“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.\u201d<\/p>\n
I didn\u2019t say this is wrong, just misleading.<\/p>\n
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:<\/p>\n
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- Residential real estate is valued based on comparable prices. Comps. The other houses on the street.<\/li>\n
- Commercial real estate valuation is based on math. And we all love math. Or at least we would if we understood this <\/em>math.<\/li>\n<\/ul>\n
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<\/p>\nYou 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\u2019s 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\u2019ve got $500,000 in this flip home.<\/p>\n
Now if this home is in a $250,000 neighborhood, it\u2019s likely you\u2019re going to have a big problem. Because when the appraiser comes, they won\u2019t be able to find comparable properties to support your price. You could easily lose a lot of money.<\/p>\n
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\u2019m proud of it, even if we only squeaked out a small profit.<\/p>\n
Related:<\/strong> 6 Reasons Investing in Commercial Property Might Be a Bad Idea<\/a><\/em><\/p>\n
Commercial real estate is entirely different. Commercial real estate valuation is based on a value formula. That formula is Value = Income \u00f7 Rate of Return. More specifically, it is Value = Net Operating Income \u00f7 Capitalization Rate.<\/p>\n
I\u2019ve covered this in detail elsewhere<\/a>, but suffice it to say that it\u2019s this math, I believe, that motivates the vast majority of the world\u2019s wealthiest people to invest in commercial real estate.<\/p>\n
Commercial real estate investors have the wonderful ability to \u201cforce appreciation\u201d by increasing the net operating income. And if they\u2019re clever enough, or fortunate enough, a shrinkage in the capitalization rate<\/a> (cap rate) will multiply their value even further. Leverage just sweetens it more.<\/p>\n
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.<\/p>\n
Often-Overlooked Commercial Investments<\/h2>\n
Multifamily<\/h3>\n
I don\u2019t think I ever considered apartments as commercial real estate before I got into the business. I\u2019m not sure why. Maybe because they aren\u2019t used for commerce (see Investopedia definition above).<\/p>\n
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.<\/p>\n
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.<\/p>\n
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.<\/p>\n
Self-Storage<\/h3>\n
I didn\u2019t think much about this over years past, and apparently the big commercial rating groups didn\u2019t either since there has not been a separate classification for this category in most past reports.<\/p>\n
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).<\/p>\n
Related:<\/strong> Why Self-Storage Investing Is Red Hot<\/a><\/em><\/p>\n
Mobile Home Parks<\/h3>\n
I just never thought about this as a valid commercial real estate class\u2014or a good investment. But I was so very wrong. Sam Zell, America\u2019s 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<\/sup> Mortgage) and Berkadia (a large lender that finances mobile home parks and more).<\/p>\n
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