Passive Investing in Commercial Real Estate - 2020 Part Two of Four

Part Two: Understanding Commercial Real Estate

In part one, I took you through the basics of passive investing and a short introduction to investing in commercial real estate. Commercial real estate investing carries a number of advantages over non-commercial real estate, including strong returns, objective price evaluations, professional relationships, and net leases. Passive investing in commercial real estate skips the day-to-day management of a property while providing investors with cash flow, equity growth, tax advantages, and the security of owning a physical asset.

With the basics finished, let’s dive into commercial real estate.

Commercial Real Estate Introduction

A good starting definition of commercial real estate is any property with five or more units. Commercial properties usually lease to tenants with an expressed interest in generating a profit, such as a business. In part one I discussed the commercial property types we will review, including industrial, medical, office and work, lofts, and storefront or retail. Part two will go into further detail on the following two elements of commercial real estate:

• Property asset classes
• Property quality categories

Commercial Real Estate Asset Classes – Explained

You may have heard that commercial real estate has four or more different asset classes. Commercial real estate is vast and complicated. For this book, I’ve segmented commercial real estate into five property types, also known as asset classes.

• Industrial
• Medical
• Office & Work Buildings
• Lofts
• Storefronts & Retail

These five property types are those that rent exclusively to business owners to generate revenue. This is an important distinction, as this offers an entirely different set of advantages for investors. Any of the above property types may be part of a mixed-use project or investment. These mixed-use investments may include housing for individuals or families. However, this eBook will only focus on the commercial side: those properties that rent to business owners. I’ve found that each asset class comes with specific features, advantages, and disadvantages.

Industrial

Industrial buildings are designed for research and development, manufacturing, logistics distribution, and the storage of goods. In general, industrial buildings require a lot of acreage, ample parking, and are located away from central business districts. These buildings often prioritize practicality and efficiency. While there are eight different types of properties, we will look at the three different general categories of industrial real estate.

1. Manufacturing. These buildings convert, fabricate, or assemble materials into goods. They are usually less than 20% of office space. They can be further classified as either light industrial or heavy industrial. Light industrial buildings are less capital intensive, consumer-oriented, use fewer energy and materials, and create general products that require fewer customized machinery. Heavy industrial buildings, on the other hand, are often far larger and more capital intensive, business-oriented, consume more energy and materials, require more logistics space, and often require large, customized machinery.

1. Warehouse. These buildings are used to store and distribute materials, goods, and merchandise. They are usually less than 15% to 20% of office space. Common building types include general warehouses, distribution warehouses, specialty storage warehouses, and trucking terminals.

1. Flex or R&D. These are multipurpose buildings that act as an industrial-office hybrid. Compared to other industrial buildings, they have 30% of or more space devoted to office space. Building types include data centers, showrooms, research and development, and laboratories.

Medical

Medical real estate properties are a specialized segment of commercial real estate. These buildings are also known as healthcare real estate. I’ve included these buildings as they are growing in popularity as a distinct focus for commercial real estate investors, especially given the major changing demographic trends in the United States. More healthcare providers are turning to third-party management of these properties as well. Specific property types include medical office buildings, hospital campuses, and nursing homes.

Office & Work Buildings

Office and work real estate are used to house single- and multi-tenant business and other professional entities. These buildings range in use, size, and location.

1. Use. I tend to divide buildings into general and specialty use office space. General office space is for companies that require few specialized improvements, such as law firms and other professional service companies. Specialty office space, on the other hand, is space that requires significant improvements, such as medical or high-tech companies, including those that require specific amenities to attract workers.

1. Size. These office buildings divide into low-, mid-, and high-rise buildings. Often, these buildings will be either mixed-use or will house a diversity of tenants, from hotels to retailers, office space and condominiums. I classify low-rise buildings are those with less than five floors, mid-rise as those with between five and 11 floors, and high-rise as those with 12 floors or more.

1. Location. Office space is usually located in either central business districts (CBDs) or the suburbs, with taller buildings located in CBDs within city centers.

Lofts

Loft commercial real estate space is another specialized segment. These properties are located in and around CBDs in major metropolitan areas. These properties often attract clients based on location and ascetic appeal, and can be converted into different property types.

Storefronts & Retail

Storefronts and retail commercial real estate are used by businesses to market and sell products and services to customers. These buildings come in a range of types, from single-tenant to multi-tenant. I group them into six types.

1. Malls. These are multi-tenant buildings housing shops, department stores, restaurants, and other specialty businesses. They range in size from 400,000 to 800,000+ square feet.

1. Power or Big Box Centers. These are special-purpose centers with a few tenants, such as department stores, off-price stores, and wholesale clubs. They range in size from 250,000 to 600,000 square feet.

1. Lifestyle Centers. These are upscale centers with a mix of specialty stores, restaurants, and entertainment, usually in an outdoor setting. They range in size from 150,000 to 500,000 square feet.

1. Community and Neighborhood Centers. These centers are oriented towards convenience or general merchandise, and can include goods and apparel. The range in size from 125,000 to 400,000 square feet.

1. Factory Outlets. These are specialty centers that house a few retailers or manufacture. These outlets sell products at a discount. They range in size from 50,000 to 400,000 square feet.

1. Strip or Convenience Centers. These are usually multi-tenant buildings arranged in a line, L-shape, or U-shape. They have a common parking lot and house a range of businesses that serve a local area. They are usually less than 30,00 square feet.

Commercial Real Estate Categories and Market Trends

In addition to asset classes, some commercial real estate divides into class categories. These categories reflect the quality, age, location, and cost of the buildings.

• · Class A. These are relatively new buildings located in CBDs and desirable neighborhoods, and include larger office buildings. They garner top rental rates, attracting top-tier clients, such as tech companies and law firms.

• · Class B. These buildings are smaller than Class A and located in less-central districts or the suburbs. Such properties are older and may have room for select improvements. Tenants select these properties to balance price, location, and quality.

• · Class C. These buildings are the oldest and are located in less-than-desirable neighborhoods. They attract tenants on a budget and may require modest to significant improvements.

I want to end with a chart showing the 2018 – 2019 spending trend in nonresidential construction, sourced from the NAIOP’s 2020 Economic Impacts of Commercial Real Estate report.

Part three next.....