Commercial real estate outperforms the S&P and pays investors passive income. Here’s how to get in on the action.
Updated Feb 8, 2023
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Despite popular belief, commercial real estate (CRE) investing isn't only for the upper class. It’s actually quite the opposite—a gold mine in a regular investor's diversified portfolio.
Cash-flowing assets and strong price appreciation are a deadly combo. CRE provides predictable, steady returns amid market fluctuations and recessions.
While the S&P 500 has averaged around 9.6% annual returns in the last 25 years, commercial real estate outperformed it, yielding average annualized returns of 10.3% despite the economic turmoil in 2008 and 2020.
With the right approach and information, commercial real estate could be your ticket to consistent money and long-term appreciation. Let's dive in and explore whether commercial real estate is a good investment in 2023.
Before diving into investments, it’s important to understand what qualifies as commercial real estate: It’s a property that’s leased out for businesses or retail purposes. While most commercial real estate properties aren’t places where people live, some are a mix between residential and commercial.
The commercial real estate category can be split up further into four main categories.
These categories can be broken down even more. For instance, retail properties include things like healthcare facilities, hotels, malls, restaurants, and bars. What a commercial property is used for can have a major impact on how it performs as an investment asset.
In a nutshell, industrial real estate is a property where things like manufacturing, warehousing, distribution, assembly, and production take place. Industrial properties are generally planned and zoned in specified areas by the local government.
Due to the area zoning, they’re strategically located outside urban areas along major transport routes. These properties usually turn out to be a great investment because of:
Retail real estate can be classified based on the type of tenant. These are pretty much any place where customers go to buy a product or service.
Office spaces can be further classified into classes A, B, and C depending on age, location, and infrastructure.
Multifamily real estate is considered a commercial property if it contains more than five units. This includes things like condos and apartment complexes that generate multiple streams of income from several individual units.
Multifamily real estate can be a great addition to a commercial real estate portfolio because it provides a certain level of diversity. You can’t generate returns on duplexes and single-family homes when they’re vacant, but a residential property that houses multiple tenants is more secure because one or two vacancies don’t put a major damper on profitability.
Residential and commercial real estate investments each have their pros and cons. While residential real estate comes with the benefit of a lower cost of entry, CRE brings in steady cash flow thanks to longer lease terms. Both are great ways to make returns, but each lends itself to different investment goals and capital constraints.
Residential real estate is more welcoming to new investors as it doesn’t require much knowledge to get started. On the other hand, commercial real estate investors need to understand the demand and supply of properties to assess potential returns compared to the broader market. In some cases, commercial real estate comes with triple net leases, which have longer terms and put the tax responsibility on the lessee.
Retail giants like Walmart usually sign triple net leases in ideal locations so that they can create consistent branding across all stores, resulting in a sense of familiarity that brings in customers. This makes it easier for investors since this minimizes maintenance costs and possibly lowers mortgage payments.
Commercial real estate tenants are usually corporations and businesses that are more likely to keep their properties in good shape, making the lives of owners easier.
Another major distinction of commercial real estate is that their value appreciates differently. Prices of residential real estate is more dependent on market supply and demand, while the profitability of commercial real estate usually depends on cash flow. This way, tenants of commercial properties have a greater impact on its value.
The general misconception of CRE investing is that it’s gatekept by the wealthy. Investors are usually misled by what the term accredited investors actually means. SEC defines accredited investors as individuals or businesses with:
The job of the Securities and Exchange Commission (SEC) is to protect investors from risk, losses, and fraud. So, the commission believes that accredited investors have the risk appetite to withstand potentially larger losses than the average retail investor.
However, accreditation doesn’t necessarily forbid other investors from the commercial real estate market. Here are some ways unaccredited investors can put their money in commercial properties.
The best returns from commercial real estate investments come from identifying opportunities and timing the market for the best time to enter and exit. Let’s look at six main factors behind any successful commercial real estate investor.
Your network is your net worth. Establishing a network of commercial real estate industry professionals in the space helps investors stay informed about opportunities and the best commercial real estate deal on the market.
Getting in touch with commercial real estate brokers, property managers, and fellow investors can get you one step closer on your journey to owning a commercial property.
Online forums like LinkedIn and Facebook can help you build relationships with real estate agents while giving you access to alpha regarding local real estate conferences, seminars, and trade shows.
Staying on top of the latest trends and developments in the CRE market helps you make informed investment decisions. Publications like Real Estate Weekly and Commercial Observer can help you read the temperature of market conditions. Consuming content about the market also helps you find the best deals and industry events happening locally or nationally.
Taking courses related to investing, analysis, property management, real estate development, and real estate law can deepen your knowledge of the real estate space and make you a more informed commercial real estate investor.
Financial analysis is a crucial part of the investor toolbox. Knowing how to assess things like cash flow, returns on investment, and financial projections help you find good commercial real estate deals. Here are the steps a financial analyst might take before investing in commercial real estate.
Most property flippers evaluate the physical condition of commercial real estate properties by visiting it, and this gives them an idea of the potential return they can get by investing in maintenance or renovations.
This skill is developed by studying comparable properties in an area while analyzing their sale and rental rates. Site visits are necessary to evaluate a property, but once this skill is mastered, the location and outlook of a property can determine optimal price and the projected returns on it.
Good negotiation skills are what secure favorable terms on an investment. Commercial real estate transactions that maximize profits require reducing costs at all ends. This skill is essential when negotiating leases with tenants, making a property purchase, or selling a property to get the best possible profit.
In short, strong negotiation skills help investors save money, minimize risks, and maximize returns on their commercial real estate investments.
The value of learning can’t be overlooked. Continual learning not only helps to make informed decisions but also to identify the niche of commercial real estate that you want to specialize in.
