Real Estate 101: How Investing In Commercial Real Estate Works
Commercial real estate is all around us. It’s a broad term used to describe property used to generate a profit, such as 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.
There are some key differences between investing in commercial real estate and traditional investments such as stocks and bonds. Unlike stocks and bonds traded on a secondary market, real estate is a scarce resource, and physical buildings hold some intrinsic value as hard assets.In general, stocks are purchased for their upside potential rather than as a source of income, hence the “buy low, sell high” heuristic that follows the stock market.
The investment model 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 charging rent for the use of the property, and second by appreciation in the property’s value over time. Let’s examine these two aspects of the investment a little more closely:
Tenants differ across all types of commercial real estate investment properties. With different tenants comes different arrangements, management needs, and lease agreements. Here are a few examples:
- Office: Cubicles and parking decks galore. Example tenants would be a law firm or start-up. The company pays the rent, and lease terms are often in the 5- to 10-year range.
- Apartment Buildings: Multifamily apartment buildings typically have individuals or families as tenants. Leases vary, but most are not for longer than a year, and some can even be month to month. This means more tenants to manage, and more payments to account for each month.
- Industrial: Picture 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. Leases are typically 5 years or more.
Appreciation and Value Add
The second contributor of potential returns from a commercial real estate investment comes from an increase in the property’s value over the period 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 unique and scarce. 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 tenants will be willing to pay higher rent, and new owners will be willing to pay a higher price to take it off your hands than you paid originally.
Appreciation through demand isn’t the only way the value of a property increases, however. Many investors take an active “value-add” approach to commercial real estate, making improvements to increase the intrinsic value of a property or its ability to earn income. One example would be updating cosmetic details and appliances in a multifamily apartment building. An update such as this can allow the owner to charge higher rent for nicer apartments. Methods outside of fixing up the property might include rezoning an adjacent parcel of land, say from residential to multifamily, so that more apartments can be built. Any money spent to update 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 rental income of $500,000 in year 1 after all of his expenses. As with all properties, some tenants leave each year. Doug renovates vacant apartments before re-leasing them out at higher rates to new tenants. Doug’s improvements increase the property’s rental income by $50,000 each year for 5 years, so by the end of year 5 the property earns $750,000 per year.
Doug sells 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 scarce resource. It always has some intrinsic value, and usually appreciates in value over time. Finally, the value of commercial real estate is derived by the larger growth of the economy as a whole.