Retail investors have a variety of options to choose from, including equity, bond, and housing markets. We think there's room for all three within a very diversified portfolio of risk assets.
Commercial real property refers to a broad category of real property assets that are purchased to benefit from income, price appreciation, or both.
Several benefits can be realized with a commercial real estate investment, including portfolio diversification, revenue, tax benefits, and "forced" price appreciation.
There are also risks in terms of market risk, credit risk, cost, and public safety.
For those who decide to invest in commercial real estate assets, there are several important advantages:
· Diversification: Fluctuations in commercial real estate prices tend to be correlated at a low level with traditional asset classes such as equities and bonds. For this reason, the property can lend an investment portfolio a different level of diversification, which is useful in case of an economic slowdown.
· “Forced” Appreciation: Unlike residential properties, which are valued on comparable sales, business space is valued on the amount of net operating income (NOI) it generates. Because net operating income is computed as the income of a property, minus operating expenses, the homeowner may have a direct impact on that equation and the overall value of the property. By pursuing strategies that seek to increase incomes (rent), reduce expenses, or both, a landlord can increase net operating income, which "forces" the value of the property to increase.
· Dispersion of Vacancy Risk: Most commercial properties have more than one lessee. This means that one or the other's decision not to renew a lease will have less impact than a residential property. For instance, in a 300-unit multi-family building, a tenant's decision not to renew a lease is relatively meaningless. Commercial real estate allows investors to spread their vacancy risk across multiple units, making them less dependent on one unit for income.
· Income: Since renters pay the monthly rent to the landlord, one of the main advantages of commercial real estate ownership is the income generated from these ongoing payments. And if the home is bought at an attractive price, revenue alone can provide a solid return.
· Lease Escalations: Commercial leases commonly include escalators that require rent increases at fixed intervals over the life of the lease. Assuming expenditures remain relatively constant, the contractual indexation of leases means that the revenue generated by the property will continue to increase over time.
· Tax Advantages: There are two major tax benefits associated with investing in commercial real estate. Because the physical condition of real property deteriorates over time, the landlord is allowed to "spend" part of its value every year to account for it. This expenditure is known as "impairment" and can be used to reduce the property tax payable. In addition, the capital gains tax realized at the time of sale can be carried forward indefinitely through the 1031 Exchange Program. if the proceeds of the sale are re-invested in another property of the same nature.
· Inflation Protection: Because the commercial reality is a physical, "tangible" asset, it tends to be a good cover for inflation. That's because developers are looking for a certain return on costs before they commit their funds. If the numerator in this calculation (Net Operating Income) is not growing fast enough to offset a cost increase (driven by inflation), developers will delay the launch of new projects, limiting the availability of stock. And in a market where supply is tight, rents tend to go up, increasing net operating income and property values. These value increases tend to keep pace with inflation, so commercial real estate can provide good coverage.
· Availability of Debt: Lastly, the revenue-generating nature of commercial properties makes them a comfortable risk to commercial real estate lenders. Regardless of the type of ownership, debt is largely available on terms generally favorable able to commercial real estate investors. While the benefits of commercial real estate investment may be substantial, this strategy is not risk-free. Prospective commercial real estate investors must consider several risks and challenges before committing capital to a transaction:
· Cost: In general, commercial properties are more costly than residential properties, which means that they require a greater initial investment. This may put them out of reach of certain investors, but it is attenuated by the fact. There are several options where investors can pool their money to buy a business asset.
· Management Intensity: Commercial properties are larger and more complex, requiring more management oversight than residential properties. On a large commercial property, there may be dozens of tenants, which means that traditional property management problems such as collecting rent and maintaining common areas may require full-time support and monitoring.
· Credit Risk: Every commercial property carries a credit risk, that is, the risk that a tenant may not be able or willing to pay his or her contractual rent. To mitigate this issue, it is essential to exercise significant due diligence on the financial situation of each current and potential lessee.
· Market Risk: Real estate markets are dynamic and constantly evolving to respond to broader macroeconomic conditions. While the tenant is renting, commercial properties are somewhat protected against these changes. But where an individual lease is to be renewed, market risk means that the tenant may decide not to renew the lease, or that the market rental rate in effect at that time is less than that which the lessee was paying during the initial term of the lease. For these reasons, it is important to understand each market's specific characteristics before investing.
· Public Safety: Commercial properties are leased from businesses, which means there are probably several people who come and go every day. This increases the risk of a person having a car accident in the parking lot, for instance, or a person slipping and falling on an icy sidewalk.
In general, there could be several other public safety problems that could put the owner at risk. To manage this risk, it is always preferable to obtain the appropriate insurance protection. There is no risk-free investment, but experience, expertise, and active mitigation strategies have the potential to reduce overall risk exposure.
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