5 Things to Consider Before Investing in Commercial Property

Investing in commercial real estate (CRE) has proven itself time and again to be a smart strategy for high-net-worth investors interested in diversifying their portfolios.

CRE compares favorably to many other forms of investment, including highly volatile stocks and bonds, in terms of predictable risk, stability, wealth creation, and current cash flow.

While investing in commercial property has many upsides, investors should consider the following fundamentals of the asset class that will help inform their approach to the category.

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5 Things to Know Before Investing in Commercial Real Estate

1. CRE is cyclical

Just like the general economy, CRE is subject to “up” and “down” cycles. In fact, those cycles tend to mirror those of the overall economy. Asset valuations rise and fall, sellers’ markets and buyers’ markets alternate, and some property sectors do better than others at different points in the cycle.

For example, in the current cycle, the multifamily (apartment) and industrial sectors are faring quite well, while the retail and hotel sectors are struggling to find their place in a challenging and changing business environment.

Understanding how cycles have progressed in the past, as well as the drivers for certain types of CRE in specific geographic markets, is helpful before completing any transactions. As we are enjoying the longest period of historical economic recovery, thinking about holding CRE assets in the long-term can prevent sleepless nights from worrying about highs or lows in the cycle.

In addition, direct real estate investments tend to be less volatile than their public counterparts. REITS tend to move in lockstep with the stock and bond markets, making them extremely susceptible to market fluctuations. While direct real estate investment may be cyclical, it is less volatile than REIT investment.

2. Capitalization matters.

The amount of debt incurred in completing a CRE transaction directly correlates to the amount of risk investors take on for that deal.

While leverage can amplify the potential returns of your investment, it comes at a price: interest. And while interest rates are currently quite low and look to remain so for a while, borrowers must cover the mortgage costs regardless of whether the property purchased is generating adequate income to cover the debt if vacancies or other property impairments occur.

In addition, the capital stack—how the investment is financed from both equity (cash) and debt (mortgage)—should be considered. Once the mortgage and operating expenses are paid, the remainder typically goes to the investor.

The capitalization structure must be factored into every CRE transaction in advance of signing on the dotted line. Careful financial analysis of the optimal mix of investor equity and mortgage debt will allow investors to maximize their returns while taking on an appropriate amount of risk.

3. Alternative categories exist.

Office, industrial, retail, and multifamily properties are considered the four main “food groups” of CRE investment. As mentioned above, fundamentals for each group change with each cycle, creating an ideal environment for investing in some groups and a less-than-ideal environment for investing in others.

However, there are more than just four primary categories in which to invest, including senior housing, student housing, data centers, call centers, self-storage, and many others. While these are less often talked about in mainstream investment circles, some investors focus exclusively in these more esoteric categories as a means to further diversify their holdings.

Investing in such alternative categories can be quite lucrative for investors who understand them and know what to look for in these properties. Some alternative investments can even deliver stronger ROI than investing in the major groups—but carry with them a potential for increased risk due to their complexity.

It’s important to research these classifications and vet properties thoroughly before taking the leap into less mainstream investments. Third-party managers and online platforms like RealCrowd offer investors a variety of tools to educate themselves on CRE categories.

4. Location is still key for investing in CRE.

No matter how good a property seems, nothing is more important to most investors than where that property is located.

Areas that boast strong job, population, and economic growth factors are a good place to start, whether these are top-tier regions like Vancouver, Toronto, New York City, Los Angeles and Chicago or emerging markets like Kelowna, Calgary and Winnipeg.

Within a strong market, investors should consider whether the asset is situated in a desirable neighborhood (called a submarket) and even down to the location on any particular block. The strength of some markets and submarkets can vary from street to street, so having a good handle on these nuances is a must.

The location of a CRE asset is a large factor that can attract and retain tenants, which are the lifeblood of any commercial property investment. A good location sets the stage for a successful investment.

5. Tenant experience is one of the most significant drivers of CRE valuation.

Regardless of what asset type an investor pursues, ensuring a great experience for the current tenants and attracting new tenants to raise occupancy levels in commercial properties are cornerstones of creating value in CRE investments.

As tenants increasingly focus on their experience in a leased space, landlords are searching for new ways to make that experience a positive one both as a means to keep current tenants happy and provide differentiated experiences for prospective tenants.

For many property owners, this means providing modern amenities that tenants want and have come to expect. These amenities could be physical, such as a rooftop terrace or outdoor kitchen; involve internet connectivity or sustainability; or be related to walkability, such as proximity to shopping, dining, and daily-needs retail stores and services.

While these amenities may mean a higher purchase price when acquiring the asset, they can also provide the basis for higher ROI through higher rental rates, higher tenant retention, and lower turnover costs.

When evaluating commercial real estate, investors should consider how amenities drive value for that property and whether that value justifies a higher purchase price—as it will likely justify a higher sales price when the investor is ready to sell the property.

Although entering the CRE investment space can seem daunting to the uninitiated, approaching the field systematically can be tremendously beneficial. Keeping in mind CRE’s cyclical nature, the impact of capitalization, alternate asset categories, property location, and experiential amenities when evaluating these investments can help guide investors toward wiser decisions that bring them closer to their financial goals.

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-Chris Kotscha