Investing in “commercial real estate” often seems like a logical next step for serious investors who want to gain best-in-class exposure to the real estate asset class. However, it’s easy to become overwhelmed after realizing that commercial real estate encompasses a significant variety of property types. Merriam-Webster defines real estate as “property in buildings and land” … if only it were that simple for commercial real estate! Many different types of buildings compose the commercial real estate landscape, and it’s helpful for investors to have a basic understanding of each property type.. The risks and rewards associated with investing in a single-tenant triple net retail storefront differ from those associated with an industrial facility or an apartment complex.
Birgo Capital is here to help introduce investors to commercial real estate property types. In this article, we’ll take a brief look at some of the major property types and each category’s primary considerations for investors.
Multifamily
Multifamily real estate is Birgo Capital’s primary investment focus, and is perhaps the easiest commercial real estate property type to understand. A multifamily real estate property contains more than one housing unit. In the real estate industry, a commercial multifamily real estate property generally contains five or more units. Properties with four units or less are classified as residential assets and considered outside of the scope of commercial real estate investment. Commercial multifamily assets range anywhere from the
6-unit building in your neighborhood to the prominent high-rise apartment complex downtown. However, both of these properties are residential in nature and provide the basic human need of shelter.
The most obvious argument for investing in multifamily properties is that people need a place to live. Multifamily demand is driven by the existence of human beings, so these investments tend to be attractive when there is a growing population, or an existing shortfall in supply. Given that population is the primary demand driver, multifamily real estate typically provides the most stable returns of any commercial real estate asset class.
Retail
Retail real estate properties range from single-tenant storefronts to neighborhood strip centers to large shopping malls. This sector has historically been viewed as an attractive way to diversify capital into an asset class that generates solid returns due to long-term leases from corporate tenants and ever-increasing consumer demand. Its primary benefits are generally viewed as the long-term leases and minimal expenses (retail tenants generally reimburse landlords for operating costs). Its primary risks include the long lead time and renovation costs associated with finding replacement tenants when a vacancy occurs. The price per square foot of retail real estate, both from an acquisition and rental standpoint, is generally the highest among commercial real estate asset classes.
Recent trends of online shopping and social distancing pose serious threats to the viability of retail real estate. Tales of once thriving shopping malls turning into escape rooms and skate parks are becoming all too common, and retail real estate investors should be wary of this trend. Birgo Capital’s view is that retail real estate still holds a place in the commercial real estate portfolio, as many consumer services still require a place of interaction. Selectively considered investments in service-oriented neighborhood might still make sense in a world where Amazon and a pandemic may permanently dislocate much of the retail real estate market.Investors should be cautious with this subsector. Location is important for all real estate investments, but it is of the utmost importance for retail investments in particular.
Office
Office real estate properties also encompasses a wide variety of asset profiles, from a small single-unit building to a downtown high-rise. Businesses rent these properties as the workspace for employees. Similar to retail properties, office assets have historically been viewed as attractive because of their stability: long-term leases to creditworthy tenants producing predictable cash flow with controllable expenses. The risks are also similar, as office investors need to be prepared to endure significant periods of vacancy and invest material funds for tenant improvements to accommodate new leases.
Prior to COVID-19, many businesses were trending away from traditional workspaces, and instead moving towards inhabiting smaller coworking spaces offered by companies such as WeWork. However, work-from-home trends brought by the COVID-19 pandemic intensified trouble on the horizon for office investments. It may be too early to develop serious conviction about long-term shifts in demand for office space. Perhaps the passing of the pandemic will bring a return to historical norms, or perhaps employees’ interactions with the office will be fundamentally altered forever. Businesses will likely need a consistent place of gathering, but the risks associated with office real estate cannot be overstated.
Industrial
Industrial real estate is itself a complex sub-asset class consisting of a variety of uses including manufacturing, storage, distribution, warehousing, or flex space. Industrial real estate properties can take various physical forms such as production plants, terminals, data centers, warehouses, or any combination of structure types. Lease durations for industrial real estate tend to be extremely long, providing stable cash flows to the owner, and prices per square foot tend to be inexpensive compared to other commercial real estate property types. These properties are often highly customized to suit the operational needs of a particular business tenant, so vacancies are often particular to property values in this subsector.
Historically speaking, the performance of industrial real estate directly correlates with the success of the manufacturing industry, which has generally done well in conjunction with American economic expansion since the industrial revolution. In recent years,, trends in online shopping and the growth of technology have increased demand for industrial properties as evidenced by the growth in rental rates for and construction of distribution centers, warehouses, and data centers. For investors that have an appetite for diversification and can stomach the downside risk of a potential vacancy, industrial real estate can provide a compelling alternative income stream.
Self-Storage
The emergence of self-storage as a real estate investment option in the last decade is extremely noteworthy. Driven in large part by urbanization trends wherein consumers have opted out of McMansions and into smaller dwellings in dense city settings, self-storage has become a very viable investment strategy for commercial real estate investors. Renters of self-storage units are generally thought of as consumers looking for “overflow” space for safekeeping of belongings. While this is true, demand for these types of properties is also supported by commercial users who might not need a full warehouse but do have an additional storage requirement that an office cannot accommodate.
Generally, the benefits of this strategy are broad diversification among many tenants, minimal maintenance and renovation costs, and relatively high cap rates. Risks are that leases are month-to-month, low barriers to entry for competitors, and uncertainty regarding long-term demand trends. Birgo’s view on this sector is that it is highly location dependent and requires a significant amount of local and operational expertise to successfully manage risk. The growth of the sector is a tailwind in that there is clearly an increase in demand, but it’s a headwind in that competitive pressures are likely to intensify with no clear endgame for an equilibrium of supply and demand.
Hospitality
Investments in properties that provide accommodation for travelers are another popular strategy. These are most often thought of as hotels, but hospitality investments can take some other forms as well, such as resorts, motels, or even apartment buildings utilized as short-term rentals on platforms such as Airbnb. Hospitality assets provide attractive cash flow as a result of income premiums generated by nightly rate revenue models as well as significant potential ancillary fees.
The COVID-19 pandemic made the risks associated with this strategy have become painfully clear. When broader economic activity slows, these assets are often the first to suffer. The potential expendability of business travel and increase in popularity of virtual meetings pose a serious threat to the hospitality industry at large. Additionally, investments in this asset class require significant capital and operator expertise.
Conclusion
Indeed, investing in “real estate” can be a much broader concept than purchasing a home! While this overview provided a basic introduction to the most common commercial real estate property types, it is not comprehensive. Topics not discussed include investments in raw land, manufactured housing (mobile homes), single-family home portfolios, medical facilities, or special purpose assets such as parking lots, theaters, or entertainment centers.
Birgo Capital advises that investors take a prudent, risk-managed approach when considering any real estate investment. Commercial real estate affords investors with the opportunity to earn outsized returns under the right conditions, but careful consideration of long-term economic trends, capital requirements, and operational expertise are necessary for real estate investors to make sound decisions.
If you want to know more about the real estate asset classes in Birgo Capital’s portfolio, schedule a call with us today.
