The Ultimate Guide to Commercial Real Estate Investing
Real estate is a well-known asset class that has been used to build wealth for centuries, defend against inflation, and is sometimes referred to as recession-resistant. For those seeking to preserve their wealth while growing their portfolios, commercial real estate has historically proven to be a powerful and relatively stable investment vehicle.
Recent economic trends have spurred investors to gravitate to yield-generating opportunities that also diversify their portfolios. Investing directly in commercial real estate offers a way to achieve both goals.
Commercial real estate also gives investors an asset characterized by stable cash flow, appreciation benefits, and substantial tax advantages when compared to other popular asset classes.
In this guide, we’ll provide an all-encompassing rundown of commercial real estate investing, including an explanation of why commercial real estate can be a reliable investment path, how to assess commercial real estate opportunities, and suggestions on how to get started if you’re new to commercial real estate investing.
- Why Invest in Commercial Real Estate
- When to Invest in Commercial Real Estate
- Where to Invest in Commercial Real Estate
- Which Commercial Real Estate Investment Categories are the Most Reliable
- How to Assess Commercial Real Estate Investments
- How to Access Resources to Invest in Commercial Real Estate
1 – Why Invest in Commercial Real Estate
Commercial real estate investment is beloved by investors seeking refuge from the volatility of public equities. Office investing provides some of the most stable returns available among real estate asset classes. The long-term nature of the underlying leases (often 5-10 years) provides office owners with predictable, stable cash flows.
Direct co-investment in commercial real estate is also attractive because of its potential to produce returns for investors uncorrelated from public markets, while providing the security of a physical asset.
Amongst the many reasons to invest in commercial real estate, here are the seven benefits that we believe are most compelling.
Commercial real estate investments have historically enjoyed a relatively low correlation with the stock market, which makes real estate a natural option for portfolio diversification. This low correlation protects your portfolio from significant loss due to a singular event.
2. Income Stream
Investing in a stabilized real estate asset provides investors with steady, day-one rental income while also offering the potential for long-term capital appreciation. Because rental income is typically scheduled out in a lease, the cash flow generally has less volatility than other investment options.
3. Capital Preservation
Real assets such as office buildings have observable, tangible value. This value is determined primarily by the quality of the building, the location, and the credit of the tenants in place, and these factors are not volatile.
4. Inflation Hedge
Property values and rent levels have historically increased with inflation. Given that those two items are primary drivers of real estate returns, a natural inflationary hedge is built into almost any real estate investment.
5. Stronger Yield Potential
Investors searching for stable yield opportunities generally look to the bond market, which has generated an average return between 5% and 6% since 1926. In comparison, direct commercial real estate investments can achieve average yields as high as 13-14% while still providing many of the same benefits as bonds.
6. Tax Advantages
Real estate has long been considered a tax-advantageous investment option. Because of legislation in recent years, commercial real estate investment has become more intriguing than ever before. If structured properly, investors can continue to defer taxes on distributions while now also claiming other deductions, such as enhanced bonus depreciation.
7. Potential for Capital Appreciation
The stock market is the most common place for investors to deploy their capital, largely due to the long-term growth prospects that stocks offer. Commercial real estate investing, however, can offer similar growth potential, albeit with a different set of underlying risk factors. For instance, by focusing on economic and demographic patterns, investors can acquire assets in locations that they believe will experience significant increases in demand or popularity, This can drive up property values and lead to strong capital appreciation.
2 – When to Invest in Commercial Real Estate
Whether you’re a bear or a bull about the economy, NOW is a great time to invest in commercial real estate.
As the number of investors seeking direct co-investment into real estate continues to rise, so does the opportunity to allocate capital on a deal-by-deal basis. Investors today also benefit from a steadily growing economy, interest rates that remain at historical lows, and commercial lenders willing to do whatever it takes to win borrowers’ business.
