Commercial Real Estate (CRE)

What Is Commercial Real Estate (CRE) and How Does It Work?

Commercial real estate (CRE) is a property that is used solely for commercial purposes or to offer a workspace, as opposed to residential real estate, which is utilized for living purposes. Commercial real estate is frequently leased to tenants for the purpose of conducting income-generating operations. This vast category of real estate can range from a single storefront to a large shopping mall.

Retailers of all kinds—office space, hotels and resorts, strip malls, restaurants, and healthcare facilities—all fall under the category of commercial real estate.

Important Takeaways

• Commercial real estate refers to properties that are used primarily for business or to generate money.
• Office space, industrial, multi-family rentals, and retail are the four basic types of commercial real estate.
• For investors, commercial real estate provides rental income as well as the possibility of capital appreciation.
• Investing in commercial real estate typically necessitates greater sophistication and capital from investors than investing in residential real estate.
• Individuals can engage in commercial real estate indirectly through publicly traded real estate investment trusts (REITs).

Commercial Real Estate Fundamentals

Commercial and residential real estate are the two main types of property in the real estate market. Residential properties are those that are used for human dwellings rather than commercial or industrial purposes. Commercial real estate is utilized in commerce, as its name implies, and multi-unit rental properties that serve as tenants' homes are considered as a commercial activity for the landlord.

Depending on the function, commercial real estate is usually divided into four categories:

1. Industrial use
2. office space
3. Rental housing for many families
4. Retail

Individual categories can also be divided into subcategories. For example, office space is frequently classified as class A, class B, or class C.

• Class A buildings are the best in terms of beauty, age, infrastructural quality, and location.
• Class B structures are typically older and less competitive in terms of pricing than class A structures. These structures are frequently targeted for restoration by investors.
• Class C structures are the oldest, typically over 20 years old, in less desirable locations, and in need of care.

Industrial properties—sites used for the manufacture and production of commodities, particularly heavy goods—are classified as a subcategory of commercial real estate by various zoning and licensing bodies.

Commercial Leases

Some firms own the structures in which they operate. The more common scenario is that the business property is leased. The building is usually owned by an investor or a group of investors, who receive rent from each business that works there. Commercial lease rates—the cost of renting a space for a set length of time—are usually expressed in annual rental dollars per square foot. Residential real estate rates, on the other hand, are expressed as an annual sum or a monthly rent.

Commercial leases typically range from one to ten years or longer, with office and retail space typically requiring five to ten-year commitments.

In comparison, yearly or month-to-month residential leases are more short-term.

The term—that is, the length—of a lease was shown to be related to the size of the space being rented in a recent study undertaken by real estate market analyst firm CBRE Group.

Furthermore, the data revealed that in a growing market, tenants would sign long leases to lock in pricing. But that isn't the only thing that motivates them. Due to the restricted availability of property that meets their needs, some renters who require huge spaces will sign extended leases.

Commercial property leases are divided into four categories, each requiring different levels of obligation from both the landlord and the tenant.

1. The renter is responsible for paying property taxes under a single-net lease.
2. The tenant is liable for paying property taxes and insurance under a double-net (NN) lease.
3. The tenant is responsible for property taxes, insurance, and upkeep under a triple-net (NNN) lease.
4. The tenant pays only rent under a gross lease, but the landlord is responsible for the building's property taxes, insurance, and maintenance.

Commercial Real Estate Management

Owning and managing leased commercial real estate necessitates the owner's full and continuing management. A commercial real estate management firm can assist property owners in finding, managing, and retaining tenants, overseeing leases and financing alternatives, and coordinating property upkeep and marketability.

Because the rules and regulations regulating such property differ by state, county, municipality, industry, and size, a commercial real estate management company's specific understanding is beneficial.

The landlord must frequently strike a balance between increasing rents while reducing vacancies and tenant turnover. Because space must be altered to accommodate the individual demands of different tenants—for example, if a restaurant is moving into a facility that was previously leased by a yoga studio—turnover can be costly for CRE owners.

Commercial Real Estate Investing

Investing in commercial real estate can be profitable and act as a hedge against stock market volatility. When investors sell their properties, they can profit from appreciation, but the majority of their profits come from tenant rents.

