Making the Jump From Single-Family to Commercial Real Estate Investing

By Ian Formigle On

The first step into real estate investing for individuals often involves investing in the asset class that they best understand – single-family residences (“SFR”). However investing in SFR often presents a number of challenges including limited cash flow, no economies of scale, binary occupancy and more. For these reason and many more, once investors are ready to begin thinking about real estate investing as part of a diversified portfolio, the logical move is to transition to commercial real estate investing. In this article we illustrate the multiple advantages CRE provides over SFR, and provide the foundational knowledge necessary for you to make the jump to commercial real estate investing.

The first step into real estate investing for individuals often involves investing in the asset class that they best understand – single-family residences (“SFR”). It’s logical for investors to start here since they have typically already been through the experience of purchasing a SFR. In addition to experience, understanding value is relatively easy as there is a lot of free online information readily available (e.g. Zillow) on the SFR the market. However, some of the challenges of investing in SFR’s are as follows:

  1. There is typically little cash flow (unless you are acquiring unleveraged)

  2. Unforeseen capital expenditures can wipe out years of cash flow and tank returns

  3. There are no economies of scale at the asset level

  4. It is extremely hands on

  5. Occupancy is binary (100% or 0%); and

  6. Most of your competition is not seeking to acquire an investment but a place to call home, which can remove objectivity from the bidding process

Therefore, once investors are ready to begin thinking about real estate investing as part of a diversified portfolio, the logical move is to transition to commercial real estate investing.

Commercial real estate is an increasingly popular alternative asset class. It is also the third largest asset class after equities and bonds. The commercial real estate market is gigantic and can require rigorous analysis and predetermined investing strategies. Yet spending the time to get up to speed on this asset class can be well worth the effort. As we noted in our article, “Invest like Harvard: The Advantages of Direct Real Estate Investing” some of the world’s most sophisticated investors invest heavily into commercial real estate and are handsomely rewarded. In recent years, commercial real estate has been the strongest performing component of diversified portfolios.

The good news is that there are similarities that carry over from SFR into the commercial real estate investing. Numerous terms and metrics such as debt, equity, loan to value, occupancy, net operating income, cash on cash returns, and dozens more apply to all forms of real estate, regardless of the product type. Yet there also are distinct differences between SFR and commercial real estate both in terms of each asset class’s merits as well as how deals are structured.

Equity deals offer greater upside

When looking at the structure under which SFR investing is conducted on most online investment platforms, it is important to understand that most residential investments listed offer a debt financing investment on a “fix-and-flip” strategy and not a traditional buy and hold strategy. In most cases, the online offering is for a short-term, fixed-rate loan, such as a 10-month bridge loan at a high single-digit interest rate.

Commercial real estate offers debt and equity investment opportunities. Debt investors provide leverage at a fixed rate for someone else to own property but with a lien on the asset as collateral for the loan. Equity investors acquire an interest in the property. Equity investors share in the upside when a property meets or exceeds expectations in operating income and they also receive their pro rata share of value appreciation at the time of a property sale. To learn more about debt investing, please check out our recent article, “Real Estate Debt Fund Investing 101”.

Building portfolio diversification 

It is true that the SFR market has attracted interest from institutional investors in recent years. However, this interest was predicated on a macro opportunity in SFR’s  that was attributable to the housing crash. Now that this once in a generation type opportunity is gone, many institutional players are actually now looking to realize profits and liquidate portfolios. The current SFR market is now largely back to being more micro-market in nature.

Commercial real estate is a substantially larger and more diverse market. For example, investment sales for commercial and multifamily properties valued greater than $5 million topped $540 billion last year alone. The stock and variety of commercial real estate is vast in comparison to SFR. With each asset class possessing its own drivers and cycles, it also creates opportunities to invest in commercial real estate for a variety of reasons and at different times. If you invest in SFR, you are always buying into (or selling into) the same macro story no matter where you invest.

There are many different points that investors can enter the commercial market for both debt and equity deals. For example, investors can place capital into institutional-quality apartments, hotels, office buildings, shopping centers and industrial facilities. Investors have more choices to select investments they are comfortable with, and, as mentioned above, it also makes it easier to build diversity into portfolios as investors continue to grow their real estate holdings. (For more information on commercial real estate portfolio diversification please see our previous article, “How to Build a Diversified Real Estate Portfolio” )

Grounded in economics 

Another consideration when comparing SFR to commercial real estate is the rationality of the market. Single-family homes that rely on a fix-and-flip model cater to the whims of today’s homebuyers. Homeownership is at its lowest level in nearly 50 years. In addition, approaching the SFR market with an analytical investor approach can be challenging as homebuyers can be fickle. A variety of wild cards can pop up to kill a sale and delay an exit strategy that can range from a bad choice in paint color to a neighbor that doesn’t do yard work. SFR prices can also be highly sensitive (far more than multifamily) to municipal decision making such as school district remapping.

In contrast, commercial real estate is more fundamentally tied to logical demand drivers. Businesses location decisions are based on facts, such as proximity to customers and workers. Retail assets depend upon daily traffic counts along its frontage, something that is easily searchable. Industrial assets require certain clear heights (e.g. 24’ or 36’), dock high or ground level loading and proximity to major roadways. That rational context makes it easier for investors to understand, analyze and draw conclusions about investment opportunities.

While more rational, commercial real estate investments can arguably be more complex. So, it is important for investors to do their due diligence and peel back the layers to look at how a deal is structured. That information is typically transparent and readily available in offering documents, but it is important to know where to look and interpret its meaning. To that point, some of the terms and resources that are unique to commercial real estate include:

  1. Sponsor promote fee structures

  2. Preferred returns

  3. Sources & uses

  4. Core, Core-plus, Value-added and Opportunistic investing strategies

  5. The capital stack

Single-family residential is good place to start real estate investing, because it does hit the “comfort zone” for many investors. It is a product type and business model that people are familiar with and it is relatively easy to understand. But for investors that are looking to tap into the true power of real estate investing and invest like the best and the brightest institutional investment managers, that means stepping up to commercial real estate assets.

Given the scale and complexities of commercial real estate investing, a great way for investors to get exposure to the asset class is to invest passively with proven operators who utilize their expertise to earn consistent returns in a more sophisticated but rational market. The CrowdStreet Marketplace is continually expanding its offerings of both debt and equity commercial real estate investing opportunities and allows you to invest directly with real estate operating companies. To learn more about online real estate investing and to register for a free commercial investing account, please JOIN NOW.

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