Investors who know more have a competitive edge since their superior understanding of the legal and regulatory regime helps them get better deals and make fewer mistakes. Learning the industry’s asset management practices helps maximize returns and minimize risks.
If you’re new to commercial real estate investing, it’s important to set goals. You should be realistic and devise a strategy that helps achieve specific investment objectives. For example, if you’re looking to build a passive income, you can establish an owner-occupied business on the property or own equity in the tenant’s business.
It’s crucial not to give in to greed—your goals should be achievable within a reasonable timeframe.
As a beginner, consider starting small in the CRE market. REITs have changed the investment landscape by enabling you to buy fractional shares of properties. You can minimize risk and get the gist of the market by fractionally investing in different types of properties.
While diversity is never bad, picking a niche and gaining experience in that niche can be beneficial by leading to more successful investments in the future.
Specializing in a specific property type like retail, office, industrial, or multifamily lets you build a deeper understanding of the market. This can be a game changer for someone who’s just entering the market.
Commercial real estate investing requires a lot of patience. In fact, a lot of strategies that yield high returns often require holding your investments for a long time.
The market sometimes turns illiquid for a few months due to low demand. This is the time to be patient and strategize. New tenants are always around the corner.
When it comes to commercial real estate investing, working with an agent can be incredibly beneficial. These professionals bring a wealth of market knowledge and expertise to the table, helping investors identify properties that meet their investment goals, negotiate favorable terms and agreements, and navigate the complex legal and regulatory requirements of the industry.
New investors shouldn’t put all their eggs in one basket. While commercial real estate investing can provide opportunities for lucrative returns, it’s important to have your portfolio diversified into other asset classes like stocks and cryptocurrencies.
Depending on your risk tolerance and budget, a well-managed portfolio can be diversified into alternate assets like private equity, hedge funds, fine art, and even collectibles like watches, fine wine, vintage comic books, and sports cards.
Once you’ve identified your investment goals and picked a niche, there are a lot of investment strategies to choose from.
The strategy you choose should be based on your financial goals, risk tolerance, and budget. You can also use commercial real estate investment platforms to easily access the asset class.
Cadre is a leading platform that sources the best commercial real estate deals for accredited investors by selling them as high-growth funds. If you’re unaccredited, platforms like Streitwise generate an average dividend passive income of 8.96% with a minimum investment of $4,600.
CRE investments come with pros and cons. Understanding the benefits and challenges associated with the asset class you’re investing in is the key to making money.
Some of the benefits of commercial real estate investing are potentially higher returns, diversification, and tax deductions. However, it also comes with several challenges like a high initial investment, a complex market, long-term commitment, and the potential to be hurt by economic downturns.
Pros
Stable cash flow
Long-term leases
Triple net leases possible
Cons
Impact of economic downturns
Narrow market for tenants
Expensive maintenance & overhead
The biggest advantage is cash flow stability due to longer lease contracts with commercial tenants. Apart from stable cash flow, the price of the real estate can depend on how recently it was renovated, the neighborhood it’s in, and what kind of businesses it’s suitable for.
Some businesses sign commercial property leases to maintain the look and feel of a property that’s in line with their brand. So, some retail tenants would sign triple net leases, which makes them responsible for paying all property overheads, including taxes, insurance, and leases.
Furthermore, commercial tenants are usually large corporations with deep pockets that can afford to maintain the property. This means you won’t likely have to worry about the property being in bad shape if the tenant ever decides to leave.
CRE investments can be risky, the main reason being tenant turnover. If the economy is struggling, finding new tenants to occupy commercial real estate can be challenging. The property owner also must cater to the potential tenants’ requirements.
Another downside of commercial real estate is the smaller market compared to residential real estate. Commercial buildings can be bad investments in times of low economic growth and reduced demand.
For example, the pandemic increased remote working, which directly impacted the demand for office spaces. This meant new commercial office spaces had trouble finding new tenants and retaining existing ones.
Owning a commercial property also means taking on the hassle of management responsibilities. Finding tenants and handling management, paperwork, and day-to-day operations can be a burden. While you can hire other people to do those things, it’ll cut into your bottom line, which means less take-home profit.
It’s important to understand trend shifts and how the market is affected. Digitization is having a profound impact on commercial real estate and how businesses operate.
The shift to e-commerce has reduced the demand for traditional retail spaces, yet it also created new opportunities for properties that cater to online businesses. This means spaces for back office operations and warehouses are in higher demand than ever before.
The steep rise in the e-commerce business increased the demand for industrial properties used for the manufacturing and distribution of merchandise.
But digitization hasn’t affected the three ‘L’s of retail properties: Location, location, location. Brands like Starbucks are always on the lookout for well-situated spots to set up shop.
The rise of remote work has helped businesses reduce costs and improve employee mobility. However, this has also increased the demand for co-working spaces. So, if the space is refurbished with the right blend of innovation and added value, office spaces can be converted into co-working cash cows.
This digitization, however, has not affected the three ‘L’s’ of retail properties: Location, location, location. Brands like Starbucks are always on the lookout for well-situated spots to set up shop.
Investing in commercial properties can be a valuable opportunity to diversify your portfolio and potentially generate higher returns than residential real estate or stocks.
It’s important to understand the commercial real estate market, the property you’re investing in, and the financial implications before making a decision. Developing skills around financial analysis, property evaluation, and negotiation will set you apart from other investors, lead you to make more informed decisions, and maximize your returns.
Additionally, setting clear investment goals and building a network of trusted professionals can help you navigate the complex and competitive world of commercial real estate. While there are challenges associated with investing in CRE, the opportunities for growth and tax benefits make it worth considering when adding real estate to your portfolio.