Commercial Real Estate

What is 'Commercial Real Estate'

Commercial real estate is property that is used solely for business purposes and that is leased out to provide a workspace rather than a living space. Ranging from a single gas station to a huge shopping center, commercial real estate includes retailers of all kinds, office space, hotels, strip malls, restaurants and convenience stores.

BREAKING DOWN 'Commercial Real Estate'

Commercial real estate is one of the three main types of real estate, along with residential and industrial. As its name implies, commercial real estate is used in commerce (residential real estate is used for living purposes, while industrial real estate is used for the manufacture and production of goods). While some businesses own the buildings they occupy, the more typical scenario is that an investor owns the building and collects rent from each business that operates there. While residential real estate lease rates may be quoted in an annual sum or a monthly rent, commercial real estate is customarily quoted in annual rental dollars per square foot. 

Lease Lowdown

Leases can run from one year to 10 years or more, with office and retail space typically averaging from five to 10 years. “Larger tenants tend to have longer leases,” said Brian McAuliffe, president in CBRE Group's (CBG) Capital Markets division. “Shorter-term leases provide more flexibility to adjust lease rents while longer leases provide more security, especially with credit tenants.” (For more, see: Exploring Real Estate Investments.)

There are four primary types of commercial property leases, each requiring different levels of responsibility from the landlord and the tenant.

Commercial Real Estate Classifications

Commercial real estate is categorized into different classes. Office space, for example, is divided into one of three classes: class A, class B or class C.

  • Class A represents the best buildings in terms of aesthetics, age, quality of infrastructure and location.
  • Class B buildings are usually older and not as competitive price-wise as Class A buildings. These buildings are often targeted by investors for restoration.
  • Class C buildings are the oldest, usually over 20 years of age, located in less attractive areas and in need of maintenance.

Commercial Real Estate Companies

A commercial real estate firm advises on how to best negotiate lease agreements that will attract and keep tenants, a useful service for property owners who need to strike a balance between maximizing rents and minimizing vacancies and tenant turnover. Turnover can be costly for owners because a space must be adapted to meet the specific needs of different tenants — say, if a restaurant is moving into a property once occupied by a yoga studio. 

There are many firms in the commercial real estate space. CBRE is the largest in the world. Other big players include Jones Lang LaSalle, Cushman & Wakefield Inc. and Newmark Knight Frank. These companies help source commercial real estate, appraise value, broker purchases and sales, manage upkeep, find and retain tenants, negotiate leases and navigate financing options. “A full-service company satisfies all of a client's real estate needs, whether they be individuals, limited partnerships or institutions,” said McAuliffe. 

The specialized knowledge of a commercial real estate company is helpful as the rules and regulations governing such property vary by state, county, municipality and industry and size.

Commercial Real Estate Outlook

The U.S. commercial property market took a hit during the 2008-2009 recession, but it has experienced annual gains since 2010 that have helped recover nearly all recession-era losses. A report issued by CBRE described the outlook for U.S. commercial real estate in 2018 as cloudy, adding that policy uncertainty is particularly weighing on the commercial real estate market as it enters the late stages of its growth cycle.

There are other indicators that suggest the commercial property market has peaked in the post-recession growth cycle. Growth in commercial property sales volume has stalled since 2016, and in December 2017, commercial real estate prices declined for the eighth-consecutive month, according to California real estate firm Ten-X. The retail sector in particular has proved a pain point in the broader commercial property market, as widespread store closures intensified in 2017 and continued into 2018. Painting the retail commercial property picture, popular mall REIT Westfield Corporation saw its stock price shed about 30 percent between mid-2016 and late 2017 before reversing some losses through January 2018.

Most firms, however, maintain that the property market remains healthy overall. Commercial real estate firm Colliers International, for example, said in a December 2017 report that robust gains in suburban submarkets and continued gains in the office sector, despite faltering momentum, are examples of robust fundamentals in the industry as it looks toward the rest of 2018.

Investing in Commercial Real Estate

Investing in commercial real estate can be lucrative and serve as a good hedge against the volatility of the stock market. Investors can make money via appreciation when they sell, but most returns are generated through rents collected from tenants.

In most cases, properties are sold by the building — one office building, one restaurant, one factory, etc. However, if a developer wants more capital to expand a project or wishes to see the returns more quickly, the project will be broken down into smaller units rather than sold as a whole. (To read more about commercial properties, check out our Exploring Real Estate Investments tutorial.)

