Historically speaking, commercial real estate investments (as alternative assets) have given many investors attractive portfolio diversifications and risk-modified returns. However, not everyone understands the inner workings of commercial real estate when it comes to investing in it.
We are surrounded by commercial real estate. It comes in the form of retail spaces, offices, apartments, and more.
Money is generated by commercial real estate through appreciation and income. Appreciation happens when a property’s value gradually increases, while building operations generate rental income.
Commercial real estate investments generally warrant more expertise, time, and capital than most investors have. Though the term is somewhat broad, commercial real estate describes the use of property to generate profits. Commercial real estate examples include warehouses, apartment buildings, farmland, malls, hotels, medical centers, industrial properties, and office buildings.
There are a number of notable distinctions between traditional investments (like bonds and stocks) and commercial real estate investments. In contrast to bonds and stocks that are frequently traded on secondary markets, real estate happens to be a resource that is scarce.
As a hard asset, it does hold intrinsic value. More often than not, stocks are bought for the selling potential they have, as opposed to their potential as an income source. This is where the stock market’s term, “buy low and sell high” stems from.
When it comes to commercial real estate, investment strategies are simple: in any given area, real estate demand is inherent. Properties are purchased by investors, who make their money back in a couple of ways:
They lease those properties and charge tenants rent to use those properties
Through appreciation over time based on the property’s value.
Let’s take a look at these two investment opportunities more closely:
Revenue from Rentals
Tenants vary when it comes to investment properties and commercial real estate. With each tenant comes different needs for property management, lease agreements, and arrangements.
Some examples include:
Parking lots and cubicles. Example – the tenant is a start-up business or a legal firm. Rent is paid by the company, and the length of the lease ranges between five and ten years.
Tenants in apartment buildings tend to be families and individuals. Leases might be either long or short term, and usually last 12 months (though shorter terms are not unheard of). Apartment buildings come with more tenants than commercial buildings do, and therefore, warrant the management of many leases. As such, more payments must be accounted for every month.
Smokestacks and warehouses are examples of industrial properties. The average tenant may be a distribution or management company. Such properties tend to be situated in areas where retail or residential properties are prominent. The lease lengths for industrial buildings generally last for (at least) five years.
Value Addition and Appreciation
Potential returns also come from investments made in commercial real estate – specifically from property value increases over the timeframe they are held by an investor. Likewise, value can also be lost on a property. In fact, even proven and disciplined investment strategies cannot guarantee gains because of external economic forces which may come about.
Real estate happens to be a scarce and unique asset class. It isn’t possible to create more land. In the center of a metropolis, such scarcity increases with demand. If there is significant demand for a property you own, or if there is a demand for the area your property is in, odds are that potential tenants will pay more rent to live there. Further, attentional buyers may be open to paying more than you did for a property and purchase it from you.
Demand-stimulated appreciation is not the sole approach to increasing a property’s value. A lot of investors use the “value-added” approach when it comes to commercial properties, improving the place to raise its income-earning potential or intrinsic value.
One instance of this may involve an update of the appliances or cosmetic details of an apartment building. These types of updates let owners charge higher prices for rent. Aside from property improvements, other methods include rezoning adjacent land parcels – perhaps to a multifamily building from a residential one – for the sake of building more apartments. Renovation expenses have the potential to raise a building’s selling price when the time comes to sell it.
An Example in the Real World
This is an example of an investment made in commercial real estate. Andrew purchases an older apartment building for about $5 million. The building has 40 apartments in it. After expenses, Andrew’s rental income for the year totals up to $500,000. Like with any property, a number of tenants move out every year. Vacated apartments are renovated by Andrew after his tenants leave before new ones are brought in. The improvements Andrew made to the property increased rental income each year by as much as $50,000. This increase happens for five consecutive years. After the fifth year ends, the property generates an annual income of $750,000.
Andrew then opts to put the building up for sale with a $16 million selling price. A buyer is open to paying a lot more than Andrew did five years prior for a couple of reasons: firstly, the apartments were renovated by Andrew, and now generate twice the income amount that was brought in before the renovations were made. Secondly, the economic growth within Andrew’s city raises property values. This is because entertainment venues and new renters made their way into Andrew’s neighborhood. Andrew made a smart investment.
In comparison to stocks, investments in commercial real estate generally offer consistent cash flow through rental revenue.
Commercial properties are hard assets, but they are also scarce resources. Commercial real estate will always have intrinsic value. That value usually appreciates over time.
Commercial real estate’s value is determined by the economy’s overall growth.
Direct investments in commercial real estate can be costly for the average investor. That’s because commercial real estate investments tend to be dominated by certain institutional investors. Projects like these warrant capital worth millions, as well as a comprehensive knowledge of how to operate and improve a property.