Commercial real estate covers everything from apartment complexes to package sorting warehouses. Learn about investing in this $20.7 trillion1 asset class.
What is commercial real estate?
Commercial real estate—or CRE—means just that: real estate intended for a commercial purpose. An easy way to think of CRE is in comparison to a single family home, whether it’s owner-occupied or rented out, which would be classified as residential real estate. Almost everything else would be considered commercial real estate.
This covers a lot of different asset types, likely much more than what initially comes to mind with the word “commercial.” Many assume commercial properties are just the offices they work in. But most of us interact with commercial real estate every day, even if we don’t realize it. Your local grocery store, the apartment complex down the street, the warehouse where your Amazon packages are sorted—all these and more all fall under the CRE umbrella.
Since many commercial real estate properties are privately owned, this creates a market for investors. Sponsors and developers, the firms behind the project, often rely on a network of individual investors to raise some of the capital (also known as equity) needed to execute their business plan. A sponsor might be looking to build a new hotel from the ground up (also known as development). Or perhaps they are looking to renovate an existing multifamily property and potentially increase rents. Or maybe they are interested in purchasing and operating an office building. In any of these situations, individuals may find opportunities to invest.
Why do people invest in commercial real estate?
Real estate is not only the world’s largest asset class, it’s also the oldest2. Commercial real estate is estimated to be worth $20.7 trillion1. Some of the world’s biggest institutions invest in real estate, including the Harvard Management Company, which manages Harvard University’s $50.93 billion endowment.
These are just a few of the reasons why private and institutional investors have included commercial real estate in their investment portfolio.
Real estate is a hard (a.k.a. physical) asset, backed by something tangible. Unlike share prices, which can be here today and gone tomorrow, its value is not directly tied to the whims of the public stock market*. The value of individual properties (also known as assets) is affected by both national and regional trends. For example, a hotel in the outskirts of Des Moines may have a very different outlook than one in Las Vegas. These localized factors can add a layer of protection from the ups and downs of the U.S. public market.
The potential to earn returns
Commercial real estate investments can potentially* pay out in two ways: with ongoing cash distributions, and/or a share of the final sale price. Properties that are fully leased to quality, long-term tenants with steady monthly rents are more likely to distribute regular cash flow back to investors, while assets that require more work may mean less cash flow now, but could lead to a payout after renovation and sale. By choosing individual commercial real estate investments strategically, you have the chance to create a balance that’s right for your portfolio and goals.
*Distributions are not guaranteed.
Unlike purchasing a residential real estate property to rent out, commercial real estate investing via a real estate limited partnership (RELP) or limited liability company (LLC) is generally hands-off, aka a “passive investment.” When you invest in a CRE deal as a limited partner, you aren’t signing up to be a landlord—you get to be a passive investor. CRE investing through a RELP or LLC can often provide investors with similar tax advantages* that come with owning rental income property, like deductions for depreciation and interest expense (depending on how the entity is set up), but without the headaches of direct ownership.
Long-term, illiquid investment
Unlike fix-and-flip residential properties, commercial real estate investing is a long game. Most projects have a 2+ year anticipated hold period—some even longer than 10 years. Real estate investments are generally illiquid, meaning you can’t sell whenever you want. However, the long-term nature of real estate allows investors to ride through multiple economic cycles.
Can help mitigate the effects of recessions
While no investment can be recession-proof, a well-diversified and strategically built portfolio with commercial real estate investments (and others) may mitigate the effects of market volatility, inflation, and recessions. Historically*, CRE is less correlated with the stock market and performs differently compared to other investment options—including residential real estate—in terms of shielding some investors from some recession effects. Factors like location, purpose, and sponsor experience can all have an effect on an asset’s performance in tough times.
Access to commercial real estate opportunities was once reserved for the incredibly wealthy and well-connected, but thanks to regulatory changes and new technology, individual investors can now add commercial real estate investments to their investment portfolio and potentially reap long-term benefits.
How can you potentially earn returns with commercial real estate?
Individual investors generally seek returns on investment in real estate in two ways: in the short-term with cash flow from the rental income, and in the long-term from any appreciation realized in a sale. Income can be distributed on a monthly, quarterly, or annual basis to the extent the property is cash-flowing, but the hopeful payout of appreciation only comes once, when the deal is complete, or “fully realized.”
