What to Know and How to Begin Investing in Commercial Real Estate

Here are the steps you need to know when investing in commercial real estate and some tips to get you started.

Most investors are at least familiar with the process of buying a home. But the idea of buying commercial real estate, with attendant larger price tags and management needs, has been largely off-limits for most investors until recent times.

To be sure, some investors might be interested in buying a single, discrete commercial property, such as smaller warehouse or retail corner. But for most, the management skills of actually operating a commercial property are likely lacking, while the size of initial investment can be daunting. Even modest commercial properties can run into millions of dollars.

However, in recent years, other avenues to buying commercial real estate have opened up not only high-net worth individuals, but nearly anyone looking to diversify their investment portfolio.

For investors who want to be “passive” or hand-off owners of commercial property, and who are seeking to balance financial portfolios, there are two excellent options today: real estate syndications, and real estate investment trusts (REITs).

More on REITs and property syndications later. For now, what is commercial real estate?

Commercial Real Estate for Beginners

In general, there are seven types of commercial property:

  1. Office
  2. Industrial-Warehouse
  3. Lodging-Hospitality
  4. Retail
  5. Residential multi-family, or large portfolio single-family detached
  6. Agricultural
  7. Special, the remainder catch-all category that can include medical, religious, or recreational properties, parking facilities, or new property types such as data centers, telecom towers or life-science R&D business parks. There are also “mixed-use” structures, such as retail-housing complexes in dense urban environments.

The advantages of owning commercial property are relatively reliable income streams, the prospects for appreciation, and the ability to leverage when making an investment. On no other asset are banks so willing to extend loans, thus allowing investors to leverage up on their equity.

As commercial properties are generally leased to credit-worthy business tenants, risks to income streams are reduced. And as rents rise over time, commercial buildings tend to appreciate.

How much money do you need to invest in commercial real estate?

Today, an investor can start buying into commercial property with limited funds, thanks to the publicly traded REITs, as well as certain real estate limited partnerships.

Through an online or discount brokerage, an investor could conceivably buy just a few shares of any particular REIT. So what are REITs?

REITs

In general, the public REITs seek revenue from large property portfolios, while 90% of net income by law is passed through to passive shareholders. Large public REITs may cull their portfolios from time to time, or sell a property if particularly advantageous, resulting in one-time capital income as well as operating revenue. However in general REIT pass-through income while looking for additional properties to add to the portfolio.

The advantages of public REITs are ease of investing and small investment size, and liquidity. That is, an investor can buy as little a few hundred dollars of a REIT online, and with mere click of a mouse, and sell the same way, through an online brokerage. In general, investors buy REITs for the dividends, and possible long-term appreciation. Moreover, in large part REIT stocks are not highly correlated with the overall stock market and thus add ballast, or diversification, to the portfolio. 

The first public REITs were legalized in the 1960s in the US, and in the 60-plus years since have become a mature industry. REITs are regarded as having solid, professional management, and generally receive good credit-ratings from agencies such as Moody’s, S&P, or Fitch.

For investors seeking liquidity, income, security and a chance at appreciation, REITs are worth a long look.

Real Estate Syndications

Real estate syndications have been through a few iterations in US history, but took a huge step forward with Jumpstart Our Business Startups Act in 2012, or the “JOBS Act,” a law intended to encourage funding of small businesses by easing certain securities-industry rules.

The short story is the JOBS Act paved the way for property syndicators to legally solicit both large and small investors broadly, and online through social media platforms, websites or mass emails.

Under the 2012 Act, crowdfunded real estate syndications opened up to accredited or in some cases to un-accredited investors, the latter being those  with a net worth under $1 million, or income under $200,000.

The JOBS Act helped create the “crowdfunded” sector of the real estate syndication business, including such syndication websites as CrowdStreet, DiversyFund, Fundrise and EquityMultiple. These crowdfunded real estate syndications generally solicit funds through projects offered online, with attendant photos, business plans, and offering memorandum.

In a real estate syndication, the practical aspects of investing will be anticipated and handled by the sponsors, that is, the expert general partners who put together the syndication. In other words, in a syndication, experienced managers handle the transaction and the limited partners (the individual investors) are more or less “passive investors.”

Individual investors choose to participate in real estate syndications, crowd-funded or otherwise, after reading “private placement memorandum” (PPM) put together by the sponsors, which explain terms of the property transaction, and how income, and profits from an ultimate sale, will be split. Many other details, such as financing arrangements and the business plan, are also discussed in PPMs.

A possible disadvantage of real estate syndications is that they are designed for investors to “lock in” their investment for a three-to-seven years period—so, no instant liquidity, as with a public REIT.

In general, real estate syndications, crowdfunded or otherwise, plan to buy, develop or redevelop a property in a three-to-seven years window, for profitable sale at the exit date. 

