Commercial Real Estate Investing

Investing In Commercial Real Estate

Investing in commercial real estate has always been smart, but over the last few years we’ve seen it grow even further in popularity. Commercial real estate investing in particular is the third largest asset class, after equities and bonds, and shows no signs of stopping. The market for commercial real estate is huge, and continues to grow year after year with new developments and projects beginning everyday. Real Capital Analytics reports that The US National All-Property Index climbed 7.1% in 2017, and the US prices now sit 23% above their pre-recession peak.

While breaking into the CRE market can be difficult at first, it is definitely worth your time as an investor to research commercial property investment opportunities. With proper due diligence and an eye for smart long term investments, investing in commercial real estate can be a secure and reliable way to generate passive income. Many of the world’s most sophisticated investors find that investing in commercial real estate is one of the strongest components of their diverse portfolios.

What is Commercial Real Estate?

Commercial real estate is a rental property that is used as a work space of for business purposes, as opposed to a living space like apartments or single family homes. Commercial properties can range in size, and can be leased to large companies or a small business. Some examples of commercial real estate include multifamily apartments, gas stations, shopping centers, hotels, strip malls, office buildings and a variety of other property types.

Commercial Real Estate Value Drivers

One of the biggest misconceptions when it comes to investing in single family residences (SFRs) versus commercial real estate (CRE) is the main value drivers behind the underlying value of the asset. While CRE experts know the difference, many first time investors are unclear about the underlying core differences between them.

Single Family Residences (“SFRs”)

The main value drivers for SFRs are:

  • The value of the land
  • The value of the structure
  • Supply and demand

Supply and demand is best understood as the overall housing market forces that can influence housing prices due to excess supply, overwhelming demand, etc. In order words, houses in San Francisco are more expensive than Toledo, Ohio.  A common misconception is that the value of rental income, known as net operating income (NOI), improves the overall value of the asset, when in fact it is not a value driver.

Commercial Real Estate (CRE)

The main value drivers for CRE are:

  • The value of the land
  • The value of the structure
  • Supply and demand
  • Net operating income (NOI)

NOI is the largest single value driver for CRE, and can have a dramatic effect on asset value.  For example, if the first three drivers all stay constant but NOI increases, the overall value of the asset will improve. Because the value of a CRE asset has substantial correlation to NOI you can make (or lose) money on a property regardless of greater market dynamics.  This makes CRE much more attractive as a investing asset.

Commercial real estate is generally defined by three separate classes: class A, class B or class C.

  • Class A: The newest and most appealing buildings to renters. They usually have high quality infrastructure features, are in great condition, and located in desirable areas.
  • Class B: Buildings that are older and cheaper. These buildings are often sought after by investors to be refurbished and upgraded to Class A properties.
  • Class C: Usually in poor condition and located in undesirable neighborhoods, these properties may be targeted for complete redevelopment.

Diversify Your Portfolio by Investing in Commercial Real Estate

As mentioned above, investing in commercial real estate can serve as a good hedge against the volatility of the stock market. While investors do earn money through appreciation at the sale of a property, most of the return is generated as passive income through rent collected from tenants. With income that can be depended on, commercial real estate is a safe way to diversify your investment portfolio while still seeing consistent consistent returns.

Diversification of your portfolio is crucial to minimizing risk and achieving a higher overall blend of return. Following Modern Portfolio Theory, investors should allocate between 10%-20% of their investments into hard assets such as commercial real estate. Doing so can lead to increased returns, lower risk and moving closer to the efficient frontier. Investors can enter the market in both debt or equity deals and have a variety of choices in the types of rental properties they are involved with.

In fact, smart investors will not only diversify their portfolios with investments in hard assets, but will diversify those hard assets as well. 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. Other factors investors will want to consider include geography, asset class, risk profile, holding period, sponsorship and business models.

*sample $210,000 portfolio

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Why Should I Invest in Commercial Real Estate?

Investing in commercial real estate has many upsides. Beyond diversifying your portfolio and providing protection from market volatility, commercial real estate also offers consistent returns and an investment in a tangible asset. Let’s break down some of the other upsides offered by investing in commercial properties.

Attractive returns: Commercial real estate returns are very attractive when compared to alternatives in other commodities like stocks, bonds and precious metals. The high yield is one reason why private and institutional investors are both heavily pursuing real estate investments. Over the long term, the National Council of Real Estate Investment has reported an average annual return of 8.8% over the last 15 years, 200 points above the average performance of the S&P 500.

Volatility and risk-adjusted returns across asset classes (annualized performance for 20-year period ended 12/31/16)

US EquityNon-US EquityUS Fixed IncomeUS Direct Real EstateREITs
Total Returns7.86%5.05%5.29%9.31%9.67%
Standard Deviation (volatility)18.46%21.86%3.63%11.37%19.59%
Sharpe Ratio (risk adjusted returns)0.310.170.430.550.30

Sources: CBRE, TIAA

Cash flow: Many investors are drawn to investing in commercial real estate because the deals are structured to deliver steady cash flow and passive income. These dividends can be paid out monthly, quarterly or annually depending on the deal and investment. With Equity investments in hard assets like office buildings, high occupancy and rising rents tend to deliver steady or rising cash flow over time. With Debt investments, participants are investing in a real estate loan, and receive portions of a fixed interest rate payment dependent on the terms of the loan. In either case investors are seeing consistent cash flow.

Equity upside: With equity investments, investors can take advantage of the appreciation of a property once it is sold. Because property values rise and falls, selling at the right time is of the utmost importance and critical to maximizing investor value. Opportunistic investors can similarly cash in by buying, fixing and flipping an asset, though these investments can be riskier. For more stable cash, flow investors will want to hold properties for an extended period of time.

Tangible assets: Portfolio managers will tell you that it’s important to allocate a piece of your portfolio to hard assets, and they’re right! Unlike buying shares in a company that may be around tomorrow, much less a year from now, hard assets like commercial real estate investment are something you as an investor can literally touch. Occupants may come and go, and property values may fluctuate, but over the long term real estate investments are almost guaranteed to appreciate.

Why Investing in Commercial Real Estate Works

Commercial property investment is considered a stable investment because of how closely it is tied to other economies and decisions based on facts. These include property proximity to customers, traffic along its frontage, building features and capabilities, and accessibility.  These predetermined and easily researchable facts make it easier for investors to understand and analyze each investment opportunity, and make rational predictions on their returns.

While those factors do make commercial real estate a more rational investment, the deals themselves can be quite complex. As with any investment its important to practice due diligence and gather a full understanding of how each deal is structured. The information you need to understand a deal’s structure is often readily available as long as you know where to look and how to interpret what you find.

The complexities and structures of commercial real estate deals is one reason why investors may want to look to proven operators to gain exposure to the sophisticated but rational asset class. One such place to gain exposure is the CrowdStreet marketplace, which is continually expanding its offerings of debt and equity commercial real estate investment opportunities. With the ability to invest directly with real estate operating companies the CrowdStreet marketplace is an easy place to gain exposure and experience in commercial real estate investing.

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