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What Is Commercial Real Estate (CRE)?
Commercial real estate (CRE) encompasses properties used for business activities rather than residential purposes. It includes a diverse range of properties, from single retail stores to expansive industrial complexes, often leased to tenants for income through rent or business operations. Leasing terms in CRE can significantly differ from residential agreements, offering unique investment opportunities and challenges.
The business of commercial real estate involves the construction, marketing, management, and leasing of property for business use.
There are many categories of commercial real estate such as retail and office space, hotels and resorts, strip malls, restaurants, and healthcare facilities.
Key Takeaways
- – Commercial real estate (CRE) is used for business functions, generating income through capital appreciation and rental income.
- The four primary categories of CRE are office space, industrial use, multifamily rentals, and retail.
- CRE leases generally have longer terms compared to residential leases, offering more stable cash flows.
- Investing in CRE can be done directly, by owning property, or indirectly, through REITs and ETFs.
- Commercial real estate often provides high rental yields and returns but requires significant capital and management expertise.
Distinguishing Commercial From Residential Real Estate
Real estate is mainly categorized as commercial or residential.
Residential properties are structures reserved for human habitation rather than commercial or industrial use. As its name implies, commercial real estate is used in commerce, and multiunit rental properties that serve as residences for tenants are classified as commercial activity for the landlord.
Commercial real estate is typically categorized into four classes, depending on function:
- Office space
- Industrial use
- Multifamily rental
- Retail
Individual categories may also be further classified. There are, for instance, different types of retail real estate:
- Hotels and resorts
- Strip malls
- Restaurants
- Healthcare facilities
Similarly, office space has several subtypes. Office structures are often 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 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 more than 20 years of age, and may be located in less attractive areas and in need of maintenance.
Some zoning and licensing authorities further break out industrial properties, which are sites used for the manufacture and production of goods, especially heavy goods. Most consider industrial properties to be a subset of commercial real estate.
Navigating Commercial Lease Agreements
Some businesses own the buildings that they occupy. More commonly, commercial property is leased. An investor or a group of investors 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—are customarily quoted in annual rental dollars per square foot. (Residential real estate rates are quoted as an annual sum or a monthly rent.)
Commercial leases typically run from one year to 10 years or more, with office and retail space typically averaging five- to 10-year leases. This, too, is different from residential real estate, where yearly or month-to-month leases are common.
Four main types of commercial leases exist, each with varying landlord and tenant responsibilities.
- 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.
Signing a Commercial Lease
Tenants usually sign a lease outlining both parties’ rights and responsibilities. The commercial lease draft document can originate with either the landlord or the tenant, with the terms subject to agreement between the parties. The most common type of commercial lease is the gross lease, which includes most related expenses like taxes and utilities.
Effective Strategies for Managing Commercial Real Estate
Leased commercial properties need regular management by either the owner or a management company.
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. Local knowledge can be important as the rules and regulations governing commercial property vary by state, county, municipality, industry, and size.
Landlords often balance maximizing rent and minimizing vacancies and turnover. Turnover can be costly because space must be adapted to meet the specific needs of different tenants—for example, if a restaurant is moving into a property formerly occupied by a yoga studio.
Profit Strategies in Commercial Real Estate Investment
Commercial real estate investment can be profitable and can be a hedge against stock market volatility. Investors can make money through property appreciation when they sell, but most returns come from tenant rents.
Direct Investment
Direct investment in commercial real estate entails becoming a landlord through 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 can employ firms that 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 the purchase of commercial real estate requires a considerable amount of capital.
The ideal property is in an area with a low supply and high demand, which will give favorable rental rates. The strength of the area’s local economy also affects the value of the purchase.
Indirect Investment
Investors can invest in the commercial real estate market indirectly through ownership of securities such as real estate investment trusts (REITs) or exchange-traded funds (ETFs) that invest in commercial property-related stocks.