Here are five other reasons why now is the time to invest in commercial real estate:
1. Increased Demand for Office Space
With a maturing millennial generation entering its prime earning years, corporate giants growing even larger, and companies eager to get workers back into offices – safely distanced – after a year of working remotely, the demand for more square footage is clear.
2. Ongoing Cash Flow
One of the most important benefits of commercial real estate is the cash flow generated from rents. Secured by leases, commercial real estate investments can deliver consistent, passive income; income that comes in regardless of market cycle.
3. Hedging Against Inflation
In general, when inflation occurs, rents rise. This rise leads to an increase in operating income, which subsequently results in an increase in property values. The nature of this dynamic allows commercial real estate to serve as a strong hedge against inflation.
4. Low Volatility
Over the long term, the value of real property in the U.S. – including commercial buildings – has consistently gone up. The counter-cyclical nature of commercial real estate, coupled with low correlation to other asset classes (when invested in directly), can act as a defensive position during times of economic pullback.
5. Appreciation Potential
Under the right ownership, commercial assets are likely to appreciate in value. This implies that there is potential to garner additional returns when an asset is sold.
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Terms to Know
Accredited Investor: The qualification standards to investment in the private capital markets, as defined by the SEC.
ROI: Return on Investment. A comparative metric that accounts for the ratio between the profits and cost of an investment.
Cost Segregation Study: The process of identifying all property-related costs that can be depreciated faster. This could be from acquired property, new construction, or even remodels or build-outs.
Net Migration: Using data from the U.S. Census – and eliminating any fluctuations caused by births or deaths – net migration determines how many people are moving to or away from each metro area.
MSA: Metropolitan Statistical Area. Delineated by the U.S. Office of Management and Budget (OMB) as having at least one urbanized area with a minimum population of 50,000.
Gateway Markets: A gateway market is a major international city that serves as an entry point into a country. These cities are often the largest or the capital cities of countries, with the highest status and name brand value; often home to either container ports for cargo ships or large international airports; and offering highly diversified economies that have many sectors and subsectors. In the U.S., the gateway cities are New York, Washington D.C., Los Angeles, San Francisco, Boston, and Chicago.
3 – Where Should You Invest in Commercial Real Estate?
When considering investment opportunities, we at Excelsior ask the question: “Which markets around the country are attracting both jobs and people that have desirability and quality of life attached to them?”
Many real estate investors have long been attracted to office investments in prime business centers of the U.S. gateway markets. However, due to recent demographic shifts driven by the millennial population, interest has been shifting to office investment opportunities in non-gateway cities, particularly secondary markets.
At our firm, we look for markets that provide residents access to affordable housing, a strong public education system, and a high quality of life.
We also target diversified economies – cities such as Nashville, Tenn.; Austin, Texas; Columbus, Ohio; Richmond, Va.; Raleigh-Durham, N.C.; and Denver, Colo. These metro areas maintain a well-rounded presence across sectors, including government, university, healthcare and professional services, and do not rely on one type of industry for broad support.
When identifying secondary and suburban growth MSAs, we encourage investors to track the following seven data points:
1. Population Growth (Net Migration)
A city’s population growth drives demand for real estate. As more people move to certain areas, the need for additional work space will follow. For commercial office properties, we’ve identified specific millennial trends (ages 18 to 34) as a strong indicator of future demand.
2. Job Growth
Where are jobs growing and corporations going? In a post-COVID environment, will large companies rethink moving a portion of their labor pool from high-rent, high wage, high tax states to those locations that offer more value?
When evaluating this metric, we also account for unemployment and average salary. The U.S. Bureau of Labor Statistics finds some of the year-to-year biggest workforce gains are in Orlando, Minneapolis and Des Moines.
3. Wage Growth
Wages have remained stagnant in the United States for decades, and the pandemic has certainly not improved this reality. Unemployment rates also rose considerably, which has added to the difficulty of rising costs overall. Wage growth is an important factor to evaluate when assessing the attractiveness of a potential investment market for commercial real estate.
