How Investing In Commercial Real Estate Works
Investing In Commercial Real Estate Works
Investing in commercial real estate as an alternative asset is nothing new, but it's still a mystery to many investors why it works.
- Commercial real estate is all around us, and includes apartments, offices, retail space, and more.
- Income and appreciation are the two ways commercial real estate earns money. Income is produced through the operation of the building, while appreciation is an increase in the property’s value over time.
Commercial real estate is a broad term describing real property used to generate a profit. Examples of commercial real estate include office buildings, industrial property, medical centers, hotels, malls, farmland, apartment buildings, and warehouses.
Historically, investing in commercial real estate as an alternative asset has provided millions of investors with attractive risk-adjusted returns and portfolio diversification. But, many investors still don’t understand how commercial real estate works as an investment vehicle.
There are some key differences between commercial real estate investing and traditional investments such as stocks and bonds. Unlike stocks and bonds traded frequently on a secondary market, real estate is a scarce resource and holds intrinsic value as hard asset. Most often, stocks are purchased for their selling potential rather than their capacity as a source of income, hence the “buy low, sell high” heuristic of the stock market.
The investment strategy for commercial real estate is simple: there is inherent demand for real estate in a given area. Investors purchase the property and make money in two ways: first, by leasing the property and charging tenants rent in exchange for use of the property; and second by appreciation in the value of the property over time. Let’s examine these two aspects of the investment opportunities a little more closely:
Rental Income
Tenants differ across all types of commercial real estate investment properties. With different tenants comes different arrangements, property management needs, and lease agreements. Here are a few examples:
- Office: Cubicles and parking decks. Example tenants would be a law firm or start-up company. The company pays the rent, and has lease terms often in the five-year to ten -year range.
- Apartment Buildings: Multi-family apartment buildings typically have individuals or families as tenants. Leases can be short term or long term, but most are not for longer than a year, and some can even be month to month. This building can have more tenants and leases to manage, and more payments to account for each month.
- Industrial: Warehouses and smokestacks. A typical tenant might be a manufacturing or distribution company. These properties aren’t generally located in areas that would be very desirable for a residential or retail property. Lease lengths are typically for five years or more.
Appreciation and Value Add
The second opportunity for potential returns from a commercial real estate investment comes from an increase in the property’s value over the period that the investor holds it. Properties can also lose value, and even the most disciplined, proven investment strategies can’t ensure gains due to outside economic forces that may arise.
In general, real estate is a unique and scarce asset class. More land can’t simply be “created.” In the middle of a major city, this scarcity is increased by demand. If demand increases for your property, or in the area right around your property, there’s a good chance that tenants will be willing to pay higher rent, and prospective buyers will be willing to pay a higher price than you paid originally to take it off your hands.
Appreciation through demand isn’t the only way the value of a property increases. Many investors take an active “value-add” approach to commercial real estate, making improvements to the property to increase its intrinsic value or its ability to earn income. One example of this would be updating cosmetic details or appliances of a multi-family apartment building. Updates such as these can allow the owner to charge higher rent for nicer apartments. Methods outside of improving the property might include rezoning an adjacent parcel of land, say from residential to multi-family, so that more apartments can be built. Any money spent to renovating a building can potentially boost the selling price of the building in the future.
Real World Example: Doug’s Apartment Building
Let’s look at a commercial real estate investment in action. Doug buys an old, 40-unit apartment building in Philadelphia for $5 million. He earns a rental income of $500,000 in year one after all of his expenses. As with all properties, some tenants leave each year. Doug renovates vacant apartments before releasing them out at higher rates to new tenants. Doug’s improvements increase the property’s rental income by $50,000 each year for five years, so by the end of year five the property earns $750,000 per year.
Doug then decides to sell the apartment building for $16 million. The buyer was willing to pay a higher price than Doug did 5 years ago for two reasons:. First, Doug renovated the apartments, which now bring in 50% more income than they did when he bought the building. Second, economic growth in Doug’s city increased property values as new renters and entertainment venues moved into the neighborhood. Nice job, Doug!
The Bottom Line
- Unlike stocks, commercial real estate investments often provide stable cash flows in the form of rental income.
- Commercial real estate is a hard asset that is also a scarce resource. It always has intrinsic value, and usually appreciates in value over time.
- The value of commercial real estate is derived by the larger growth of the economy as a whole.
DISCLAIMER: This blog/article has been curated from an alternate source and is designed for informational purposes to highlight the commercial real estate market. It solely represents the opinion of the specific blogger/author and does not necessarily represent the opinion of Pacific Coast Commercial.
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