Exposure to the sector also derives from investing in companies that cater to the commercial real estate market, such as banks and realtors.
Benefits of Investing in Commercial Real Estate
A major advantage of commercial real estate is its appealing leasing rates. In areas where new construction is limited by a lack of land or restrictive laws against development, 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 with an office tower.
Other Benefits
Commercial real estate benefits from comparably longer lease contracts with tenants than residential real estate. This gives commercial property owners stable cash flow.
In addition to offering a stable and 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.
Like all forms of real estate, commercial space is a distinct asset class that can provide an effective diversification option to a balanced portfolio.
Challenges in Commercial Real Estate Investment
Complex rules often discourage direct investment in commercial real estate.
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 employ people who have it.
Another hurdle is the risks associated with tenant turnover, especially during economic downturns when retail closures can leave properties vacant with little advance notice.
The building owner often 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.
Directly buying commercial property costs more than buying residential property.
Moreover, while real estate in general is among the more illiquid of asset classes, transactions for commercial buildings tend to move especially slowly.
Pros
- Hedge against stock market losses
- High-yielding source of income
- Stable cash flows from long-term tenants
- Capital appreciation potential
Commercial Real Estate’s Response to the COVID-19 Pandemic
The global COVID-19 pandemic beginning in 2020 did not cause real estate values to drop substantially. Except for an initial decline at the beginning of the pandemic, property values have remained steady or even risen, much like the stock market, which recovered from its dramatic drop in the second quarter (Q2) of 2020 with an equally dramatic rally that ran through much of 2021.
This is a key difference between the economic fallout due to COVID-19 and what happened a decade earlier. It’s unclear if remote work, started during the pandemic, will permanently affect office space needs.
In any case, the commercial real estate industry has still yet to fully recover. Consider how American Tower Corporation (AMT), one of the largest United States REITS, was priced at roughly $250 per share in June 2022. Fast-forward one year, the REIT traded at roughly $187 per share in June 2023. At the end of June 2024, it was at about $194.
Future Trends and Predictions for Commercial Real Estate
After major disruptions caused by the pandemic, commercial real estate is attempting to emerge from an unclear state.
In a mid-year update released in May 2024, JPMorgan Chase concluded that the multifamily, retail, and industrial sub-sectors of commercial real estate remain strong despite interest rate increases.
However, it noted that office vacancies were rising. Vacancies nationwide stood at a record-breaking 19.6% in the final quarter of 2023.
What Is the Difference Between Commercial and Residential Real Estate?
Commercial real estate refers to any property used for business activities. Residential real estate is used for private living quarters.
There are many types of commercial real estate including factories, warehouses, shopping centers, office spaces, and medical centers.
Is Commercial Real Estate a Good Investment?
Commercial real estate can be a good investment. It tends to have impressive returns on investment and considerable monthly cash flows. Moreover, the sector has performed well through the market shocks of the past decade.
As with any investment, commercial real estate comes with risks. The greatest risks are taken on by those who invest directly by buying or building commercial space, leasing it to tenants, and managing the properties.
What Are the Disadvantages of Commercial Real Estate?
Rules and regulations are the primary deterrents for most people to consider before investing in commercial real estate. The taxes, mechanics of purchasing, and maintenance responsibilities for commercial properties are buried in layers of legalese, and they can be difficult to understand without acquiring or hiring specialist knowledge.
Moreover, it can’t be done on a shoestring. Commercial real estate even on a small scale is an expensive business to undertake.
The Bottom Line
Commercial real estate offers investors the chance for steady rental income and capital appreciation. This type of investment typically demands more capital than residential properties but can yield significant returns. For those without the means or expertise for direct investments, publicly traded REITs present an accessible alternative. The commercial real estate sector, encompassing everything from industrial sites to office spaces, provides opportunities for profit through rentals and property appreciation. However, the sector also demands careful consideration of market conditions, tenant management, and regulatory complexities.
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