The Diversity and Phases of Commercial Property Investing.

Brick and mortar retail is melting down. However, this doesn’t mean that commercial properties are crashing in general. Although online retail continues hammering away at brick and mortar, some retail malls are showing promise when repurposed into multiuse communities offering homes with convenient access to restaurants, entertainment, medical clinics, and even retail. Still, commercial properties include much more than retail stores.

The Diversity Commercial Real Estate Investing Offers

Commercial property investing offers a tremendous number of sectors and niche sectors. The major sectors are:

• Office Buildings

• Industrial (including manufacturing, warehouses, and specialty)

• Retail/Restaurant

• Multifamily

• Land

Commercial properties are incredibly diverse within each major category. For instance, office buildings include everything from a 100 story building in NYC to a small accounting office on Main Street USA. And although the commercial property investing cycle follows the macro economy, each category has individual cycles within the macro cycle. Notably, student housing, manufactured homes, and industrial properties have been the top performing commercial real-estate sectors over the past 12 months, according to Green Street Advisors. And counter to the single-family residential market, multifamily housing investing has slowed substantially during the same time.

Market and sector knowledge is critical to your success with commercial property investing. If you have personal knowledge about a particular commercial sector, stay with that sector. If you have no knowledge about a sector, gain the knowledge you need before investing. Even if you're only the landlord, you don't want to invest in a hotel if you don't know anything about the hospitality industry. Same thing with the manufacturing sector. You don't want to own an industrial strip if you don't know the best use of the property to maximize cash flow.

Commercial Real Estate Valuation

Commercial property investing differs in many ways from residential investing. Property income, expenses, and values are calculated differently and success requires speaking the language of commercial real estate fluently. Along with sector knowledge, you need to learn new profit and loss formulas before investing commercially. In residential you may have only bought properties for 75% of after repair market value or rentals that cash flowed 15% above expenses. In commercial real estate, you need to understand cap rates, net operating income, and loan to value ratios. These are not difficult but you need to fully understand what each means and how they affect your profitability before moving into commercial property.

Residential property valuations are heavily dependent on an appraisal comparing similar houses in the neighborhood. Commercial values are much more dependent upon the amount cash each generates. There are other valuation methods. For one, the Income Capitalization method is based primarily on the amount of income an investor expects to receive from a particular property. An example is a building purchased for $1 million, and expected to yield 8 percent based on local market research. That $80,000 per year in expected income could be increased by improving inefficiencies and/or by passing along some costs to the tenant, like electric or water usage. Something that commercial property investors look for are rents that can easily be increased because they are below market.

Expected future income capitalization is reflected in the present value. Value is linked to rental income via the property’s cap rate. The equation for the property value is:

Current Value = Net Operating Income / Cap Rate

The cap rate is calculated from market sales of comparable properties in the same neighborhood. The cap rate can be adjusted to account for unique features of the property, such as high-quality tenants or an unattractive/outdated façade.

The advantage of the income approach for commercial property investing is that it accommodates recent sales activity of comparable properties and is adjusted for unique factors. Its disadvantage is that it doesn’t account for vacancies, which might lead to an overstated net operating income (NOI) and value.

Commercial Real Estate Phases

Not every element is present during every cycle phase but these are the signals you are looking for. Also, specific sectors can go through these phases separate from the macro cycle (such as retail and multifamily are today).

A better term than phases is probably the circle of commercial real estate phases because each phase consistently follows the other. For instance, recovery begins after recession and precedes expansion.

Recovery. This is broadly defined as declining vacancy rates following recession without new construction occurring. Typically, a recession occurs when new construction exceeds the demand created during expansion. Recovery occurs when excess inventory from the previous expansion is finally absorbed (e.g. vacancy rates drop). The latter part of the recovery phase is a mostly balanced market.

Expansion. When demand during the recovery phase exceeds available inventory, the market begins expanding with new construction. This is typically noted with rapid rent increases. Of course, rent growth means more income which rises the value of existing (ready to occupy) properties. During the early to mid-expansion phase is a good time for commercial real estate investors to sell for the highest profit. As long as demand grows faster than supply, vacancy rates continue to fall and the expansion continues.

Hyper supply. At some point, supply catches up with demand. The first indication is when the pace of rent increases slows. This is near the point of equilibrium, and marks the end of the expansion phase. When the supply of new construction exceeds demand, vacancies begin to rise and rents begin to fall. If new construction slows enough a severe downturn is avoided. However, because new construction takes a long time to become occupant ready, new construction already in the pipeline often leads to hyper supply.

Recession. When the oversupply becomes massive, it leads to a recession. It’s noted by increasing vacancies that cause rents to be lowered. Losses can occur from lower rents and rising interest rates if balloon payments come due. This is not the time to sell. Recession is a buyers’ market because the next phase in the circle of commercial property investing is recovery.

By Wendy Patton