categories can be quite lucrative for investors who understand them and know what to look for in these properties. Some alternative investments can even deliver stronger ROI than investing in the major groups—but carry with them a potential for increased risk due to their complexity.

It's important to research these classifications and vet properties thoroughly before taking the leap into less mainstream investments. Third-party managers and online platforms like RealCrowd offer investors a variety of tools to educate themselves on CRE categories.

self-storage

  1. Location is still key for investing in CRE.

No matter how good a property seems, nothing is more important to most investors than where that property is located.

Areas that boast strong job, population, and economic growth factors are a good place to start, whether these are top-tier regions like New York City, Los Angeles, San Francisco, and Chicago or emerging markets like Raleigh, N.C.; Salt Lake City; Austin, Texas; Nashville, Tenn.; and Portland, Ore.

Related: 7 Barriers to Entry for Wannabe Commercial Real Estate Investors (& How to Overcome Each)

Within a strong market, investors should consider whether the asset is situated in a desirable neighborhood (called a submarket) and even down to the location on any particular block. The strength of some markets and submarkets can vary from street to street, so having a good handle on these nuances is a must.

The location of a CRE asset is a large factor that can attract and retain tenants, which are the lifeblood of any commercial property investment. A good location sets the stage for a successful investment.

  1. Tenant experience is one of the most significant drivers of CRE valuation.

Regardless of what asset type an investor pursues, ensuring a great experience for the current tenants and attracting new tenants to raise occupancy levels in commercial properties are cornerstones of creating value in CRE investments.

As tenants increasingly focus on their experience in a leased space, landlords are searching for new ways to make that experience a positive one both as a means to keep current tenants happy and provide differentiated experiences for prospective tenants.

For many property owners, this means providing modern amenities that tenants want and have come to expect. These amenities could be physical, such as a rooftop terrace or outdoor kitchen; involve internet connectivity or sustainability; or be related to walkability, such as proximity to shopping, dining, and daily-needs retail stores and services.

While these amenities may mean a higher purchase price when acquiring the asset, they can also provide the basis for higher ROI through higher rental rates, higher tenant retention, and lower turnover costs.

When evaluating commercial real estate, investors should consider how amenities drive value for that property and whether that value justifies a higher purchase price—as it will likely justify a higher sales price when the investor is ready to sell the property.

Although entering the CRE investment space can seem daunting to the uninitiated, approaching the field systematically can be tremendously beneficial. Keeping in mind CRE’s cyclical nature, the impact of capitalization, alternate asset categories, property location, and experiential amenities when evaluating these investments can help guide investors toward wiser decisions that bring them closer to their financial goals.

Which type of commercial investment are you considering? What questions do you have?

Comment below!

Adam Hooper is co-founder and CEO of RealCrowd, one of the nation’s leading direct online real estate investment platforms. He also runs an educational
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    Nina Grayson Investor from Los Angeles, CA
    Replied 8 months ago
    Great post, Adam. Quite thorough and spot-on. I would add Mixed-Use to the alternate investment products. Mixed-Use retail/housing is popular in CA right now, with office/housing (live/work) a close second. I believe Mixed-Use (any mix) will be the next iteration of CRE, such as Student Housing/Self Storage for example.
    Adam Leitman Bailey Attorney from New York, NY
    Replied 8 months ago
    Great piece! Its very informational and hits a lot of points that many other commercial investment articles don't
    Nick Childs Real Estate Agent from The Woodlands, Tx
    Replied 7 months ago
    Good Post
    Hein A. Rental Property Investor from Queens, NY
    Replied 7 months ago
    Great article on CRE! Thanks Adam.
    Lynda Robison
    Replied 5 months ago
    Have my deceased husband's estate of 39.9 commercial zoned, undeveloped property, shared with 3 other family owners. Trying to sell it hasn't worked because "rumors" on the street is that "word" has gone out not to touch it because specific political entities want it and are waiting us out until we are desperate enough to give it to them, say at $5k for the entire 39.9 acres, so nobody dares to contact us or the Broker. Was suggested by retired military judge friend to do the land lease, NNN, but have no idea how to market it for that purpose since the Broker contract has expired, and everybody is dealing with "fear" of upsetting the ones in power. It's got highway frontage on both sides, only 1 mile outside of city limits, commercial businesses all around it, utilities available to be developed on the property, and the state's transportation dept. bought a small piece as a right-of-way when widening the state highway through it, and then gave the right-of-way back to us--their appraiser did the appraising during a bust-cycle at $21,000 per acre, and the county already said that it was worth $35,000, or more, during a boom-cycle, which they were in the middle of before this 2020 virus. Left the probate court open for the Judge to deal with any family drama of contesting it, as done in the past when my husband inherited it from his parents, and then never got to benefit from it because of the family drama of fighting over it. They've gone quiet for now while the probate is still open, but have said they intend to keep it from me, and 2 of the owners are refusing to pay their 1/3 share of the property taxes to make it go into a tax auction, we've been told, but our atty states that if sold/leased, their 1/3 share would be withheld by the Judge to pay their taxes, and then released to them what's left over of their share of the distribution. Got a scam letter from American Property Investment Group in California stating upfront that they won't pay top dollar for it. Was told by one of the political investors that only 4.8 acres is wanted by the county politicians to have a gas station and fast-food restaurant there because it would allow the oil and gas semi-trucks to park there while eating, which they can't do inside the city limits because lack of parking space at the same gas station/fast food restaurant owner's business. How do you buck the "system" and either sell the entire 39.9 acres, as per the probate order, or get a good NNN lease in place for that gas station/fast-food restaurant on the 4.9 of it, that's on the south side of the state highway, and then NNN lease the rest of the 35+ acres on the north side of the state highway? And get the Judge's approval, with no contesting from family dramatists, to close the probate and move forward?? (we figure, after following the NNN lease suggestion from the friend, that a buyer may step forward eventually after seeing the development...or....we may just keep the NNN leases....depending on how lucrative it could become. Liked the billboard company idea to add to the mix--sounded like the cell tower requires divided property, which the county refuses to do unless we, the owners, are willing to pay tens of thousands of dollars "developing" it with paved roads, utilities, etc. Any suggestions??