The “Big Three” Return Metrics
These three terms are the basis for evaluating returns on commercial real estate deals. The actual metrics can and do change throughout the lifecycle of the deal, until the asset is sold and the deal is fully realized. Below, we define each of these metrics further.
Internal Rate of Return (IRR): IRR is an interest rate that measures the potential profitability of an investment over the investment hold period. It’s a return metric that allows you to compare multiple investments with different cash-flow timing. For example, let’s say you invest $10,000 today in a real estate deal with a three-year hold. After year one you receive a distribution of $1,000 followed by another $1,000 distribution at the end of year two. At the end of year three, the property is sold and you recover $11,000. You’ve received a total of $13,000 in cash flow distributions and sale proceeds, including return of capital. The realized IRR from this investment was 10%. Let’s look at a second investment in which you also might’ve invested $10,000 over a three-year hold, except this time there are no annual distributions (perhaps this is a development deal which typically would not produce cash flow early on in the investment) and you must wait until the end of year three to recover $13,000 upon sale of the property. The realized IRR in this example would be only 9.1% due to the deferral of receiving the entire $13,000 until the very end. IRR is a way to account for the time value of money—earlier cash flows from an investment are worth more than later cash flows.
Equity Multiple: The total cash distributions received from an investment, divided by the total equity invested. Essentially, it’s how much money an investor could make on their initial investment. For instance, an equity multiple of 2.50x means that for every $1 invested in a CRE project, an investor could be expected to get back $2.50 (including the initial $1 investment).
Hold Period: The time between when the investment is made and when the property sells. Since real estate investments are illiquid, investors can’t sell their investment before the end of the hold period, unlike public stocks which can be sold at any time. Sponsors generally target a hold period of 3-5 years, although some investments target as long as 10 years.
Individual deals have different plans for how to distribute earnings to investors, and understanding the structure can help you make choices that align with your investment goals.
Net Operating Income (NOI) is the basis for calculating distributions. Simply put, NOI is all revenues from a property minus all operating expenses. For example, an apartment community’s revenues might be monthly rent, laundry, and pet rent; operating expenses could include maintenance, insurance, property management services, legal fees, utilities, taxes, etc. Hopefully the revenue of the apartment complex is higher than its expenses, so that the NOI is a positive number. Gross rental revenue - Operating Expenses = Net Operating Income
If you subtract debt service, operating reserves, and capital expenditures from NOI, you get Net Cash Flow, the money that is actually paid back to all providers of capital based on their position in the capital stack. This priority order is called the hierarchy of distributions. Your position in the capital stack dictates how likely it is that you’ll receive distributions from either the ongoing cash flow of an investment or the final sale. Debt holders are paid first, then equity holders. Those in the bottom layer get their payments first, and so on as you move up the stack until all the money is distributed. Investors should be aware that distributions to the common equity holders are generally made at the sole discretion of the sponsor, unlike dividends, which, once declared by the issuing company, must be paid out.
In order to fully understand cash flow distributions, you also need to understand the basic structure of private equity real estate deals. The structure generally comprises the General Partner (“GP” or “Sponsor”) and the Limited Partners (“LPs”). In the case of a limited liability company, the GP is typically referred to as the “Manager” and the LPs are the “members.” As an investor in CrowdStreet Marketplace offerings, you would typically be participating on the LP side. The proportions of cash flow splits and profits owed to the GP versus the LP are outlined in what’s known as the “waterfall” set forth in the operating agreement of the issuer. The purpose of the waterfall structure is to incentivize the Sponsor to align their interests with those of the LPs by entitling the Sponsor to potentially earn outsized profits, or promoted interest, if certain performance hurdles are exceeded. Each deal is structured differently from the next in terms of the proportions of cash flow or profit splits as well as who has major-decision-making rights, or control over the investment.
Commercial real estate is broken up into a number of asset classes, risk profiles, and property classes. All of these features, combined with local and national market factors, affect how a deal might perform.
The asset class is simply the type of property. Multifamily, industrial, office, and retail are considered the four primary categories, but there are many subcategories and smaller asset classes. Let’s define and look at these types.Multifamily real estate spans a wide range of residential properties that technically can includes all buildings made up of at least two adjacent housing units with shared physical systems like walls, roofs, heating and cooling, utilities, or amenities. Apartments are the most common type of multifamily asset, but other subcategories include:
- Cold storage
- Last-mile distribution
- Data centers
Retail real estate properties are designed and constructed specifically for selling consumer goods and services. Malls are often the first example that comes to mind, but retail also includes everything from the large power centers structured around grocery or big-box stores to the small convenience center with a dry cleaner, nail salon, and local pharmacy.
