IMPORTANT THINGS TO KNOW ABOUT INVESTING IN COMMERCIAL REAL ESTATE

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INTRODUCTION

The commercial real estate market has been generating strong returns for investors. For property owners in the right sectors, the rent checks are rolling in and property values are rising.

This is especially true in hot corners of commercial real estate – warehouses, apartments, grocery-anchored retail, self-storage, medical offices and data centers have been performing well during the pandemic and in the post-pandemic era. Some other sectors are delivering less stellar results.

A recent Moody’s Analytics study showed that commercial real estate sales surged by over 50% since 2020.

High-risk bundled commercial real estate loans have been very popular recently.

Many amateur investors are relying on real estate crowdfunding initiatives. These crowdfunding initiatives, known as real estate investment trusts or REITs, allow novice investors to find easier inroads to commercial real estate investment.

Read on for an overview of the commercial real estate market and what investors need to know.

Building personal wealth via medical office investment is the future of investment. Learn more today at Alliance CGC.

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OVERVIEW OF COMMERCIAL REAL ESTATE

Commercial real estate encompasses any type of real property used for business purposes. Some businesses own their commercial real estate, but in most cases, the businesses operating in commercial properties are tenants who pay rent to the investors who own the property.

For investors looking for commercial real estate exposure, there are a variety of options. An investor can directly buy an office building, a shopping center, a distribution center or an apartment complex.

Investors also can take a smaller stake in a single property via crowdfunding. Or an investor might purchase shares of a real estate investment trust, which pools a portfolio of properties and then sells the portfolio to investors.

1. LOCATION, LOCATION, LOCATION IS A CLICHÉ – IT’S ALSO TRUE

Location plays a crucial role in determining the performance of any piece of commercial property. In grocery-anchored retail, for instance, success hinges heavily on traffic counts, nearby population and the income levels of surrounding areas.

Buy a grocery-anchored center near affluent residents, and you’re likely to do well. Similar demographic analysis applies to self-storage centers – nearby homes drive that business, too. For industrial properties, the location calculus shifts to factors such as proximity to major highways, rail lines, airports and seaports.

Distribution centers often seek locations near interstate highways. For data centers, location is about proximity to a different type of infrastructure – namely fiber optic lines that carry Internet traffic. In the medical office sector, proximity to a hospital or to population centers can drive value.

2. PAY CLOSE ATTENTION TO MARKET DYNAMICS

Commercial real estate can be less volatile than other investment options. However, market shifts do happen, and these changes can impact occupancy rates, the rental rates and the stability of your income flows.

A very relevant case can be made from the Covid-19 pandemic. As an investor, you need to keep a close watch on broader economic trends and what they mean for commercial real estate. Here’s how a variety of property types are faring in the post-pandemic world:

WAREHOUSES ARE IN HIGH DEMAND

Chances are you’ve shifted much of your shopping to Amazon and other ecommerce alternatives to brick-and-mortar retail. This dramatic shift in consumer behavior has created a boom in the warehouse sector.

Distribution space is very much in demand. Amazon has been ramping up its ownership of warehouses, and FedEx and UPS also need more space.

This trend also is affecting brick-and-mortar retailers, who are seeing less demand in stores but more demand for their ecommerce operations.

APARTMENTS ARE HOT

Home prices soared to record levels in 2020, then rose even higher in 2021. In early 2022, the inventory of existing homes for sale plunged to an all-time low. In other words, homeownership is getting more expensive, and more challenging.

As a result, many Americans who might have bought homes are renting instead. And it’s a great time to own apartments – rents are rising sharply, and occupancy levels are high.

TRADITIONAL RETAIL IS STRUGGLING

The strongest shopping malls continue to thrive, but marginal malls are struggling. In an era when consumers can buy just about anything they want online, department store chains such as Macy’s and JCPenney have fallen on hard times.

That’s not to say that retail is going away altogether – consumers still like to touch and feel products before they buy, and humans remain social animals who view shopping as a social experience.

But the old model of shopping at regional malls is under pressure.

OFFICE SPACE IS A MIXED BAG

By 2022, the U.S. economy had recovered the jobs it lost to the coronavirus recession. However, the pandemic spurred a dramatic change in how white-collar workers and employers view their jobs.

Many workers no longer are keen on commuting to the office five days a week, and many employers have accepted a new reality, one that allows workers to never come into the office, or to work in person just a couple of days a week.

Some employers and some office owners insist that in-person work is the most productive form of working, and that office demand eventually will return to normal.

However, two years after the pandemic first locked down the U.S. economy, it became clear that a number of employers were embracing remote work, both as a way to keep workers happy and to reduce their office expenses.

And in many cities, commercial real estate investors were seeking ways to transition office buildings into housing.

BUT MEDICAL OFFICE IS STRONG

Traditional office space might be a question mark, doctors’ offices are a different story. Medical office buildings often are overlooked simply because most real estate investors do not understand the nuances of this property type.

Medical office space can be a stable income-producing addition to your portfolio. Medical offices are on an upward trajectory – and demand for these assets is on the rise.

3. UNDERSTAND COMMONLY USED FINANCIAL METRICS

There are two primary tools commercial real estate investors use to determine the value of a property -- net operating income, or NOI, and capitalization, or cap, rate. NOI is the bottom line figure generated by a property.

To calculate NOI, an investor sums up rents and other income, then subtracts operating expenses (but not capital expenditures, debt service and taxes). This number reflects a property’s profitability on a quarterly or annual basis.

