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6 Commercial Investments Most Investors Don’t Consider

6 Commercial Investments Most Investors Don’t Consider

6 min read
Paul Moore

Paul Moore is the managing partner of Wellings Capital, a private equit...

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Are you among the many investors who want to make the leap from residential to commercial real estate?

If so, you should probably start by knowing how commercial real estate is defined. I didn’t for years. You could say I was narrow-minded.

What Is Commercial Real Estate?

What do you think of when you hear the words “commercial real estate?”

For years I thought of shopping centers, malls, and skyscrapers. I also pictured industrial complexes like warehouses or factories. I doubt I ever thought of apartment buildings, cell towers, or mobile home parks.

But my narrow definitions would have been incomplete.

Even the definitions online are misleading, in my opinion. Investopedia says, “Commercial real estate (CRE) is property used exclusively for business purposes or to provide a workspace rather than a living space. Most often, commercial real estate is leased to tenants to conduct business. This category of real estate ranges from a single gas station to a huge shopping center. Commercial real estate includes retailers of all kinds, office space, hotels, strip malls, restaurants, and convenience stores.

“Commercial real estate along with residential real estate comprises the two primary categories of property. Residential includes structures reserved for human habitation and not for commercial or industrial use. As its name implies, commercial real estate is used in commerce.”

I didn’t say this is wrong, just misleading.

Commercial real estate can include many assets that some consider residential and more. For the purposes of this discussion, and not at all as a definition, I propose that we segregate residential and commercial real estate as follows:

  • Residential real estate is valued based on comparable prices. Comps. The other houses on the street.
  • Commercial real estate valuation is based on math. And we all love math. Or at least we would if we understood this math.

commercial-property

You may fancy yourself as Chip and Joanna Gaines Jr. You may buy a home for $200,000 that needs a lot of work. You fix what’s broken and beautify it to the nth degree. You build out the basement and the attic. You add a large addition and the finest landscaping in the neighborhood. At the end of the day, you’ve got $500,000 in this flip home.

Now if this home is in a $250,000 neighborhood, it’s likely you’re going to have a big problem. Because when the appraiser comes, they won’t be able to find comparable properties to support your price. You could easily lose a lot of money.

This happened to me once on a much smaller scale. My son and I over-beautified a flip home in Roanoke, Virginia. Thankfully we found a cash buyer who fell in love with the home and could see the value of the upgrades we had made. I’m proud of it, even if we only squeaked out a small profit.

Related: 6 Reasons Investing in Commercial Property Might Be a Bad Idea

Commercial real estate is entirely different. Commercial real estate valuation is based on a value formula. That formula is Value = Income ÷ Rate of Return. More specifically, it is Value = Net Operating Income ÷ Capitalization Rate.

I’ve covered this in detail elsewhere, but suffice it to say that it’s this math, I believe, that motivates the vast majority of the world’s wealthiest people to invest in commercial real estate.

Commercial real estate investors have the wonderful ability to “force appreciation” by increasing the net operating income. And if they’re clever enough, or fortunate enough, a shrinkage in the capitalization rate (cap rate) will multiply their value even further. Leverage just sweetens it more.

So commercial real estate, for the purpose of this article, is real estate that is valued based on math rather than comps. This includes industrial, retail, hotels, office, restaurants, and more.

Often-Overlooked Commercial Investments

Multifamily

I don’t think I ever considered apartments as commercial real estate before I got into the business. I’m not sure why. Maybe because they aren’t used for commerce (see Investopedia definition above).

There are two classes of apartments: residential multifamily and commercial multifamily. Residential multifamily is financed using a residential loan and the values are based on comps. This is generally buildings with two to four units.

Commercial multifamily is financed through a commercial loan. Many people make another division between small commercial multifamily and large, based on the size needed to hire an onsite staff. This is typically 40 or 50 units in an urban setting or about 70 to 80 units in a typical suburban apartment complex.

Cap rates, the measure of value per unit of income, have been very compressed for multifamily for years since the financial crisis. This means these assets are very pricey (lower cap rate = higher price, since that is the numerator in our value equation). Cap rates in the range of 4% to 6% are common.

Self-Storage

I didn’t think much about this over years past, and apparently the big commercial rating groups didn’t either since there has not been a separate classification for this category in most past reports.

But there are almost 54,000 self-storage facilities in the U.S., which is about the number of McDonald’s, Starbucks, and Subway restaurants combined. Self-storage has become quite popular in the past decade and the cap rates have shrunk from around 10% or so to the 5% to 7% range (expensive).

Related: Why Self-Storage Investing Is Red Hot

Mobile Home Parks

I just never thought about this as a valid commercial real estate class—or a good investment. But I was so very wrong. Sam Zell, America’s top commercial real estate investor, got in on this trend early. He owns over 150,000 mobile home park sites. Warren Buffett also got in early and owns the largest manufacturer of mobile homes (Clayton) as well as one of the most aggressive lenders (21st Mortgage) and Berkadia (a large lender that finances mobile home parks and more).

Cap rates in this asset class have compressed from the 10% to 14% range down to 6% to 8% or so. Green Street Advisors recently referred to mobile home parks as the darling of all commercial real estate. And in the midst of the COVID-19 stock market meltdown in late February, a Wall Street Journal article trumpeted the power of investing in mobile home parks and an MHP stock that has increased by 4,100% since the housing crash.

Caravan and camping, static home aerial view. Porthmadog holiday

Cell Towers

Investing in cell towers was actually my first failed commercial investment. It was late 2000 and I was bored. I located a cell tower company and asked them where they needed better coverage in my region, and they told me about a rural dead spot they wanted to fill.

I found five acres for sale by owner in that area and acquired it quickly for about $18,000. Within months I was under a conditional contract with the cell tower company. I was already thinking about what I’d do with that hefty monthly check. And also, where I’d find my next deal.

They had a year for due diligence and 9/11 hit right in the middle of that time period. The tower company closed its office and I never heard from them again. Years later I tried to restart that strategy and after months of location work, I abandoned it again. It wasn’t as easy as it looked.

But cell towers are still a great investment. In exchange for a quarter of an acre of land and a deeded easement for access, investors can earn a steady income for decades. Another way to accomplish this is to buy out someone else’s existing income stream for a cash payout from you. Or to invest with someone who does.

This sector has obviously grown a lot during COVID-19, and I think it will continue to do so. Speaking of sectors that have grown during COVID-19…

Data Centers

Data centers have exploded in the past several years. Just as retail’s demise is accelerating during COVID-19, data center demand has gone up. Zoom and other online meeting platforms have taxed the limits of the existing infrastructure. Emerging technologies like the Internet of Things, artificial intelligence, 5G wireless, augmented reality, and autonomous cars will stretch demand to new heights.

Most BP investors haven’t thought about investing in this sector. It seems to be at a higher level, and unlike self-storage and mobile home parks, there are no mom-and-pop operators to cherry-pick. You could certainly invest passively through a real estate investment trust.

Senior Living

Multifamily is largely overheated. Even though fundamentals remain strong, many syndicators are looking to dial in on a specific type of multifamily to obtain a better yield. Senior living fits that bill for some.

I’m not talking about skilled nursing facilities specifically, though this sector may include that. I’m talking about independent living communities that are becoming increasingly popular. Two of my investor friends have pursued this sector and are experiencing great results.

Summary

There must be a reason that almost everyone in the Forbes 400 (the wealthiest of the wealthy) invests in commercial real estate. Maybe it’s time for you to check it out, too!

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Are you investing in commercial real estate? Where?

Tell us your preferred sector in the comments.