Hospitality real estate includes hotels, motels, and other short-stay accommodations. This asset class is mainly divvied up by the services and amenities on offer, as well as the “flag” or operating brand (Hilton, Marriott, Holiday Inn, and so on).
Self-Storage facilities vary in size, quality, and construction. They can be designed and built specifically for self-storage or converted from a prior use such as a warehouse, car dealership, or vacant big-box retail.
Both national and local market conditions affect each asset class differently—for example, the COVID-19 pandemic hit hospitality especially hard4, but overall provided a boost to the industrial sector by driving up e-commerce sales5. At the regional level, multifamily rents may grow in a market, where population growth is soaring, while they may decline in a region where people are leaving.
We’ve published our outlook for each asset class in our CRE Market Outlook and will update it as trends shift.
Every commercial real estate project falls into one of four risk profiles. Each level is a bit like a step up on a ladder in terms of taking on more risk, and in theory, being compensated for that risk with a higher targeted return. Let’s define and look at them.
- Core investments are often considered the least risky offering. They’re generally in highly desirable locations in major markets with a full slate of quality tenants, stable income, and little need for renovations. The tradeoff, however, is that they tend to have the lowest annualized return because there isn’t much room to improve NOI (and ergo, the potential to increase distribution amounts to investors). However, the stable nature of these properties often translates into more stable cash flow.
- Core-plus investments are known as “growth and income” investments. The cash flow can be less reliable, but they often predict a higher rate of return than core investments. The term “core-plus” was originally defined as “core” plus leverage.
- Value-add properties typically have some management or operational problems, need some fixing up, and/or are low on capital. By sprucing up the asset, the sponsor strives to raise rents, attract better tenants, or lower operating costs, and therefore create the potential to up the net operating income. This in turn can increase the overall value.
- Opportunistic investments are often the most high risk/high reward. They either require significant rehabilitation or are being built from the ground up (known as development). They have the chance to reach the highest rate of return for investors, but they can have little to no in-place cash flow at the start.
CRE properties are graded on a simple A, B, C scale depending on their overall quality and key characteristics. The property class ratings are applied to all asset classes. Class A real estate properties are the top tier in their respective market, featuring high-end finishes, modern design, state-of-the-art mechanical systems and technology, and extra amenities. Building class B is a step down in terms of building quality, location, and amenities—the asset may have been considered Class A when first built, but with age has moved down a grade. Building class C is the lowest rated tier and is generally fairly run down and in need of major updates.
Learn more about classes of property in real estate.
Just as the neighborhood and school district can affect the value of a single-family home, a commercial property’s location can influences its outlook just as much as its features. However, it would be a mistake to only look for commercial real estate investment opportunities where residential property values are highest.
Regional characteristics like population growth and employment base can factor heavily into market outlook, as may a subjective desirability, or a market’s “vibe.” People create opportunity—where the people want to go, commerce will generally follow. So investing in a deal in a mid-size city or larger town on an upward trajectory can potentially be a better strategy than an aging metro losing residents, or even the top “24-hour” cities like New York City or San Francisco. We call these up-and-coming markets like Nashville, TN; Milwaukee, WI; and Austin, TX “18-hour cities,” and we believe they’re some of the overall best places for CRE investments.
Of course, the outlook for individual asset classes can vary greatly between regions. Local factors like a comparatively high concentration of research universities, for example, can create opportunity for life sciences investments in markets like Raleigh/Durham6. What’s successful in one location doesn’t necessarily translate into another.
Another geographic strategy that can help investors identify areas of untapped potential is to seek out deals in Opportunity Zones. Established through the Tax Cuts and Jobs Act of 20177 to encourage long-term investment in low-income areas, Opportunity Zones were intended to offer investors both the “feel-good” factor of having a meaningful impact on a community and tax incentives that can make an otherwise solid deal even more attractive to some investors.
The most potentially lucrative tax benefit of Opportunity Zones comes from reinvesting capital gains in a Qualified Opportunity Fund (QOF). The tax on the initial gain is deferred—and even ultimately reduced—and you could potentially avoid federal capital gains tax on any additional gains produced by the QOF investment.
More than 8,7008 zones have been identified in both rural areas and the cores of major cities, giving investors access to large markets that otherwise might be a little exclusive.