The cap rate, meanwhile, calculates the ratio of net operating income to a property’s value. So, if a $1 million property throws off $100,000 of NOI, the cap rate is 10. If a property sells for $2 million with creating $100,000 of NOI, the cap rate is 5.

The bottom line:

A lower cap rate means a property traded for a premium, while a higher cap rate suggests a discount. During cyclical peaks for commercial real estate, cap rates fall, reflecting competition for properties. Similarly, the hottest property sectors and property types will see lower cap rates, a phenomenon sometimes referred to as “cap rate compression.”

During down times in real estate cap rates rise. Out-of-favor property types and struggling geographic areas also experience higher cap rates.

4. CONSIDER A VALUE-BASED APPROACH

Institutional investors in real estate tend to focus on the most richly valued markets. These deep-pocketed players often focus their acquisitions on such primary markets such as New York City, San Francisco, Los Angeles, Boston and Washington, D.C.

This strategy calls for investing in richly valued markets with the idea that supply constraints in those gateway cities will keep driving values higher.

Smaller investors might not be able to compete in these markets, but the good news is that secondary and tertiary markets can perform quite well. Greg MacKinnon, director of research at the nonprofit Pension Real Estate Association, analyzed decades worth of commercial real estate data to come to this conclusion: Commercial real estate investments bought at high cap rates significantly outperform properties purchased with low cap rates.

This result was consistent no matter how MacKinnon sliced and diced the numbers, including by property type and by timeframe.

MacKinnon’s research provides valuable insight for commercial real estate investors who want to limit their risk while maximizing their returns. In some ways, his conclusion is obvious: Searching for good deals, rather than simply paying top dollar for glamorous properties in hot markets, will make you richer over time.

For investors, the wisest strategy might be to focus acquisitions on secondary markets with less buzz and less interest from big players. To borrow a concept from Wall Street, real estate investors might be wiser to leave the growth investing to the biggest investors and focus instead on finding relative bargains, a hallmark of value investing.

5. YOUR TENANTS WILL COVER MANY OF YOUR COSTS

The “triple net lease” is the most common type of contractual arrangement between tenants and landlords. Under this type of agreement, the landlord doesn’t pay – or nets out -- three major occupancy costs: building maintenance, property insurance and real estate taxes.

In a triple net lease, these costs become the legal responsibility of the tenant; the landlord passes the cost onto the tenant. Tenants with triple-net leases pay their proportionate, or pro rata, share of operating costs.

Triple net leases are common across property types – they’re standard at office, retail and industrial buildings. This is important for investors because it means that a fully occupied building is all but certain to deliver positive cash flow.

6. COMMERCIAL REAL ESTATE INVESTING OFFERS MANY TAX BENEFITS

Real estate investors can reduce their tax liability by way of numerous tax breaks and deductions offered through the U.S. tax code. Property owners can deduct the reasonable costs of owning, operating and managing a property.

Depreciation offers another tax advantage – the IRS lets commercial property owners write down the value of commercial buildings over a period of 39 years. Taxpayers can deduct depreciation as an expense against taxable income.

If you sell your commercial real estate investment for a profit, there’s another tax break available: You can defer capital gains taxes through a 1031 exchange, an IRS-approved tactic that allows investors to delay taxes due sales of commercial real estate, so long as they roll any proceeds into a similar property within a given period of time.

It’s important to remember that the U.S. tax code is endlessly complicated, so be sure to consult with a tax professional about how these tax breaks apply to your unique situation.

7. YOU CAN USE LEVERAGE IN YOUR FAVOR

Using other people’s money is a proven way to boost investment returns. Smart investors know they use leverage to super-charge their returns. To give a back-of-the-napkin example, say you pay $2 million for a commercial property and resell it five years later for $4 million.

At first glance, that’s a healthy return of 100%. However, if an investor made a down payment of $500,000 for the property and took a mortgage for the rest, the return becomes $2 million on an investment of $500,000 – and the return is magnified to 300%. This type of leverage is made possible by the nature of commercial real estate investing.

Because the underlying asset is a physical property, lenders are willing to accept it as collateral. Investors typically can finance about 75% of the property’s value.

8. THE RISKS ARE REAL

We’ve focused so far on the benefits of investing in commercial real estate, but we don’t want to gloss over the downside. True, over the long run, commercial real estate appreciates in value.

But that doesn’t mean your property is guaranteed to stay fully leased and to sell for more than you paid. Indeed, commercial real estate has been so hot that now is a good time to consider the risks.

Your investment could fall prey to many things – an exodus of tenants, costly litigation, a change in supply and demand for real estate in your local market, a downturn in the overall economy, weakness in local labor conditions, unfavorable population trends, natural disasters, stricter regulations. Economic shocks can come quickly.

You can mitigate the risks through a combination of strong due diligence and expert advice. However, it’s worth noting that even the most successful investors can and do lose money on some of their investments.

CONCLUSION

If you aim to take the plunge into commercial real estate investment, keep in mind these fundamentals of property markets:

  • Location is king.
  • Returns can vary widely by property type.
  • Understand NOI and cap rates.
  • Consider a value-investing approach – that is, targeting properties with higher cap rates.
  • Understand the benefits of triple net leases.
  • Tax benefits are an important part of your investment strategy.
  • Leverage can greatly boost your returns as a property investor.
  • Despite all of these benefits, there’s also the risk that you’ll lose money.

For more guidance about investing in commercial real estate, visit Alliance Group Companies.

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