What Is Commercial Real Estate?
What comes to mind when you hear the words “commercial real estate?”
For a long time I thought of shopping centers, malls, and skyscrapers. I also pictured industrial complexes like warehouses or factories. But my narrow definitions would have been incomplete.
Even definitions online can be misleading. Investopedia says, “Commercial real estate (CRE) is property used exclusively for business purposes or to provide a workspace rather than a living space. Most often, commercial real estate is leased to tenants to conduct business. This category of real estate ranges from a single gas station to a huge shopping center.” Commercial real estate includes retailers of all kinds, office space, hotels, strip malls, restaurants, and convenience stores.
Commercial real estate can include many assets that some consider residential and more. For the purposes of this discussion, and not at all as a definition, I propose that we segregate residential and commercial real estate as follows:
- Residential real estate is valued based on comparable prices. Comps. Other houses sold on the street, in the neighborhood, etc.
- Commercial real estate valuation is based on some pretty basic math.
To really compare lets look at a hypothetical flip you could do. You may buy a home for $200,000 that needs a lot of work. You fix what’s broken and beautify it to the nth degree. You build out the basement and the attic. You add a large addition and the finest landscaping in the neighborhood. At the end of the day, you’ve got $500,000 in this flip home.
Now if this home is in a $250,000 neighborhood, it’s likely going to be a big problem. Because when the appraiser comes, they won’t be able to find comparable properties to support your price. You could easily lose a lot of money, a lot can hinge on the appraisal.
Commercial real estate is and entirely different “calculation”. Commercial real estate valuation is based on a value formula. That formula is Value = Income ÷ Rate of Return. More specifically, it is Value = Net Operating Income ÷ Capitalization Rate. For more info on calculating commercial real estate and some other approaches that are used check out this page on valuepenguin.com
Commercial real estate investors have the powerful ability to “force appreciation” by increasing the net operating income. And if they’re clever enough, or fortunate enough, a shrinkage in the capitalization rate (cap rate) will multiply their value even further. Leverage just sweetens it more.
So commercial real estate, for the purpose of this article, is real estate that is valued based on math rather than comps. This includes industrial, retail, hotels, office, restaurants, and more.
Overlooked Commercial Investments
There are two classes of apartments: residential multifamily and commercial multifamily. Residential multifamily is financed using a residential loan and the values are based on comps. This is generally buildings with two to four units.
Commercial multifamily is financed through a commercial loan. Many people make another division between small commercial multifamily and large, based on the size needed to hire an onsite staff. This is typically 40-50 units in an urban setting or about 75 units in a typical suburban apartment complex.
Cap rates, the measure of value per unit of income, have been very compressed for multifamily for years since the financial crisis. This means these assets are very pricey (lower cap rate = higher price, since that is the numerator in our value equation). Cap rates in the range of 4% to 6% are common.
I didn’t think much about this over years past, and apparently the big commercial rating groups didn’t either since there has not been a separate classification for this category in most past reports.
There are over 55,000 self-storage facilities in the U.S., which is nearly the number of McDonald’s, Starbucks, and Subway restaurants combined. Self-storage has become quite popular in the past decade and the cap rates have shrunk from around 10% or so to the 5% to 7% range, so more expensive.
Mobile Home Parks
Warren Buffett also in early and owns the largest manufacturer of mobile homes (Clayton) as well as one of the most aggressive lenders (21st Mortgage) and Berkadia (a large lender that finances mobile home parks and more).
Cap rates in this asset class have compressed from the 10% to 14% range down closer to 6% to 8%. Green Street Advisors recently referred to mobile home parks as the darling of all commercial real estate. And in the midst of the COVID-19 stock market meltdown in late February, a Wall Street Journal article trumpeted the power of investing in mobile home parks.
Data centers have exploded in the past several years. Just as retail’s demise is accelerating during COVID-19, data center demand has gone up. Zoom and other online meeting platforms have taxed the limits of the existing infrastructure. Emerging technologies like the Internet of Things, artificial intelligence, 5G wireless, augmented reality, and autonomous cars will also continue the ever increasing demand to new heights.
Many investors haven’t thought about investing in this sector. Unlike self-storage and mobile home parks, there are no mom-and-pop operators to cherry-pick. You could certainly invest passively through a real estate investment trust.
Multifamily is largely overheated. Even though fundamentals remain strong, many syndicators are looking to dial in on a specific type of multifamily to obtain a better yield. Senior living fits that bill for some.
I’m not talking about skilled nursing facilities specifically, though this sector may include that. I’m talking about independent living communities that are becoming increasingly popular.
There must be a reason that almost everyone in the Forbes 400 (the wealthiest of the wealthy) invests in commercial real estate. Maybe it’s time for you to get started!