Commercial real estate or CRE is a property used exclusively for business purposes or to provide a workspace. Commercial real estate investing can be lucrative to investors since it serves as a hedge against inflation, low interest rates and the volatility of the stock market.
Investors can profit from property appreciation as well as tenant rents. However, most returns out of commercial real estate investing comes from tenant rents.
Like all real estate, CRE often moves in the opposite direction to the stock market, making it a profitable venture and effective diversification option to equities in a portfolio.
Commercial real estate is often leased to tenants to conduct business. It is typically classified into five main sectors: Industrial, Office, Retail, Multifamily and Special purpose
CRE includes many other property types such as self-storage, medical, elder care, land, hotel, gas stations, shopping centres, restaurants, farmland, warehouses and convenience stores.
Commercial real estate investing can be done in the following ways:
- Direct investment
- Indirect investment
Under direct investment, investors become landlords through the ownership of the physical property. Direct investment in commercial real estate is best suited for those who have considerable knowledge about the industry or who can hire specialists having expert knowledge about the industry.
Though CRE is a high-reward deal, it requires considerable amount of capital as well as involves risk, so it is typically suited for high net-worth individuals.
An area with low CRE and high demand is ideal for commercial real estate investing for generating potentially high rental yields. The local economy also plays a vital role and one of the factors which contributes to high returns out of commercial real estate investing.
Another way for commercial real estate investing is through indirect investment. Under this option, investors may invest in the commercial market indirectly through the ownership of various market securities such as Real Estate Investment Trusts (REITs), exchange-traded funds, or by investing in companies that cater to the commercial real estate market, such as banks and realtors.
Real estate investment trusts or REIT
The great majority (over 80%) of these property companies are known as Real Estate Investment Trusts (REITs) and have greater tax benefits than other listed property companies. REIT companies don’t pay corporation tax on their assets on the condition that 90% of profits are paid to shareholders as dividends, which, in turn, could mean higher payouts. REIT investors pay either 20% or 40% tax, because they’re classed as property-letting income.
There are different types of property trusts such as brick and mortar fund and property security fund.
The brick and mortar fund invests in property or selection of properties directly, and the manager of the fund owns the property.
Property security fund invests in property companies by investing in shares.
This fund has a disadvantage compared with the brick and mortar one as it is affected by the performance of the stock markets while the brick and mortar fund can be more stable. In the case of brick and mortar fund, financial returns are generated by rental income and activities directly associated with the management of property assets.
Why is commercial real estate a good investment?
Investing in commercial real estate can be very rewarding. While many invest in the sector with the objective of future wealth and security, for many it is about tax benefits and investment portfolio diversification.
Attractive leasing rates make commercial real estate investing one of the most attractive investment options. Investment in commercial real estate at locations with less supply and high demand, may maximise the potential for growth as there are impressive returns and considerable monthly cash flows. The average return on investment for commercial properties is 6 to 12 percent. Industrial buildings generally rent at a lower rate, though they also have lower overhead costs compared to an office tower.
The longer lease structure for commercial real estate investing in the UK offers a number of benefits to investors. The typical lease length for a London office varies between 10 to 15 years, while the average least length is approximately 8 years for the rest of the UK. This is much higher than that of residential property which ranges from six months to a year.
The lease contracts with tenants in case of commercial property are comparatively longer than that of residential real estate. The long lease length ensures a cash flow stability for the commercial real estate landlord till the long-term tenants occupy the property. Commercial real estate provides a lower vacancy risk as commercial properties usually have more available units.
Commercial real estate involves less competition compared with other real estate investments as commercial real estate is perceived to be relatively difficult and one which involves high costs. Therefore, the real estate space is less saturated with other investors.
Appreciation and value addition
Apart from the rental income, another advantage of commercial real estate investing is in terms of capital growth. The potential returns from a commercial real estate investment comes from an increase in the value of the property while the investor holds it. In general, real estate is a unique and scarce asset class. As land is limited, more demand raises scarcity. If the demand for a property or for areas right around the property rises, it will push up the value of the property. Prospective buyers will be willing to pay a higher price for the property. It is likely that the demand for the property will continue to rise over time, resulting in further potential capital growth. Similarly, the demand will reflect on rental prices and would-be tenants will be inclined to pay a higher rent for the property.
Apart from rise in appreciation through demand, value-addition is also an important method for appreciation of property value. Renovations can be vital in raising the rental prices of a property. Renovations can potentially boost the selling price of a property in the future.
Though commercial real estate investing may seem somewhat difficult at the beginning, the skills and competencies required for commercial real estate are basically the same as that of residential property investing, however the scale of investment grows exponentially. Any investment involves risks and it is more so for commercial real estate investment, and an investor should find ways to mitigate the risk.
This article is for information purposes only.
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.