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: ?
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:
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.
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!
Historically, direct commercial real estate investment has been out of reach for the everyday investor. This is because investments in commercial real estate are typically dominated by institutional investors as projects require millions of dollars in capital and a deep reservoir of expertise for improving and operating a property. Homepage Realty makes it possible for all investors to invest directly in a diversified portfolio of private market commercial real estate for low fees, low minimums and the potential for high returns.