4. Access to Quality Education
Access to quality education is one of the driving forces behind where families choose to work, live, and play. When assessing investment markets, look at data from sources such as the U.S. News Best High Schools rankings. You can determine the availability of quality education by calculating the average college readiness score of all public schools in the metro area and comparing it to that of all the other ranked metro areas.
5. Access to Affordable Housing
The steep hurdle to investing in coastal gateway cities is their high cost of housing. Realtors and other trade groups compare home prices to local median income. As much as anything, home costs relative to other cities is what attracts real estate investors.
6. Rising Rental Rates
Increased rent means landlords bring in more revenue. This factor is, naturally, a clear sign of an attractive region for investors in commercial real estate.
7. Discount to Replacement Cost
A sales price below replacement cost is generally considered one potential indicator of attractive pricing for the buyer. We believe that a consistent approach to estimating replacement cost is a necessary starting point in order to evaluate the discount a given price represents. In addition, an examination of the relationship between current rents and replacement rents (the rent necessary to justify new construction) is a helpful tool to estimate the potential for future rent growth.
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4 – Which Commercial Real Estate Investment Categories are the Most Reliable
Commercial real estate investments can show more resilience than other investments, but not all asset classes of real estate investments are created equally. The properties likely to best perform in a recessionary environment will have four characteristics:
- Good location
- Strong fundamentals and functionality
- Sufficient cash flow
- Modest capital needs
Here are four types of commercial real estate assets that have been proven to be durable when times get tough:
The four Ds — downsizing, divorce, dislocation and death – are aspects of real life. Recessions tend to exacerbate these life events, leading to increased rental activity in the self-storage space. When companies and consumers downsize, self storage spaces see higher demand. In fact, self-storage REITs were the only real estate asset type that was positive during the recession in 2008.
Medical Office Buildings
Medical office buildings (MOB) should provide investors with long-term rent upside even in the event of a downturn, according to industry experts. MOB tenants tend to have strong credit, though every tenant is unique and should be evaluated on an individual basis. Medical office buildings that possess anchor high-credit, long-term tenants can potentially attract even more of the same, as healthcare providers generally prefer to be situated near complementary services.
Mobile Home Parks
Mobile home parks have been called “the darling of all commercial real estate.” That’s a pretty big label considering investors looked down their nose at this asset class a few years ago. Mobile home parks tend to be recession resistant, limited in supply, in high demand because of the affordable housing crisis, enjoy low competition and low operating costs.
Multi-Tenant Office Properties in Suburban Growth Markets
Though not in line with historical trends, we’d like to introduce the idea that multi-tenant offices – specifically located in suburban growth markets – deserve a place at the table. The belief being that secondary and suburban markets will continue to see increased population and job growth post-pandemic. Income-oriented, multi-tenant office space – especially when anchored with credit-quality, long-term tenants (WALT 5+ years) – has the makings of a resilient asset in the midst of a recession. Landlords benefit from long term leases and banks look favorably upon them.
5 – How to Assess a Potential Commercial Real Estate Investment
When assessing a real estate investment, the most important consideration is the ROI, which represents the potential of income-producing assets. A higher ROI implies that the profits you’ll receive from an investment property compare favorably to its cost. As an investor, this metric is key to comparing several different investment opportunities.
Being able to accurately calculate the potential profits from an investment property before acquisition is crucial to gauging and increasing the chance of a successful investment.
How is ROI calculated? The formula is simple:
ROI= (Proceeds from Investment – Cost of Investment)/Cost of Investment
- Calculate the expected annual rental income
- Subtract rental expenses from annual rental income
- Compute your % share of the net income
- Divide your net income by your total investment
To calculate ROI, you need to have a firm grasp on which variables affect these data points.
One of the main benefits of investing in real estate is the potential for immediate income: tenant rental payments. If a property you are considering investing in comes with tenants already in place, you will want to consider a few variables in their leases before determining if it is a suitable investment:
1) The amount of time left in a tenant’s lease. Is their lease about to run out? If so, what is the likelihood they will renew?
