What Is Commercial Real Estate?
Commercial real estate (CRE) is property utilized solely for business purposes or to provide a workspace. This broad category encompasses everything from a single storefront to an extensive shopping center and is typically leased to tenants to engage in income-generating activities.
From office buildings and residential duplexes to restaurants and warehouses, CRE comes in various forms. Individuals, companies, and corporate entities can profit from commercial real estate by leasing it out or through capital gain upon resale.
CRE includes several subcategories such as retail of all kinds, office spaces, hotels, resorts, strip malls, restaurants, and healthcare facilities.
Key Takeaways
- CRE properties are designated for business or income-generating purposes, not for living accommodations.
- Unlike residential real estate, CRE can create profit through rental income or capital gains.
- The primary classes of CRE include office space, industrial use, multifamily rentals, and retail sectors.
- Investing in CRE offers potential rental income, property appreciation, and diversifies an investment portfolio effectively.
- Publicly traded REITs offer an accessible entry point into CRE investment for individuals.
Understanding Commercial Real Estate
Commercial real estate and residential real estate dominate the real estate property landscape. Residential properties are designated for human habitation, whereas CRE is employed in commerce. Multi-unit rental properties serving as residences are also considered commercial activities due to their income-generating aspect.
CRE is primarily divided into four classes based on function:
- Office Space
- Industrial Use
- Multifamily Rental
- Retail
Additionally, each category can be further refined. Retail real estate includes subdivisions such as hotels and resorts, strip malls, restaurants, and healthcare facilities. Office spaces are categorized as Class A, B, or C:
- Class A: Premium buildings displaying exemplary aesthetics, age, quality infrastructure, and prime locations.
- Class B: Older buildings that are generally more cost-competitive. Investors often target these for restorations.
- Class C: Buildings often exceed 20 years in age, situated in less desirable locations and requiring maintenance.
Commercial Leases
While some businesses own their occupied buildings, leasing is more prevalent. Typical commercial leases range from 1 to 10 years, with average terms for office and retail spaces spanning 5-10 years. General lease types include:
- Single Net Lease: Tenant covers property taxes.
- Double Net (NN) Lease: Tenant pays for property taxes and insurance.
- Triple Net (NNN) Lease: Tenant is accountable for property taxes, insurance, and maintenance.
- Gross Lease: The tenant pays only the rent, while the landlord handles taxes, insurance, and maintenance.
Managing Commercial Real Estate
Managing CRE properties involves identifying, leasing, and maintaining them, often done through specialized management companies. Balancing rent optimization and minimizing vacancies are crucial due to potential costly turnovers.
How Investors Profit From CRE
Investing in CRE can be lucrative, particularly through direct or indirect investments:
Direct Investment
Investors become landlords, managing the physical property. This often requires substantial industry knowledge or the hiring of specialized firms. Ideal investments are made in areas with limited CRE supply and high demand.
Indirect Investment
Investors may engage in CRE indirectly via market securities, such as REITs or ETFs related to commercial real estate.
Advantages of Commercial Real Estate
- Attractive Leasing Rates: High returns and substantial month-to-month cash flows.
- Longer Lease Contracts: Provides stable cash flow over extended periods.
- Capital Appreciation Potential: Maintained and updated properties can appreciate over time.
- Diversification: Offers distinct asset class benefits to diversify portfolios.
Disadvantages of Commercial Real Estate
- Regulatory Complexity: Investment involves navigating intricate legal and administrative layers.
- Tenant Turnover Risks: Different tenant needs may require costly refurbishing that can erode profits.
- High Capital Requirements: Direct investments demand significant capital, with inherently illiquid properties moving Slowly through transactions.
Commercial Real Estate in the COVID-19 Era
The COVID-19 pandemic temporarily impacted CRE; however, property values have generally stabilized or increased since. The pandemic accelerated the trend towards remote work, impacting corporate office space demand, notably B- and C-class buildings, whereas A-class facilities with long-term leases have fared better.
Commercial Real Estate Outlook and Forecasts
Post the 2008-2009 recession, the CRE market demonstrated consistent gains. While challenges arose during the COVID-19 pandemic, the sector continues to show resilience. The future outlook suggests softer demand for office spaces but leaves room for potentially growing sectors within CRE.
Residential vs. Commercial Real Estate
Residential real estate is solely for living spaces, while CRE encompasses any property used for business activities, such as hospitals, shopping centers, and office spaces.
Is Commercial Real Estate a Viable Investment?
With potential for attractive returns and monthly cash flows, CRE can be lucrative but also carries inherent risks requiring specialized knowledge or experienced counsel.
Disadvantages of Commercial Real Estate
CRE involves navigating extensive rules and regulations, high capital requirements, and higher risks related to tenant turnover due to the diverse needs of commercial tenants.
The Bottom Line
Commercial real estate presents a compelling investment opportunity driven by rental income and capital appreciation potential. While requiring more capital and expertise, it remains a valuable asset class, with REITs offering accessible entry points for individual investors.
Related Terms: Residential Real Estate, Real Estate Investment Trusts, Property Management, Lease Types.
References
- CBRE Group. “2021 U.S. Real Estate Market Outlook”.
- Amazon. “Andy Jassey Update on Amazon Return to Office”.
- Yahoo. “American Tower Corporation (AMT)”.
- J.P. Morgan. “2019 Commercial Real Estate Outlook”.
- J.P. Morgan Chase. “2023 Midyear Commercial Real Estate Outlook”.
- CBRE. “Office/Occupier (U.S. Real Estate Market Outlook 2023)”.