Investing Directly

Investors can make direct investments, in which they own the physical property and so become landlords. People that either have a lot of information about the market or can hire firms that do are the ideal candidates for direct investment in commercial real estate. Commercial real estate is a high-risk, high-reward proposition. Because CRE investing necessitates a significant amount of capital, such an investor is likely to be a high-net-worth individual.

The ideal property is located in a location with a low supply of CRE and a high demand for it, resulting in favorable rental rates. The value of a CRE purchase is also influenced by the strength of the local economy.

Investing through a third party

Alternatively, investors can indirectly invest in the commercial market by purchasing market securities such as real estate investment trusts (REITs) or exchange-traded funds (ETFs) that invest in commercial property-related stocks, or by purchasing commercial real estate-related companies such as banks and realtors.

Commercial Real Estate Benefits

Attractive leasing rates are one of the most significant advantages of commercial real estate. Commercial real estate can have outstanding returns and monthly cash flows in places where the quantity of new construction is either limited by land or by law. Industrial buildings typically have cheaper rents than office towers, but they also have lower overhead expenditures.

In comparison to residential real estate, commercial real estate benefits from comparable lengthier lease arrangements with tenants. As long as long-term tenants inhabit the facility, the commercial real estate owner benefits from a significant amount of cash flow stability.

Commercial real estate, in addition to providing a steady, reliable source of income, has the potential for capital appreciation if it is well-maintained and kept up to date. And, like all types of real estate, it is a distinct asset class that may effectively diversify a well-diversified portfolio.

Commercial Real Estate's Drawbacks

Most people who desire to invest in commercial real estate directly are discouraged by rules and regulations. Commercial property taxes, purchase mechanics, and maintenance responsibilities are hidden beneath layers of legalese. These standards vary by state, county, industry, size, zoning, and a variety of other factors. Most commercial real estate investors either have specific knowledge or have employees on their payroll who do.

Another stumbling block is the increased risk of tenant turnover, which is especially important in an environment where unexpected retail closures leave premises vacant with little warning.

When it comes to dwellings, one tenant's needs are frequently similar to those of prior or future residents. In a commercial building, however, each tenant may have quite distinct needs, necessitating significant renovations. The building owner must then modify the area to meet each tenant's unique profession. Due to the cost of improvements for incoming tenants, a commercial property with a low vacancy rate but significant tenant turnover may nevertheless lose money.

Buying a commercial property is substantially more expensive than buying a residential property for people wishing to invest directly. Furthermore, while real estate is one of the more illiquid asset sectors in general, commercial building transactions move at a particularly slow pace.

Pros

• Protect yourself against the stock market.
• Source of revenue with a high rate of return
• Long-term tenants provide consistent income flow.
• Potential for capital growth

Cons

• More money is needed to invest directly.
• Increased government regulation
• Renovation costs will be higher
• a non-liquid asset

Commercial Real Estate Forecasts and Outlook

The commercial real estate sector in the United States suffered a beating during the crisis of 2008-2009, but it has been steadily improving since 2010. These benefits have aided in the recovery of losses suffered during the recession.

According to Forbes, the retail sector has been a source of pain in the broader commercial property market, with widespread shop closures increasing in 2017 and continuing into 2018. For example, between mid-2016 and late 2017, the stock price of popular mall REIT Westfield Corporation fell by nearly 30% before reversing part of the losses in January 2018. Unibail-Rodamco SE paid $15.8 billion for Westfield, forming Unibail-Rodamco-Westfield (URW). 

According to most studies, the real estate market is still in good shape. In its "2019 Commercial Real Estate Outlook," J.P. Morgan mainly reiterated this sentiment, noting that 2019 marked the ninth consecutive year of rising commercial property rentals and prices.

It's worth noting that the global COVID19 epidemic, which began in 2020, did not result in a significant decline in real estate values. Property values have stayed stable or even increased, with the exception of a brief decline at the start of the pandemic, much like the stock market, which has recovered from a severe collapse in Q2 2020 with an equally dramatic rally that has lasted much of 2021. This is a significant difference between the economic consequences in 2020 and what occurred a decade ago. What is unknown is whether the mandated remote work environment for most Americans, which began in 2020, will have any long-term influence on corporate office demands.

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