Advantages to Commercial Real Estate

One of the biggest advantages of commercial real estate is the attractive leasing rates. In areas where the amount of new construction is either limited by land or law, commercial real estate can have impressive returns and considerable monthly cash flow. Industrial buildings generally rent at a lower rate, though they also have lower overhead costs compared to an office tower.

Commercial real estate also benefits from comparably longer lease contracts with tenants than residential real estate. This gives the commercial real estate holder a considerable amount of cash flow stability, as long as the building is occupied by long-term tenants.

Disadvantages to Commercial Real Estate

Rules and regulations are the primary deterrent for most people wanting to invest in commercial real estate. The taxes, mechanics of purchase and maintenance responsibilities for commercial properties are buried in layers of legalese that shift according to state, county, industry, size, zoning and many other designations. Most investors in commercial real estate either have specialized knowledge or a payroll of people who do.

Another hurdle is the increased risk brought with tenant turnover, especially relevant in today's market, when unexpected retail closures have left properties vacant with little notice in advance. With residences, the facilities requirements of a given tenant are almost the same as any previous or future tenant. With a commercial property, each tenant may have very different needs that require costly refurbishing. The building owner then has to adapt the space to accommodate each tenant's specialized trade. A commercial property with low vacancy but high tenant turnover may still lose money due to the cost of renovations for incoming tenants.

Who Should Invest in Commercial Real Estate?

Those who have a business, for starters. It can be financially beneficial to own your own workspace rather than rent it.

Aside from that, people best suited for investing in commercial real estate are those who either have a considerable amount of knowledge about the industry and its legal, financial and regulatory aspects, or can employ people who do. Commercial properties are a high-risk, high-reward area of real estate investing that will appeal to sophisticated investors looking for a challenge. As you may have guessed, such an investor is likely to already be a high net worth individual since in commercial real estate, investing often requires a considerable amount of startup capital.

That said, there is a wide range of commercial properties, from mega malls and office towers to small warehouses and single-shop buildings. When looking at commercial properties purely as an investment, the most important factors are supply and demand. The ideal property is located in an area where vacancy is low and the space available for new developments is limited. Low supply and high demand mean favorable rental rates as well as the hedge of a higher rate of appreciation. The strength of the local economy of the area will also affect the value of your purchase, so you will want to check employment rates via the Bureau of Labor Statistics (BLS) along with other economic growth and strength metrics.

Whatever sort of property, or scale, you can think of, just make sure that you can handle the time and costs associated with an investment in commercial real estate.

How to Invest: Directly

Finding direct investments is straightforward: Commercial real estate firms like those listed above all have a range of listings nationwide. Prominent websites for residential property, such as Trulia and Realtor.com, also include searchable databases of commercial listings. Another site, LoopNet, specializes in commercial property.

An investor can purchase a small retail space or storage center directly or through a private partnership, but the down payment requirements tend to be much higher than for residential properties: think 30% at least. Real estate limited partnerships are another option, though these also often require a considerable investment.

How to Invest: Indirectly

Michael Orzano, senior director of global equity indices at S&P Dow Jones Indices — which releases the S&P/Case-Shiller Home Price Indices, a leading measure of home prices in the U.S. — cautions against buying property outright, given the many headaches that plague management companies and/or landlords: “Direct investment in commercial real estate is not practical for most investors, given the large investment required to purchase a single property and the oversight required to manage the building or buildings.” Investors who don't want to deal with all the hassles of direct ownership (or don't have the capital to purchase entire properties) can still get into the game in several ways.

One is via real estate investment trusts (REITs). Commercial real estate REITs hold a portfolio of properties (as a mutual fund holds stocks or bonds), but are publicly traded; this makes them easy to buy and sell, providing liquidity in a field that is notoriously illiquid. The managers of REITs handle all the details of purchase, maintenance, tenants, and so on. They also receive special tax considerations and typically offer investors high yields; they can be geared towards providing income, capital appreciation or both.

“The most convenient way for most individual investors to tap the commercial real estate marketplace is through REITs,” says investment consultant Christian Thomas, formerly with Glastonbury, Conn.-based USI Advisors. “REITs were established by Congress just for that purpose, and most have daily pricing.” (For more, see: What Are the Risks of REITs?).

And, if you want further diversification, "index-based products, such as ETFs that track property and REIT benchmarks, provide a cost-effective means of accessing a diversified portfolio of REITs,” Orzano notes.

Another way to tap into the commercial realm is via commercial mortgage-backed securities (CMBS), interest-paying bonds that hold bundles of commercial mortgages.

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