"Buy land" Mark Twain once said. "They're not making it anymore."
It is a philosophy that has built and sunk countless fortunes. If you stay up late enough, you'll see infomercials encouraging you to get rich off real estate systems. Hang out on the FTC's website long enough and you'll see countless busts for real estate scams promising the exact same thing.
Yet understanding how we buy and sell property is important, even if you don't plan on getting into the game just yet. And while you may never decide to open up your own Quiznos or buy into the local strip mall, that means knowing the basics of commercial real estate too.
What Is Commercial Real Estate?
Commercial Real Estate (CRE) a form of zoning restriction. It refers to one of the three basic property types that municipal governments assign, the other two being residential and industrial. These are not the only three forms of zoning. In fact, this area of the law gets complex and specific. However, most properties in a town or city will have a commercial, industrial or residential zoning, and in a densely populated area almost every property will be zoned either commercial or residential.
While this article will not discuss residential and industrial zoning at length, in a nutshell they refer to properties that are restricted to housing and manufacturing/packaging/transportation respectively.
By contrast, commercial zoning restricts the property to light businesses that have some sort of relationship with the public or consumers. This typically refers to businesses like retail shops, restaurants and bars or office spaces. Almost any consumer-facing or non-industrial business can operate in commercial real estate.
What Are the Types of Commercial Real Estate?
Commercial real estate is a massive term. It can apply to almost any property used exclusively by the owner for business purposes. This can include office buildings, bars and restaurants, entertainment spaces, shopping centers, parking lots, storage facilities and even apartment buildings.
While the last may seem counterintuitive, the key issue to a CRE designation is how the owner uses the property. The owner of an apartment building uses it as a business, leasing the property to tenants in exchange for rent. Technically the property's primary use is as a business. Residency is secondary to that purpose.
Ultimately, the properties that do not count as commercial real estate are generally owner-occupied single family homes and industrial zones. Even a single family home might be zoned as commercial real estate if the owner rents it out.
Note that many people, including real estate professionals, cite manufacturing/transport as a form of CRE. This is a common use reflecting the fact that the same professionals generally handle both commercial and industrial real estate, however most, if not all, jurisdictions zone these uses separately.
While not a legal distinction, many real estate agents separate commercial real estate into five major segments:
• Office Space
This includes any building used primarily for a services or otherwise professional firm. It can be consumer-facing or not, but if the office is consumer-facing it is not used to sell physical products or food.
This generally means apartment buildings. The size and scope of a multifamily commercial space will vary widely by its location, from suburban duplexes to 20-story urban towers.
• Retail Space
This is the most expansive category, including everything from flower shops and supermarkets to the local deli and the local Walmart (WMT - Get Report) . As a general rule it will include any business that buys and sells physical products on a daily basis, including food and drinks.
This refers to hotels, from a large resort property to small motels by the side of the road. Any business that provides short-term stays will be considered a hospitality business.
There is substantial overlap between healthcare and office space, as most hospitals will include offices. However, any business that has facilities to directly provide care on the premises will also be considered a form of healthcare real estate, from a massive hospital to your local doctor.
This is a general "other" category that sweeps in businesses from your local movie theater to a bowling alley or video arcade. Many will also include a retail presence, such as providing a bar or gift shop.
This is by no means a comprehensive list, however, it is an overview of the most common forms of commercial real estate.
Within these categories, commercial real estate agents also use a three-tier ranking system for office buildings and apartments. This is not a legal standard, no more than the categories above are. Instead, it's a way to organize buildings by desirability:
• Class A
The best buildings, with the best amenities, in the best location. Generally Class A real estate means that this is the highest value property for the particular region. Real estate agents charge the most for these properties and typically seek the most prestigious tenants.
• Class B
The middle of the road. Most real estate is considered "Class B." These buildings represent the average for their market in terms of quality, management and location. Rent at a Class B building will generally be considered the normal market rate for offices and apartments.
• Class C
Below average. These are older buildings, of lesser quality, in less desirable parts of town. An agent will charge below-market rents for a Class C property, and depending on its location this building may be targeted for purchase and renovation.
The Pros of Investing in Commercial Real Estate
There are many ways to invest in commercial real estate, but the two most common are direct investment (where you actually buy an ownership stake in a property) and marketed securities such as indexed mutual funds, exchange-traded funds and Real Estate Investment Trusts.
The main advantage to commercial real estate investment is stability. Leases in this industry tend to be long, with many lasting for five years or more. What's more, these leases tend to be relatively valuable and can charge high margins, particularly for access to desirable locations.
This effectively creates debt-based income for the better part of a decade, so long as the renting entity doesn't go out of business. What's more, in urban markets, the demand for real estate has spent decades getting stronger with each passing year. Few spaces remain empty for long, creating a relatively stable investment with natural appreciation that isn't subject to the short-term fluctuations of the stock market.
As Mark Twain said, land is the only thing they're not making more of. As long as there are people to buy things and businesses to work, they'll need a place to do it.
The Cons of Investing in Commercial Real Estate
That might make it seem like commercial real estate is an obvious choice for investments. It isn't.
First, commercial real estate is still very vulnerable to the economy. If businesses begin to close, they stop paying rent altogether and a property is left empty and searching for new tenants. This is a particularly acute problem for modern investors given the "retail apocalypse," which has left many previously lucrative properties gutted and scrambling for tenants.
Further, while the stock of available land may not be growing, the pool of investors always is. Competition in commercial real estate is fierce, with new properties being built all the time and competitors seeking to underbid or outperform each other constantly. This means that commercial real estate can move quickly, sometimes bafflingly so, and in ways that can make it very hard for laypeople to understand.
A parking lot might seem like the perfect investment in one part of town, right up until someone half a mile away builds a parking deck or the big-box anchor store goes out of business.
Finally, directly investing in commercial real estate is expensive. If you are beginning to feel out this market, you are almost certainly better off doing so through fund-oriented securities. Buying into a specific property is typically a large commitment and a speculative one. If the project goes well it can make you quite a lot of money.
If it goes badly, you can lose just as much.
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