What Is Commercial Real Estate – CRE?
Commercial real estate (CRE) is property used exclusively for business purposes or to provide a workspace rather than a living space. Most often, commercial real estate is leased to tenants to conduct business. This category of real estate ranges from a single gas station to a huge shopping center. Commercial real estate includes retailers of all kinds, office space, hotels, strip malls, restaurants, and convenience stores.
The Basics of Commercial Real Estate
Commercial real estate along with residential real estate comprises the two primary categories of property. Residential includes structures reserved for human habitation and not for commercial or industrial use. As its name implies, commercial real estate is used in commerce.
Some zoning and licensing authorities further break out industrial properties—sites used for the manufacture and production of goods, especially heavy goods—but most consider it a subset of commercial real estate.
Commercial real estate is categorized into four classes, depending on function: office, industrial, multifamily, and retail. Individual spaces are also categorized. Office space, for example, is characterized as class A, class B or class C.
- Class A represents the best buildings in terms of aesthetics, age, quality of infrastructure, and location.
- Class B buildings are usually older and not as competitive—price-wise—as Class A buildings. Investors often target these buildings for restoration.
- Class C buildings are the oldest, usually over 20 years of age, located in less attractive areas, and need for maintenance.
- Commercial real estate is property used solely for business purposes, versus residential real estate, which is living space.
- The four classes, of commercial real estate, include office, industrial, multifamily, and retail.
- Commercial real estate provides income, as well as some capital appreciation, for investors.
- Investing in commercial real estate requires more sophistication and funds from investors than does residential real estate.
- Publicly traded real estate investment trusts (REITs) are a feasible way for individuals to invest in commercial real estate.
Some businesses own the buildings they occupy. However, the more typical scenario is the property is leased. Usually, an investor owns the building and collects rent from each business that operates there. Commercial lease rates—the price to occupy a space over a stated period—is customarily quoted in annual rental dollars per square foot. Conversely, residential real estate rates quote as an annual sum or a monthly rent.
Commercial leases can run from one year to 10 years or more, with office and retail space typically averaging between five and 10-year leases.
In a 2017 study conducted by real estate market analyst firm CBRE Group, Inc., analyst Alex Krasikov found that the term—length—of a lease was proportional to the size of the space being leased. Further, the data showed that tenants would enter long leases to lock in prices in a rising market environment. But that is not their only driving factor. Some tenants with requirements for large spaces will enter long leases due to the limited availability of property that matches their needs.
There are four primary types of commercial property leases, each requiring different levels of responsibility from the landlord and the tenant.
- A single-net lease makes the tenant responsible for paying property taxes.
- A double-net (NN) lease makes the tenant responsible for paying property taxes and insurance.
- A triple-net (NNN) lease makes the tenant responsible for paying property taxes, insurance, and maintenance.
- Under a gross lease, the tenant pays only rent, and the landlord pays for the building's property taxes, insurance, and maintenance.
Managing Commercial Real Estate
Of course, keeping CRE leased in full on an ongoing basis is the goal of any owner. Often the landlord must strike a balance between maximizing rents and minimizing vacancies and tenant turnover. Turnover can be costly for CRE owners because space must be adapted to meet the specific needs of different tenants—say if a restaurant is moving into a property once occupied by a yoga studio.
Property owners may wish to employ a commercial real estate management firm to help them find, manage, and retain tenants, oversee leases and financing options, and coordinate property upkeep and marketability. The specialized knowledge of a commercial real estate management company is helpful as the rules and regulations governing such property vary by state, county, municipality and industry, and size.
Investing in Commercial Real Estate
Investing in commercial real estate can be lucrative and serve as a hedge against the volatility of the stock market. Investors can make money through property appreciation when they sell, but most returns come from tenant rents.
Investors can use direct investments where they become landlords through the ownership of the physical property. People best suited for direct investment in commercial real estate are those who either have a considerable amount of knowledge about the industry or who can employ firms who do. Commercial properties are a high-risk, high-reward real estate investment. Such an investor is likely to be a high-net-worth individual since CRE investing requires a considerable amount of capital.
The ideal property is in an area with low CRE supply and high demand which will give favorable rental rates. The strength of the area's local economy also affects the value of the CRE purchase.
Alternatively, 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.
Advantages of Commercial Real Estate
One of the biggest advantages of commercial real estate is attractive leasing rates. In areas where the amount of new construction is either limited by land or law, commercial real estate can have impressive returns and considerable monthly cash flows. Industrial buildings generally rent at a lower rate, though they also have lower overhead costs compared to an office tower.
Commercial real estate also benefits from comparably longer lease contracts with tenants than residential real estate. This long lease length gives the commercial real estate holder a considerable amount of cash flow stability, as long as long-term tenants occupy the building.
In addition to offering a stable, rich source of income, commercial real estate offers the potential for capital appreciation, as long as the property is well-maintained and kept up to date. And, like all real estate, it often moves in the opposite direction to the stock market, making it an effective diversification option to equities in a portfolio.
Hedge against stock market
High-yielding source of income
Stable cash flows from long-term tenants
Capital appreciation potential
More capital required to directly invest
Higher renovation costs
Disadvantages of Commercial Real Estate
Rules and regulations are the primary deterrents for most people wanting to invest in commercial real estate directly. The taxes, mechanics of purchasing, and maintenance responsibilities for commercial properties are buried in layers of legalese. These requirements shift according to state, county, industry, size, zoning, and many other designations. Most investors in commercial real estate either have specialized knowledge or a payroll of people who do.
Another hurdle is the increased risk brought with tenant turnover, especially relevant in an economy where unexpected retail closures leave properties vacant with little advance notice.
With residences, the facilities requirements of one tenant usually mirror those of previous or future tenants. However, with a commercial property, each tenant may have very different needs that require costly refurbishing. The building owner then has to adapt the space to accommodate each tenant's specialized trade. A commercial property with a low vacancy but high tenant turnover may still lose money due to the cost of renovations for incoming tenants.
For those looking to invest directly, buying a commercial property is a much more costly proposition than a residential property. Also, while real estate, in general, is among the more illiquid of asset classes, transactions for commercial buildings tend to move especially slowly.
Real World Example of CRE Forecast
The U.S. commercial property market took a hit during the 2008-2009 recession, but it has experienced annual gains since 2010. These gains have helped recover nearly all recession-era losses.
The "2019 U.S. Real Estate Market Outlook," an annual report issued by CBRE, believes:
Although it is late in the economic cycle, the outlook remains very good for all four major commercial real estate asset types. There will be minimal appreciation in values, but income returns should remain healthy.
However, other indicators suggest the commercial property market has peaked in the post-recession growth cycle. According to California real estate firm, Ten-X Growth, commercial property pricing ended 2018 up just 1% from 2017.
A Ten-X report noted that the 2018 final total for commercial properties confirms their view of the late economic cycle pricing. The firm's research found that vacancies are rising, rent growth is slowing, and market interest rates are on the rise
As reported by Forbes, the retail sector, in particular, has proved a pain point in the broader commercial property market, as widespread store closures intensified in 2017 and continued into 2018. For example, popular mall REIT Westfield Corporation saw their stock price shed about 30% between mid-2016 and late 2017 before reversing some losses through January 2018. Unibail-Rodamco SE acquired Westfield for US$15.8 billion, creating Unibail-Rodamco-Westfield (URW).
Most firms, however, maintain that the property market remains healthy overall. J.P. Morgan, in its "2019 Commerical Real Estate Outlook," largely echoed CBRE's view stating that 2018 was the ninth year of increases in commercial property rents and valuations. Morgan predicts this pace will slow but continue and do not see a downturn until after 2019.