When people hear the term “commercial real estate,” they may think of downtown office buildings, large shopping centers, or local grocery stores. However, CRE includes a much wider span of property types and investments.
What is commercial real estate?
Commercial real estate (CRE) is property used for commercial purposes, such as offices, retail centers, and warehouses.
Unlike residential real estate, CRE is generally leased to businesses. One important exception to this, however, is multifamily buildings with five or more living units. They’re leased to individuals and families but are still considered commercial real estate due to their size.
In other words, commercial real estate includes all property types except single-family homes and buildings with up to four living units. This makes it a giant industry that attracts a lot of capital investment. In the U.S. alone, the CRE market is worth over $20 trillion.
Types of commercial real estate
There are four main types of commercial real estate properties:
1. Office space
Offices contain workspace for corporate and professional enterprises. Think finance, healthcare, tech, and other companies that need desk space for their staff.
The commercial real estate industry further classifies office space as Class A, B, and C:
- Class A: These are the market’s best buildings. They’re generally new, have the latest amenities, and are located in prime locations (e.g., the central business district).
- Class B: These are functional but dated buildings. They could be 10-20 years old, in need of some improvement, and located in good but not ideal locations.
- Class C: These are a market’s least desirable buildings. They may be 20+ years old, need significant repair, or be located in low-traffic areas (e.g., on the city outskirts).
2. Industrial use
Industrial properties are used to manufacture and handle goods. Common examples include factories, warehouses, and oil refineries. However, data centers (now in growing demand due to the rise of AI) are generally also considered industrial real estate.
Due to its potential for environmental and safety hazards, industrial real estate is the most regulated CRE property type. However, it also tends to require the least maintenance.
3. Retail
Retail real estate refers to properties where consumers go to pay for goods or services. This includes shopping centers, grocery stores, restaurants, hotels, casinos, gyms, and other establishments where you might spend money.
Though some retail properties have been heavily impacted by the rise of online shopping, retail still makes up a big part of CRE.
4. Multifamily rental
Multifamily properties are buildings with multiple residential rental units (5+ in CRE). They enjoy consistent demand from a wide tenant pool (even during recessions) and are considered a relatively stable investment as a result.
Some common forms of multifamily real estate include apartment buildings, senior housing, manufactured housing communities, student housing, and low-income housing.
Commercial real estate leases
For investors, commercial real estate leases drive rental revenue. They set the lease length (typically 5-10 years), the rental rate (usually quoted per square foot on an annual basis), and other lease terms.
For example, an office building tenant may have a 5-year lease at $30 PSF/YR. For a 3,000 SF space, that’s $90,000 per year or $7,500 per month.
However, commercial real estate leases can also vary in terms of who is responsible for various property expenses. Here’s a breakdown of the most common types of commercial real estate leases:
- Gross lease: The tenant pays rent, while the landlord covers property taxes, insurance, and maintenance costs.
- Single net lease: The tenant pays rent plus property taxes, while the landlord covers insurance and maintenance costs.
- Double net lease: The tenant pays rent plus property taxes and insurance, while the landlord covers maintenance costs.
- Triple net lease: The tenant pays property taxes, insurance, and maintenance costs on top of rent.
Of course, the lease structure will directly impact your potential returns. For example, a triple net lease shifts costs onto the tenant, offering investors more predictable income. However, it may also require higher tenant screening standards. In contrast, a gross lease may offer smaller profit margins, though you’ll have greater control over how your property is maintained.
Pros and cons of investing in commercial property
Now that you know what commercial real estate is, consider the pros and cons of commercial real estate investing.
