Commercial

Understanding Commercial Real Estate (CRE)

Commercial real estate is typically categorized into four classes, depending on function:

• Office space
• Industrial use
• Multifamily rental
• Retail

Individual categories may also be further classified. There are, for instance, a number of different types of retail real estate:

• Hotels and resorts
• Strip malls
• Restaurants
• Healthcare facilities

Similarly, office space has several subtypes. It is often characterized as class A, class B, or class C:

Class A: represents the best buildings in terms of aesthetics, age, quality of infrastructure, and location.
Class B: buildings are usually older and not as competitive—price-wise—as class A buildings. Investors often target these buildings for restoration.
Class C: buildings are the oldest, usually more than 20 years of age, located in less attractive areas, and in need of maintenance.
Note that some zoning and licensing authorities further break out industrial properties—sites used for the manufacture and production of goods, especially heavy goods—but most consider it a subset of commercial real estate.

Commercial Leases
Some businesses own the buildings that they occupy. However, the more typical case is that the commercial property is leased. Usually, an investor or a group of investors owns the building and collects rent from each business that operates there. Commercial lease rates—the price to occupy a space over a stated period—are customarily quoted in annual rental dollars per square foot. Conversely, residential real estate rates quote as an annual sum or a monthly rent.

Commercial leases will typically run from one year to 10 years or more, with office and retail space typically averaging five- to 10-year leases. This can be contrasted with more short-term yearly or month-to-month residential leases.

There are four primary types of commercial property leases, each requiring different levels of responsibility from the landlord and the tenant.

A single net lease makes the tenant responsible for paying property taxes.
A double net (NN) lease makes the tenant responsible for paying property taxes and insurance.
A triple net (NNN) lease makes the tenant responsible for paying property taxes, insurance, and maintenance.
Under a gross lease, the tenant pays only rent, and the landlord pays for the building’s property taxes, insurance, and maintenance.
Managing Commercial Real Estate
Owning and maintaining leased commercial real estate requires full and ongoing management by the owner. Property owners may wish to employ a commercial real estate management firm to help them find, manage, and retain tenants, oversee leases and financing options, and coordinate property upkeep and marketability. The specialized knowledge of a commercial real estate management company is helpful, as the rules and regulations governing such property vary by state, county, municipality, industry, and size.

The landlord must often strike a balance between maximizing rents and minimizing vacancies and tenant turnover. Turnover can be costly for CRE owners because space must be adapted to meet the specific needs of different tenants—for example, if a restaurant is moving into a property once occupied by a yoga studio.

How Investors Make Money in Commercial Real Estate
Investing in commercial real estate can be potentially lucrative and serve as a hedge against the volatility of the stock market. Investors can make money through property appreciation when they sell, but most returns come from tenant rents.

Direct Investment
Investors can use direct investments where they become landlords through the ownership of the physical property. People best suited for direct investment in commercial real estate are those who either have a considerable amount of knowledge about the industry or can employ firms that do. Commercial properties are a high-risk, high-reward real estate investment. Such an investor is likely to be a high-net-worth individual since CRE investing requires a considerable amount of capital.

The ideal property is in an area with low CRE supply and high demand, which will give favorable rental rates. The strength of the area’s local economy also affects the value of the CRE purchase.

Indirect Investment
Alternatively, investors may invest in the commercial market indirectly through either ownership of various market securities, such as real estate investment trusts (REITs) or exchange-traded funds (ETFs) that invest in commercial property-related stocks, or investment in companies that cater to the commercial real estate market, such as banks and Realtors.

Advantages of Commercial Real Estate
One of the biggest advantages of commercial real estate is attractive leasing rates. In areas where the amount of new construction is limited by either land or law, commercial real estate can have impressive returns and considerable monthly cash flows. Industrial buildings generally rent at a lower rate, though they also have lower overhead costs compared with an office tower.

Commercial real estate also benefits from comparably longer lease contracts with tenants than residential real estate. This long lease length gives the commercial real estate holder a considerable amount of cash flow stability, as long as long-term tenants occupy the building.

In addition to offering a stable and rich source of income, commercial real estate offers the potential for capital appreciation, as long as the property is well-maintained and kept up to date. And, like all forms of real estate, it is a distinct asset class that can provide an effective diversification option to a balanced portfolio.

Disadvantages of Commercial Real Estate
Rules and regulations are the primary deterrents for most people wanting to invest in commercial real estate directly. The taxes, mechanics of purchasing, and maintenance responsibilities for commercial properties are buried in layers of legalese. These requirements shift according to state, county, industry, size, zoning, and many other designations. Most investors in commercial real estate either have specialized knowledge or a payroll of people who do.

Another hurdle is the increased risk brought with tenant turnover, especially relevant in an economy where unexpected retail closures leave properties vacant with little advance notice.

With residences, the facilities requirements of one tenant usually mirror those of previous or future tenants. However, with a commercial property, each tenant may have very different needs that require costly refurbishing. The building owner then has to adapt the space to accommodate each tenant’s specialized trade. A commercial property with a low vacancy but high tenant turnover may still lose money due to the cost of renovations for incoming tenants.