Commercial Real Estate Management: A Primer | RE Investing

Commercial real estate management is a whole different beast than residential management—from lease structures to property issues to prospective tenants.

Here are four things to know about being a great commercial property manager.

Types of Commercial Real Estate

First, let’s briefly go over the five (sometimes six) categories of commercial real estate:

Multifamily
Office
- Medical Office
Retail
Industrial
Hospitality (i.e., Hotels)

Others may split the classifications differently, dropping medical offices and instead adding a category referred to as “Special Purpose.” This might include everything from churches to amusement parks.

For our purposes, we’ll disregard multifamily, which in terms of property management is somewhat similar to residential properties. Instead, let’s focus here on retail and office.

As noted above, it’s a very different game! After all, the tenants in your properties are other businesses, so (typically) they will understand the basics of contract law and the like.

It’s also less personal (usually, at least). You’re less likely to have a tenant scream in your face because something went wrong with the property. Alternatively, you’re more likely to get a letter from their attorney in the mail!

1. Commercial Property Leasing

To begin, leasing commercial real estate is far more arduous than residential leasing. This is largely because the annual sum or monthly rent for a commercial lease is a much bigger dollar amount, lease terms are typically much longer, and (in multi-tenanted buildings) there are usually far fewer units. Therefore, each tenant is substantially more important in commercial real estate than in residential real estate.

Prospective tenants are unlikely to walk through the door of a commercial property, requesting a tour from a property manager. Instead, commercial real estate agents often represent clients who are looking to find a property to lease.

In that way, leasing in the commercial world looks much more like buying and selling than it does in the residential world. It’s important for managers to think of it this way and in turn market aggressively for potential tenants.

At the same time, it’s even more important than residential real estate to not arrive at a point of desperation. Given how important each tenant is, a bad one will hurt you all the more. It’s almost always better to have a vacant property than a bad or delinquent tenant.

Commercial leases are either a gross lease (the owner pays all the utilities, taxes, and insurance) or a net lease. There are several types of net lease, but the one you’ll hear about most often is a triple-net lease.

In such a lease, the tenant pays for everything (taxes, insurance, and utilities) except capital improvements on the building and the mortgage. These are generally sought after by owners but are most likely to be accepted with large units or single-tenant buildings.

The structure of commercial leases differs from residential, as well, in that they are rarely a standard template. There are many more things to consider and negotiate.

For example:

Tenant improvements—or concessions given to the tenant to pay for renovations—are common as each business requires something a bit different in the space they are leasing.
Moving expense reimbursements are also common.
Percentage rent is fairly common in retail. This is where the owner receives a certain percentage of the tenant’s gross income above a certain point.
Expense stops may occur, too. This is where the owner will pay utilities before, and the tenant will pay after, a certain threshold is met.

And these are just a few ways commercial leases are much more complicated than residential. Needless to say, unlike residential leases, they are usually painstakingly negotiated.

2. Tenant Mix in Commercial Real Estate

Yet another factor that makes commercial real estate unique is the tenant mix. And by this, I don’t mean tenant quality. Obviously when renting a house or apartment, it’s important to screen any prospective tenant to make sure they will be able to pay their rent. You need to vet businesses the same way when renting out a commercial property. By tenant mix, I’m referring to the types of businesses leasing the property.

Tenant mix is by far the most important in retail, particularly in multi-unit buildings (such as malls, strip malls, power centers aka retail parks, etc.).

Recently, I spoke with Dave Claflin, media representative for Legacy Development in Kansas City, Mo. He stressed the essential nature of finding the right mix of tenants.

As Claflin noted, it’s not only important to avoid putting what would be considered low-end tenants in a high-end complex (for example, a liquor store), it’s also important to find tenants that complement each other.

Some tenants—for example, a movie theater—tend to attract customers that will shop at nearby stores. In contrast, having shops that are too similar in the same building can reduce the amount of people who visit the entire property. If you have two jewelry stores but no athletic apparel stores, people seeking athletic apparel won’t go to that strip mall (or whatever type of property) and therefore won’t end up shopping or eating at other establishments on the premises either.

One outlet Legacy opened during the height of the Great Recession languished at 20 percent occupancy.

“Banks were willing to extend credit but needed the occupancy to reach 50 percent,” Claflin told me.

Meanwhile, there were qualified tenants who wanted to lease there. But unfortunately they didn’t fit the mix in terms of quality and type, so Legacy passed on them.

