Investing in Commercial Real Estate? | Consider These 5 Things First
Making the jump from residential to commercial real estate can be a daunting prospect for new investors. But, the rewards for moving into the commercial realm more than justify the learning curve.
In this article, I’ll cover five things every new investor should consider prior to diving into commercial real estate.
Consideration 1: Commercial Real Estate’s Cyclical Nature
When you work with commercial real estate professionals, you gain two primary advantages. The first is their technical expertise, that is, a rock solid understanding of the fundamentals of commercial real estate.
The second benefit, while less concrete, proves just as critical. Working with commercial real estate professionals gives you access to years of experience - and the associated good judgment - they’ve gained from living through the recurring ups and downs of the market.
As with the economy, writ large, the commercial real estate realm faces market fluctuations. And, while many asset classes tend to mirror the broader economy (e.g. industrial, office, and multifamily properties), some provide counter-cyclical hedges, that is, they often resist larger economic downturns (e.g. student housing and medical space).
Recognizing the above, investors should factor the following three items into their calculus prior to any deal:
● Commercial real estate is cyclical.
● Exactly how a particular property will respond to an economic cycle will differ by A) asset class, and B) market.
● New investors should work with commercial real estate professionals to understand the historic, cyclical trends of a target property type and location before any deal.
Consideration 2: Multiple Niches Exist
Investing in residential real estate tends to be fairly straightforward. While strategies may differ, investors basically focus on one asset class - places for people to live.
Commercial real estate, on the other hand, offers a far wider variety of asset classes and investment strategies, all of which will affect a deal’s profitability.
Broadly speaking, the following six categories fall under the commercial real estate umbrella:
● Multi-family
● Office Space
● Industrial
● Medical
● Hospitality
● Retail
And, within these, multiple subcategories exist, each of which will perform differently depending on economic cycles and specific markets.
Some investors choose to focus solely on a single commercial niche, becoming subject-matter experts in a particular strategy and asset class. On the other hand, some choose to invest in a variety of categories to provide a diversification hedge against broader economic downturns.
The important takeaway for new investors is that, in commercial real estate, multiple niches exist, each of which comes with its associated pros and cons.
Local commercial real estate professionals can help you determine the best property type and investment strategy for your market and unique situation - need help finding reliable ones in your area? Drop us a note!
Consideration 3: The Tenant Comes First
Though cliche, there’s a reason why the retail and hospitality industries live by the phrase the customer is always right - customers drive revenue.
And, with commercial real estate, placing the needs of the tenant first drives both revenue and valuation, making a good tenant experience critical to a property’s performance.
First, providing an outstanding tenant experience minimizes turnover and vacancy, both of which drive a property’s NOI. Second, in commercial real estate, valuations are driven by NOI-related capitalization rates - not sales comps - meaning that maximizing your NOI will also maximize your property’s valuation.
While countless paths exist for improving a commercial tenant’s experience, here are a few of the more common options:
● Tenant improvement allowances (initial and lease extension options)
● Lease incentives / rent concessions
● Modern amenities
● High-quality, responsive property management
● Tenant-to-landlord feedback mechanisms
Consideration 4: Location Matters in Commercial Real Estate, Too
Residential real estate agents echo the phrase location, location, location. This absolutely matters in commercial real estate, too.
Regardless how solid a property seems, experienced investors understand that a commercial property’s location will ultimately drive its performance - for better or worse.
In addition to looking at the macroeconomic trends of an area, investors need to understand how location relates to a particular asset type. For example, customer convenience and accessibility will drive the success of an outparcel-type retail location (e.g. standalone coffee shop or fast food property on the outskirts of a regional mall).
Conversely, access to major highways and transportation infrastructure will dictate success for many industrial sites (e.g. Amazon-type distribution warehouses).
Bottom line, investors have to look beyond the property and understand exactly how its location will impact performance to truly grasp a deal’s potential.
Analyzing local commercial real estate markets can be challenging for new investors, so please drop us a note for help working through the process.
Consideration 5: Capitalization Pros and Cons
In commercial real estate, a deal’s capitalization structure represents the unique blend of debt and equity financing in a given project. Whereas residential real estate offers fairly uniform financing options (e.g. 20% down, 30-year mortgage), the financing options available on commercial deals prove far more diverse.
Broadly speaking, two ends to the capitalization spectrum exist: debt-focused and equity-focused. However, these financing options represent a spectrum, and investors have the flexibility to structure a deal’s capitalization anywhere along it. With that said, it helps to understand the pros and cons inherent to each end of the spectrum.
Debt-focused capitalization structure
● Pros: Leverage (i.e. the use of debt to purchase a property) can significantly amplify an investor’s returns, and the interest portion of the mortgage payments is tax-deductible.
● Cons: Higher debt equals higher risk, as investors need to pay their mortgage every month, regardless of how a property is performing.
Equity-focused capitalization structure
● Pros: An equity-heavy capital structure lowers risk for investors, as owner distributions are not mandated (i.e. fixed costs). In other words, if a property is not performing well for a period of time, the owners just don’t receive a distribution (as opposed to defaulting on a loan). Additionally, interest payments are either minimized or completely eliminated, depending on the level of equity.
● Cons: Every additional equity investor dilutes the returns available to the original investor, that is, bringing in more investors means they’ll share a deal’s upside with you.
One right answer doesn’t exist to the question of a deal’s capital structure. Rather, investors need to consider the above pros and cons to both debt and equity financing to determine what makes the most sense for a specific project.
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We recognize that, even after outlining the above information, investing in commercial real estate can seem daunting.
That’s why we’re here to help. The Pocket Broker team lives and breathes commercial real estate, so drop us a note to see how we can help you achieve your unique objectives!