Pros of investing in commercial real estate
Here are the advantages of investing in commercial real estate:
| High leasing rates | CRE leasing rates can reach up to $80+ PSF in NYC and other big metros, generating high revenues for investors. |
| Stable cash flow with long-term leases | Unlike in residential real estate, 5-, 10-, and even 20-year leases are fairly common in CRE, resulting in stable cash flow. |
| Potential for capital appreciation | Commercial property values tend to rise over time. The average 25-year annualized return for private commercial real estate investments is 10.3%. |
| Lower overhead costs for industrial properties | Industrial properties tend to be simple structures that require minimal maintenance, keeping overhead costs low (especially if you have a triple net lease in place). |
| Portfolio diversification | Commercial real estate has a low (and sometimes negative) correlation with the stock market, making it a great hedge against stock volatility. |
| Tax benefits | CRE owners can take advantage of many tax benefits, including 1031 exchanges and writing off property expenses, depreciation, and mortgage interest. |
| Professional tenant relationships | Unlike in residential real estate, CRE tenants tend to be business-oriented, leading to more professional and lucrative relationships. |
| Scalability | In CRE, you can leverage financing options and economies of scale to grow your investment portfolio faster than you could otherwise. |
| Opportunity for active management | Value-add investment strategies like renovation or optimizing operations can boost your CRE returns. |
| Physical asset | Commercial real estate is a physical asset that will always retain some value, no matter the market. After all, there will always be a demand for space to live and work. |
Cons of investing in commercial real estate
Here are some commercial real estate challenges:
| Complex regulations and legal requirements | Zoning laws, building codes, and lease agreements can be complicated (and vary by state), requiring most investors to get legal counsel. |
| High initial investment costs | Commercial buildings can be expensive. For example, a 10,000 SF building at $300 PSF costs $3 million, setting a high barrier to entry. |
| Tenant turnover risks | While CRE tenants tend to stay for long periods, they can be hard to replace, resulting in long vacancies that hurt your cash flow. |
| Customization costs for tenants | Building configuration needs can vary widely from tenant to tenant, requiring owners to set aside funds for tenant improvements (TIs). |
| Illiquidity | Commercial real estate is notoriously illiquid, meaning it’s hard to buy and sell due to the lengthy and costly transaction process. |
| Economic sensitivity | CRE values are subject to broader economic trends. Case in point: The COVID-19 pandemic led to a major drop in office occupancy and values. |
| Specialized knowledge required | To successfully invest in commercial real estate, you need a deep understanding of markets, leases, and property management. |
| Maintenance and operational challenges | Staying on top of a commercial property’s repair, maintenance, and security needs can be a time-consuming and costly responsibility. |
| Higher risk with single-tenant properties | While single-tenant commercial real estate properties can offer stable cash flow, they can also lead to a complete loss of income during vacancies. |
| Market volatility | Fluctuations in interest rates and CRE demand can lead to unpredictable cash flow and returns. |
How can you invest in commercial real estate?
There are many ways to invest in commercial real estate, all of which fall into two categories:
Direct investment
Direct investment means buying a commercial building directly from the seller. This often requires getting a mortgage from a lender who specializes in CRE investments or raising funds from other investors.
From there, you must find tenants, create lease agreements, and actively manage and maintain the property (or hire a property manager to do this for you).
This investment strategy is best for experienced real estate investors who have a deep understanding of the local market and a strong professional network (real estate agent, lawyer, broker, etc.) they can rely on to close the deal.
Indirect investment
Indirect investment is a more passive approach to CRE investing. It involves having an ownership stake in a commercial property.
Here are the three most common indirect investment strategies:
- Real estate investment trusts (REITs): These are companies that own and manage large portfolios of CRE properties, shares of which can be traded like stocks on the stock market. This is a great way to get exposure to CRE for minimal effort and cost.
- Crowdfunding: Real estate crowdfunding platforms let deal sponsors raise funds from small-time investors online. Usually, investors must be accredited, but some deals let non-accredited investors participate.
- Limited partnerships: Team up with another investor as a limited partner (LP). This means you (and others) contribute funds to a deal while the general partner (GP) handles the property acquisition and management.
Indirect investment is best for new real estate investors with little experience or capital and those who don’t want to actively manage property. Keep in mind, however, that you also give up some of the return potential that comes with direct investment.
Factors to consider before investing in commercial real estate
No matter what type of CRE investing you pursue, you must do your due diligence and get a grip on commercial real estate risk management to maximize your potential returns.
1. Market research and trends
Carefully analyze local supply and demand trends. Target markets with low supply and high demand, which will help boost rental rates and your eventual cash flow.
Avoid markets oversaturated with your CRE property type or facing falling demand due to economic headwinds (e.g., shrinking job opportunities).
From there, it’s important to monitor trends by carefully tracking financial metrics for your investment portfolio via integrated accounting services. If you notice the market underperforming, it may be time to change your investment strategy.
2. Location and accessibility
Within markets, look for commercial real estate properties located in prime locations. These could be lots near public transportation, popular amenities, or other thriving CRE buildings.
Aim for high-traffic areas that could bring more business to your tenants, thereby raising demand for the property.
3. Tenant demographics
Pay attention to local demographic trends. For example, is the population growing or shrinking? What about the top industries in the area?
This can tell you a lot about local tenant stability and whether a commercial building will make a good long-term investment.
4. Financing and budgeting
Explore different funding options, including CRE loans and partnerships with other investors. The right financing can supply the capital you need for a deal and enhance your returns.
To compare different funding options, calculate your expected return on investment (ROI) with each. Some options may provide positive leverage, while others result in negative leverage.
5. Legal and regulatory compliance
Get familiar with local zoning laws, building permit requirements, and tax obligations. You need to know this upfront to get a full picture of a deal.
The last thing you want is to buy a commercial property only to realize that you can’t use it for its intended use, build how you want, or hit your return target due to tax expenses.
6. Environmental considerations
As business owners and tenants become more environmentally conscious, it’s important to design (and remodel) commercial buildings with sustainability in mind.
Depending on the market, you may also need to track your building’s energy emissions and keep them under certain limits. Consult a local legal professional to learn more about the environmental regulations in your area.
The bottom line
Ultimately, commercial real estate is a major asset class that can be a lucrative long-term investment. However, earning a high ROI requires carefully studying the market, building a strong professional network, and optimizing investment management with the right software.