It was difficult, to be sure, but they were able to weather the storm. And eventually, they leased the available units, then sold the building at the best cap rate in Kansas City history!

Lesson here: patience (and demanding the right tenant mix) pays off.

In addition to the owners, tenants are also often concerned with tenant mix. Many times tenants will demand clauses that prohibit the owner from leasing to a similar business, as to prevent direct competition from moving in next door. This is referred to as a co-tenancy clause.

Other such clauses can allow a tenant to get out of their lease if an anchor tenant (those with broad appeal and a big draw) leaves. So, for example, think about a strip mall with a Target and several smaller shops. If Target leaves, the other stores that have leases with such a clause can opt out of their remaining lease term.

Many would do just that because the anchor tenant is what brought so many people to the area; without it, business is likely to dry up. That being said, when an anchor tenant leaves and the owner cannot find a new one, this is often the first step in the death spiral of a mall or other multi-tenanted retail outlet.

Add this to the fact that you are dealing with fewer tenants, and it becomes clear that commercial real estate is generally riskier than residential real estate. Indeed, with single-tenant buildings, you may not have issues with co-tenancy, but if the tenant leaves, you will in fact go from 100 percent occupancy to zero!

On a single house, that might not be that bad. But on the 15,000-square-foot building where Walgreens used to be (or the other 15,000-square-foot building across the street where CVS used to be), such a vacancy could devastate your bottom line.

On the plus side, commercial leases are usually around 10 years. And if you can lock down one of those triple-net leases, pretty much every expense is on the tenant.

If it’s a well-established business, there’s also very little risk of delinquency. So, when commercial real estate works, it works great! But keep in mind the risk is certainly higher.

3. Standard Management of Commercial Real Estate

While leasing is the most important part of commercial real estate, there are, of course, still the same sorts of standard issues a property manager will have to deal with.

One tenant may be upset at another for noise or parking issues. Common area maintenance and utilities are often charged back to the tenants based on the square footage they occupy, and there may be disagreements about that, too.

Capital improvements will need to be done and decisions will need to be made about when, how, and who will do them. And, of course, general maintenance and upkeep will need to be performed.

But here’s where things start to differ. Managers will need to work with the owners to put together budgets and make decisions on how to proceed with repairs and things of that nature. This is uncommon in residential real estate (other than multifamily) and thereby an added challenge of commercial.

4. The Future of Commercial Management

Flex time arrangements and working from home is definitely impacting office building occupancy. The move toward shared work spaces is adding to this.

Simultaneously, just-in-time inventory management has reduced the amount of industrial space needed all while increased global trade has increased its need. And, of course, Airbnb has definitely taken a sizable bite out of the hospitality industry.

But the biggest shift in commercial property demand is seemingly in retail. The shadow of Amazon appears to be covering all.

As Scott Galloway notes in his book The Four: The Hidden DNA of Amazon, Apple, Facebook, and Google, “Amazon grew its revenues $28 billion in 2016 in a retail environment where growth is essentially flat.”

Galloway also points out that between 2006 and 2016, Amazon’s stock price increased 1,910 percent. All of the other retailers in the top 10 declined except Walmart, which increased a paltry 2 percent.

The others ranged from Target (minus 15 percent) to Sears (minus 95 percent).

Brick and mortar retailers have obviously had to adapt. And the way they have done this is by shifting toward a more “experiential” tenant mix. This is also in line with consumer preferences, as society has become more attuned to actually doing fun things (especially with friends and family) as opposed to just shopping.

Claflin with Legacy Development notes that, in the past, mixed-use retail outlets would have a makeup of 90 percent retail and 10 percent restaurants and entertainment. That mix has moved closer to 70/30 today.

Restaurants, movie theaters, and bowling alleys are doing well, and even arcades have made a comeback. New niche joints are popping up, too, such as Blade & Timber, where you can try your luck at hatchet throwing, or Chicken N Pickle, where you can eat some chicken and then go play a game of pickle.

Expect there to be a marked increase in these types of establishments in the coming years.

There will always be a place for brick and mortar retail, as there will always be a place for all real estate. (This is, of course, one nice thing about investing in it!)

But that doesn’t make real estate resistant to change. As such, dealing with the impact of e-commerce and the internet will continue to be one of the greatest challenges to both managers and investors alike.

What do you think about the future of commercial real estate?

Let me know in a comment below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.