Commercial Real Estate and Main Advantages
In this article we discuss what is the commercial real estate and what are the main benefits of this asset class.
Commercial real estate refers to all asset types which provide rentable space for work rather than living, in contrast to residential real estate, with the exception of multifamily properties which are considered commercial due to large capital size.
The main commercial property types are the following:
* Office: there are different kinds of office spaces suitable for hosting blue-collar workers from Class A buildings: prime Central Business District (CBD), suburban Class C buildings, and whole office parks and research centers.
* Industrial: properties that serve the manufacturing, logistics and warehouse needs of local or international businesses; mainly represented by warehouse facilities distribution centers.
* Retail: asset class is represented by small single tenant (strip) and large (“power”) shopping centers or regional malls occupied by multiple retailers.
* Multifamily: apartment complexes like suburban garden apartments, urban midrise, and high-rise apartment buildings usually located in larger metro areas.
* Hotels/Hospitality: property types range from all-inclusive brand-name five-star hotels to smaller boutique properties and extended stay hotels.
* Self-Storage: property with storage spaces that are rented to multiple tenants to store their private or small business belongings on a monthly basis or longer.
* Health Care: properties related to the services of healthcare providers like hospitals, senior housing, skilled nursing facilities etc.
* Student Housing: housing that serves undergraduate or graduate college students; near university campuses.
* Manufactured Housing: a type of affordable housing mainly represented by mobile home communities and recreational vehicles.
New property types are emerging which are often considered alternatives within the real estate market itself. These are not driven by the same demand principles as the traditional real estate market and include for example: data centers, cell towers, casinos, energy transmission infrastructure, timberland and farmland.
Why Invest in Commercial Real Estate?
The four main benefits most often associated with investing in commercial real estate are regular income, asset appreciation, principal reduction, and tax benefits due to depreciation.
Commercial real estate investing has been the most proven way of building wealth for a long time. Although any sector of the real estate market, whether residential or commercial, can always present a good investment opportunity, commercial properties in general offer higher financial reward than residential properties. The residential real estate market, which includes rental apartments or single-family homes, is often associated with higher risk due to shorter lease periods (up to a year) and low tenant diversification (1 tenant per property). Shorter lease periods make the cash flow associated with these properties more susceptible to the economy and market conditions. Any downturn or upturn in the economy would hit the residential market first (excluding the hospitality sector), translating into an increase or decrease in cash flow. For example, in single-family homes, imagine the one and only tenant defaults on the rental payments due to employment cuts caused by an economic slowdown. In this case 100% of your rental revenue is at risk. In the commercial real estate market, however, the lease terms are regularly signed for 3 to 10 years. This gives investors time to react to the market conditions. In addition, investing in a commercial building provides an opportunity to distribute your risk among dozens of tenants, which carries a certain protection to at least the majority of your income in the event of default by one or more payors.
Stable Cash Flow
Real estate investments are able to generate steady cash flow with net income distributed to investors monthly, quarterly, or annually. The income stream provided by the property is typically significantly higher than a stock dividend. By owning a stake in a commercial real estate deal, you are engaging in an opportunity to receive a stable or increasing and predictable income, which can easily become passive income by outsourcing its management.
Leases in commercial real estate properties are secured for a longer period of time with terms agreed in advance, which means that you as an investor can easily foresee the level of your future income. Businesses usually need stability so the leases for commercial space are longer. While rents for single-family homes are signed for 1 year or shorter, the majority of commercial properties sign for longer than 3 years. In some cases, tenants secure the space for more than 10 years, such as triple-net leases (NNN). Where lease agreements tend to be short like for self-storages, multifamily or hotels, the income base is so diverse that there is virtually no risk of losing 100% of the income overnight and lease replacements are very cheap.
Appreciation of an Asset
Appreciation is an increase in property value due to either positive improvements in the market economic conditions or improvements to the property itself which lead to an increase in income. Commercial real estate assets typically gain value over time. Thus, investors in advance assume that they will be able to cash in on their investment upon sale. The values of the commercial properties are closely linked to their NOIs (net operating income). This is because the property value is calculated using capitalization rate, or cap rate. Property Value = NOI / cap rate. Thus, the higher the NOI upon sale or the lower the cap rate in relation to the NOI and cap rate at purchase, the higher the value of a property when sold.
Property appreciation is the most crucial part of overall return on investment. As an example, assume two investors each invest $200,000 into a $1.5 million property. Without too much optimism we can assume the property will be sold for $2 million after 5 years. If their mortgage was amortized over 30 years, the investors would have paid down the mortgage by approximately $200,000 in 5 years. And if we add the capital gains and debt amortization together, each of the investors were able to turn their initial $200,000 into $350,000 (ignoring taxes and fees to simplify the example) in 5 years. Property values increase and decrease during market cycles, so in addition to an expectation of future capital appreciation, exit timing is crucial for investors in the commercial property market.
Amortization (Principal Reduction)
Over time, the principal reduction of a mortgage is one of the greatest advantages of investing in commercial real estate. What is so great about it is that monthly amortization of the debt is covered from the cash flow received from tenant rent payments. Every time tenants cover their rental payments, a portion of their rent goes to covering mortgage payments which leads to increase in investor ownership in the property over time. For example, on the day of purchase the LTV for the mortgage was 80% and thus your ownership in the property amounted to only 20% while the property value was $1.5 million. However, over the holding period of 5 years $200,000 of the debt was repaid as in the above example. This $200,000 would add 13% to your share in the ownership structure and thus your equity in the property is 33% upon sale without committing any more money to the project.
Depreciation (tax deferred income)
The IRS allows investors to reduce their yearly taxable revenue by deducting applicable depreciation. It is expected that property will lose value as it ages, thus depreciation is deducted in tax reporting. However, in reality property depreciation is a non-cash item and does not impact the amount of cash distributed to investors in any given period. The truth is that the value of real estate is governed by the market conditions, location, demand and supply parity, and tenant mix to the greatest extent. In most cases the property gains in value rather than loses as the government assumes. For example, assume the purchase price of the property was $1.5 million and according to the IRS the recovery period for commercial assets is 39 years; therefore the amount deductible from your annual income for tax reporting is $1.5 million / 39 = $38,500, and if the tax rate is 35%, this will come to 35% x $38,500 = $13,500.