On the positive side, the sponsors of a modern syndication usually have financial interests closely aligned with those of the passive investors, and a defined target date of exit. That is, both the sponsors and the passive investors hit their main payday when the project is sold, and funds and gains returned to investors.

Because real estate syndication investors have foregone the “liquidity premium,” in that they have agreed to “lock up” their investment for a number of years, in general they can command higher long-term returns than REIT investors (in the same way, buyers of long-term bonds are rewarded with higher interest rates than investors in same-quality short-term bonds).

What To Look For When Investing in Commercial Real Estate

For the investor who plans the purchase of a discrete asset—an actual property—there are legions of calculations to considered, such as the asset type (i.e., office, industrial, retail), the geographic and neighborhood location, the age and condition of property, transactions costs, potential financing, tax considerations, and managerial concerns.

For investors who plan to acquire real estate through REITs or limited real estate partnerships, there are different considerations.

To be sure, investors may still wish place a wager on, say, retail vs. industrial properties, or on a geographic location when buying a REIT stock. But in general, REITs are heavily covered on Wall Street by analysts and such financial-media sites as Seeking Alpha, and REIT portfolios are publicly disclosed. There are few secrets in REIT-land, and shares are traded continuously. An individual investor might outsmart the market who buying REITs, but just as likely not. For example, while the office and retail markets may look unappealing in times of pandemic, Wall Street has “priced that in” concerning REIT stocks exposed to such markets. So, out of favor stocks become “cheap”—indeed, many a contrarian haunts Wall Street, looking for bargains.

However, rather than trying to beat the market, individual investors probably wish to note how REITs pay dividends, and dividend track records of public REITs. Some REITs offer higher dividends than others, usually a measure of the amount of risk inherent in the REIT shares. Other REITs have long track records of increasing dividends, which may be an important consideration for some.

On real estate syndications, there is perhaps more to consider for investors. Real estate syndications, crowdfunded or otherwise, in general are not followed by an analyst community. This makes the reading of the offering memorandum, which is similar to a prospectus, an important ritual of syndication investing. The individual investor must perform some level of due diligence.

The track record of the syndicator is important, as well as the split in profits among investors and sponsors.

Some investors may wish to visit the actual syndication project site, to get a feel for the property. There is some level of comfort in knowing how much banks are expected to extend on a syndication property—the banks will have had professional appraisers review the bank loan.

Another advantage of investing in a real estate syndication is the learning experience. The investor who seriously studies the offering memorandum, perhaps visits the project site and meets with the sponsors, will gain wealth of knowledge. That investor may wish to subsequently to purchase a discrete small commercial property, perhaps in a team, or partnership, with few other investors.

Indeed, buying into a real estate syndication may be an excellent, low risk way of “learning the ropes” of property investing.

How Do You Know if a Commercial Property is a Good Investment?

Even professionals would like to know the answer to this question, and there are no guarantees in the investing world. Some experts advise buying property only in cities with growing populations and employee-bases, which, as a general rule, probably provides a great deal of downside protection.

There are additional variations of this question also: Is a property a good investment, but on a risk-to-reward scale? A very safe investment might yield too little.

Some of the answers for individual investors may come down to timelines, relative risk-version and returns sought.

The investor in a public REIT is liquid at all times, and can easily convert the shares into cash, as for emergencies, or perhaps to seize another investment opportunity that appears fleeting. For such an investor, a “good” commercial property investment is one that can be sold quickly.

Another investor may be seeking high yearly yields, as offered by some public REITs, and especially “mortgage REITs,” aka mREITs, which large invest in commercial mortgages. The higher yielding REITs are more risky, and there are prospects for depreciation, but some investors may need steady income checks.

Other investors may be willing to wait for higher total returns, as offered by real estate syndications, but which will take three to seven years to mature.

In general, investing in property, especially when working through professionals, is one of the less-risky investments available.

It is not unusual for investments in venture capital enterprises, or other industries exposed to disruption, to go entirely bust.  For example, more than a few retailers have disappeared entirely from the US markets in recent years.

But businesses and people will always need land and space in which to operate. The landlord may rent to dot.com companies in one era, or blockchain gurus in the next, but a well-placed building will always rent, and value will not go to zero—and may, indeed, appreciate over time.

Conclusion

There is no perfect answer to the questions of how to start investing in commercial real estate, and what makes a good property investment.

The good news is that investing in commercial property, once almost solely the province of the wealthy, and then the well-connected, has been opened up to average investors as well, through the public REIT and real estate syndication sectors.

Commercial property offers solid returns, and relatively low risk, and more protection against downside valuations than most other asset classes. For investors seeking income and appreciation but relative security, commercial property is a very viable option.

In addition, for investors who want to learn about buying commercial property, the participation in a real estate syndication as a passive investor may be an excellent and relative safe learning experience.

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