Commercial real estate (CRE) investing provides investors an opportunity to generate income while owning physical assets.
While residential real estate tends to garner more attention, commercial real estate offers unique benefits like stable cash flows, tax advantages, portfolio diversification, and potential for appreciation.
There are several ways to invest in commercial real estate, each with its own pros, cons, and risk-reward profiles.
This article will provide an overview of the most common CRE investment strategies, explain how each one works, and discuss the potential rewards as well as risks associated with each approach.
With a proper understanding of the available options, investors can determine which strategy best aligns with their investment objectives, risk tolerance, and desired level of involvement.
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What Is Commercial Real Estate And Why Invest In it?
Commercial real estate (CRE) refers to properties used exclusively for business purposes rather than residential living.
Common types of CRE properties include office buildings, industrial warehouses, retail centers, multifamily apartment complexes, hotels, and mixed-use developments.
CRE provides a tangible asset class that historically has a low correlation with other asset classes like stocks and bonds, making it an excellent portfolio diversification tool. Other benefits of CRE investing include:
- Stable cash flows – The majority of income comes from tenant leases that provide reliable rental income. Leases are typically long-term (3-10 years).
- Tax advantages – Depreciation deductions lower taxable income while deferred capital gains taxes allow for reinvestment of proceeds.
- Appreciation – Property values and rents tend to increase over time, especially in strong economic environments.
- Leverage – Banks may finance up to 80% of a property’s value, magnifying returns for the owner’s equity.
- Hedge against inflation – Rents and property values typically rise with inflation.
CRE investing does come with risks like vacancies, tenant defaults, property damage, and fluctuating property values.
However, for investors willing to take an active management approach, CRE offers better risk-adjusted returns compared to most asset classes.
Companies such as Gparency have lowered the cost of arranging and completing real estate transactions by disrupting the typical commission-based approach that most brokerage firms adopt to introduce a membership program.
Lower transaction costs result in higher returns for investors and this portrays how technology can revolutionize commercial real estate investing.
Top 4 Commercial Real Estate Investment Strategies
There are four main investment strategies that can be adopted when it comes to investing in commercial real estate.
Which strategy works best for each person and organization depends on their risk tolerance, financial situation, available capital, financing opportunities, and expected outcome. Here is an in-depth description of these four strategies.
#1 – Core Investing
Core investing involves acquiring fully leased, quality properties in prime locations. These stabilized assets generate predictable cash flows with a relatively low risk.
How Does it Work?
Core properties require little to no improvements after acquisition. They are well-maintained, have high occupancy rates (90%+), and strong tenants with long-term leases.
Core investors utilize conservative underwriting focused on current in-place income rather than speculation.
Rewards
Core CRE produces a stable income and the strategy carries a relatively low risk. Leverage magnifies returns while providing principal preservation. Less management is required compared to higher-risk strategies.
Risks
Properties are often bought at peak prices, limiting upside. Cash flow yields tend to be lower than higher-risk strategies.
Typically, in the 5-7% range. The lack of property value appreciation can lead to negative returns after factoring in expenses.
Pros – Stable cash flow, lower risk, leverage, and principal preservation.
Cons – Lower returns, less upside, and peak pricing.
#2 – Value-Add Investing
Value-add investors seek out properties with potential for improvement. By renovating, re-leasing units, and addressing operational issues, they can increase rental income and property value.
How Does it Work?
Value-add properties often have high vacancies, deferred maintenance, or below-market rents.
Investors address these issues by performing renovations, adding new amenities, applying better property management practices, and improving leasing terms.
The goal is to turn around struggling assets, fill vacancies, and increase NOI.
Rewards
Properly executed renovations and re-positioning leads to stronger cash flows and increased property value.
Target returns typically range from 12-20%. Value-add deals can provide a way to enter top markets at a discount.
Risks
Failed execution leads to lost time and money. Projects may run over budget or hit delays. Market timing is key – improvements must be completed before the next downturn. Identifying the right properties takes expertise.
Pros – Discounted acquisitions, higher NOI, forced appreciation, and higher returns
Cons – Execution risks, cost overruns, and accurate market-timing capabilities needed.
#3 – Development
With development, the investor takes raw land and creates an income-producing property through the construction process. The end result can be either rented or sold upon completion.
How Does it Work?
Developers purchase land and construct new CRE assets like office towers, industrial parks, retail centers, or apartment complexes. They assemble a team to design, budget, finance, and build the project.
Rewards
The development strategy offers the greatest potential returns but requires expertise. Profits can come from both rental income and property appreciation. Completed projects in top locations garner high valuations.
Risks
High upfront costs, construction risks, and the possibility of low demand upon completion make development very risky. Many factors from weather to labor issues can delay projects and blow budgets.
Pros – Create the asset as desired, high potential returns, and easier to maintain control over the project.
Cons – High risk, significant capital and expertise required, and ordinary income tax treatment.
#4 – REIT Investing
Real estate investment trusts (REITs) are companies that own and often operate income-producing real estate properties. Investors can buy shares in REITs to gain exposure to portfolios of properties.
How Does it Work?
There are two types of REITs – equity REITs, which own properties, and mortgage REITs, which provide financing to developers and investors. Equity REITs generate profits for investors from rents and growth in property values. They offer a liquid way to gain diversified CRE exposure.
Rewards
REITs offer steady dividends along with capital appreciation potential. They offer exposure to high-quality properties, liquidity, transparency, and diversification. The minimum investment required is typically very low.
Risks
Investors lack control over specific assets. Vulnerability to market swings and economic downturns that depress share prices. Reliance on the management team’s decisions. Fees can eat into returns.
Pros – Liquidity, diversification, passive ownership, and low minimum investment.
Cons – No control, vulnerable to market swings, and over-reliance on managers’ expertise.
Bottom Line
Commercial real estate presents investors with various ways to generate income while owning tangible property assets.
Core investing provides stable cash flows with lower risk but less upside. Value-add offers greater returns through improvements to struggling assets but requires hands-on effort.
Development has the highest profit potential and consists of creating new properties but also carries a high level of risk.
REITs allow small investors to gain professional CRE exposure by owning shares of a diversified portfolio.
There is no single best CRE strategy. The right approach depends on factors like your investment goals, time horizon, risk tolerance, and desired involvement level.
Many investors choose a mix of strategies to build a balanced commercial real estate portfolio.
The key is understanding the unique risk-reward profile of each technique in order to pursue the ones that are a better fit for your needs and investment style.
With the right expertise and strategy mix, commercial real estate can enhance any investment portfolio.