2) The financial security of the tenant. Are they credit worthy? Will they stay in business?
3) The amount of space a tenant occupies relative to the total building size. How much risk are you taking on if that tenant were to leave?
Common expenses of owning an investment property include utilities, maintenance, property taxes, and insurance. These costs can add up quickly, so it’s essential to have a thorough understanding of a property’s operating expenses and how they compare to your total rental income.
Another reason that investors flock to real estate is for its potential to appreciate. When considering an investment, key indicators such as year-over-year job growth, population growth, economic growth and industry diversity have historically been important factors driving the increase (or decrease) in property value over time.
When evaluating a potential investment, it is extremely important to consider the capital expenditures that may be needed after your initial investment. In order for your property to appreciate, you may need to invest in updates and renovations in addition to the ongoing maintenance and repairs. These capital expenditures can be costly in the short-term, but in the long run they substantially increase the potential for appreciation.
Is This Property a Good Investment?
After considering all of the variables and calculating your potential ROI, you’ll have to come to a conclusion about whether this investment is worthwhile.
If you’re unsure about the ROI you have projected, you may want to consider working with a partner that can walk you through the process we’ve highlighted above and help you assess the potential of a commercial real estate investment.
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6 – How to Access Resources to Invest in Commercial Real Estate Investing
One of the most common challenges many real estate investors run into is having enough cash reserves to participate in all of the deals that interest them. If your goal is to create an asset stack, you first have to focus on capital accumulation.
One often overlooked source of investment capital is Cash Value Whole Life Insurance. Using life insurance as an investment vehicle yields unique benefits. Life insurance is uncorrelated to the market, allows tax-free accumulation and distribution, delivers tax-free dividends, and is 100% creditor protected (depending on the state).
When you leverage life insurance cash value as a source of capital, you can essentially create your own private “bank” by readjusting the flow of your money. In essence, you are procuring a loan from the insurance company in order to deploy capital. Not only can this method of capital accumulation allow you leverage you may not have known you had, it can also help to grow its value in one of the most tax-efficient ways allowable.
Watch this webinar to learn about the power of Cash Value Whole Life Insurance as an investment vehicle and real world examples of how it works.
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Resources for Commercial Real Estate Investing
If you’re just getting started in commercial real estate investing, here are some additional resources that might be helpful.
- Best Cities For Jobs: Growth In America Is Tilting To Smaller Cities (Forbes)
- The Demographics Driving Real Estate Investments in Non-Gateway Cities (Pensions & Investments)
- Even Before Coronavirus, Census Shows U.S. cities’ Growth was Stagnating (Brookings)
- Millennials Continue to Leave Big Cities (Wall Street Journal)
- Second-tier Cities Boom, but Can They Keep up with Growth? (BizWomen)
- Diversified Economies Matter (Emsi)
- What Makes a Real Estate Market a Gateway Market? (Mashvisor)
- Real Estate Recession: Who Gets Impacted and How (Million Acres)
- Our friends at StoneCentury Financial can provide a complete breakdown of an investment property with their ROI calculator so that you know exactly what you’re getting into before investing.
After one of the most volatile periods in history, people are looking to allocate their portfolios to secure long-term, reliable investments, such as real assets. The benefits of commercial real estate include tax benefits; higher yields than public markets; the ability to lock in long-term debt at attractive costs; physical assets with capital preservation; and labor and material costs continuing to rise with inflationary pressures on the horizon.
The stable nature of commercial real estate has always been one of its main attractions. If commercial real estate isn’t already a part of your wealth management strategy, now is the time to add this asset to your portfolio.
Ready to get started with a commercial real estate investment?
If commercial real estate is a market that sounds appealing to you, please reach out to us. We would be delighted to work with you to assess the best commercial real estate investment options for your particular circumstances and goals.
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