Commercial Real Estate Investing 101 (CRE101) is an essential primer on the world of commercial real estate investing, answering basic questions investors commonly have, as well as furnishing key terms and definitions, for example:
What is “Net Operating Income”?
How does real estate compare to other asset classes?
What is the difference between direct and indirect real estate investing?
Is there an easy way to determine my investment strategy?
Why even invest in commercial real estate?Drawing from these basics, readers will be ready to proceed into more advanced topics introduced in the followup to CRE101, RealCrowd’s Valuation Series. As such, it’s the first of many steps in becoming a more informed, capable—and profitable—investor. Enjoy!
Commercial real estate is one of the most dynamic investment classes in the world. Commercial real estate is the only major asset class that produces high yields, significant equity buildup, can be efficiently leveraged for massive gains, has the security of a hard asset that you can see and touch (intrinsic value regardless of an income stream), and provides some of the best tax advantages.
One of the biggest advantages of Commercial Real Estate is the high annual cash return that it produces. In fact, commercial real estate income stream can produce three times the average stock dividend yield and four times the average bond yield. The chart below demonstrates the income each asset class produces based on a $1 million investment.
It is recommended by leading experts that investors have a portion of their investment portfolio in income producing real estate. David Swenson, Chief Investment Officer of the Yale Endowment, a trustee of TIAA-CREF (a Fortune 100 financial services organization), and the author of Unconventional Success: A Fundamental Approach to Personal Investment created what is known as the Yale Model which has produced staggering returns of nearly 14% annually. The portfolio has 22% of its assets in income producing real estate investments.
Commercial Real Estate is a very simple investment vehicle. The basic premise of making money in real estate is simplified below:
Unlike other asset classes, commercial real estate is typically leveraged with financing. Sure you can purchase stocks on a margin account or commodities at a fraction of their price, but only commercial real estate provides rental income that covers debt payments. This makes commercial real estate an outstanding long-term investment class because as your tenants pay down the financing for you, equity is built up in the asset. Once you no longer have debt payments, your cash return instantly increases multiplying your cash flow multiple times over.
Real Estate also allows for magnified equity buildup on a shorter-term basis by using financing, which is illustrated below. If you were to purchase a $10 million asset all cash and sell the asset in the future at $11 million, you have made $1 million profit, a 10% return.
However, if you were to purchase a $10 million asset utilizing only $1 million of your own money and financing the remaining (allowing the rental income to make the debt payments), then sell the asset, you have also made $1 million profit, however achieved a 100% return.
Investing in a Real Estate Investment Trust (REIT) is a popular way to “diversify” into real estate. However when you invest in a REIT you do not actually own real estate, you own a share of stock in a company.
The following are notable attributes of REIT investing:
High FeesA private REIT can charge up to 17% up front before your investment even touches the real estate. A recent REIT prospectus disclosed the following fees - sales commissions=6.5%, dealer manager fee=3.5%, organization and offering expenses=2.42%, acquisition fees=1.75% and acquisition expenses=0.96%!!! For every $100 you invested, less than $85 actually went towards the real estate! Additionally, a REIT is only required to distribute 90% of the income generated by its properties back to investors, significantly lowering overall returns.
Lower Average ReturnsThe average publicly traded REIT dividend is 3.4%, significantly lower than average returns from direct commercial real estate ownership. Many individual properties can distribute an cash return ranging from 6% to 12% annually
High VolatilityGiven that REIT shares are stocks traded in the stock exchange, they are subject to the high volatility and market shifts of the stock market as a whole.
Lack of ControlThe REIT structure is designed to provide an investment similar to what mutual funds provide for stock investing. Although there is a diversity of assets, there is also a lack of control over which assets are being purchased. Just as many investors have control of investing in individual stocks on platforms like E*TRADE and Scottrade, they now have similar control over their commercial real estate portfolio through RealCrowd.
Less TransparencyAlthough REITs have strict reporting guidelines, most investors know very little about the properties in a REIT portfolio. Direct real estate ownership increases the overall transparency of the investments.
Now that you know the benefits of commercial real estate investing, which assets should you consider? That answer is that it really depends on what your personal beliefs are about the real estate market. The founders of RealCrowd had the benefit of literally thousands of interactions with investors across the United States that purchased office, industrial, retail and multi-family properties and have summarized investors’ mindset for each asset class to the right.
Just like how there are different types of stocks such as growth stocks where shares are expected to grow at an above average rate, there are different types of opportunities in the commercial real estate investment world. A summary of the types of CRE opportunities are listed in the chart on the right.
Commercial Real Estate is an excellent longterm investment that matches very well with a variety of investment objectives. The following is a summary investment objectives by generation.
AbsorptionAbsorption is the way commercial real estate investors gauge tenant demand and is measured in square footage. Total absorption is the total new square footage leased by tenants. For example, if a building had 20,000 square feet of new leases in 2013, its total absorption is simply 20,000. The more relevant metric to view is net absorption which is the total new square footage leased minus the total square footage of tenants that no longer occupy their suites in a given time period. If a building had 20,000 square feet of new leases in 2013 and 5,000 square feet of tenants leaving, its positive net absorption is simply 15,000 square feet. Absorption can be measured by building or by entire markets.
Capitalization Rate (Cap Rate)The cap rate is the percentage of funds you paid for the building that comes back to you annually (not taking financing into consideration). As an example, if you purchased a building for $1,000,000 that returned $60,000 annually, your cap rate is simply 6%.The calculation is $ NOI ÷ $ Price = Cap Rate %
Cash-on-Cash ReturnThe cash-on-cash return is the percentage of funds you invested in the building that comes back to you annually after making financing payments. Your cash-on-cash return is often higher than your cap rate if favorable financing is put in place.
Contract RentContract rent is the current rent being paid by the tenant according to their lease. Contract rents are measured by square footage in commercial real estate. For example, if an office tenant is paying $21,000 a year for 1,000 square feet of space, their contract rent is $21.00 per square foot per year. Contract rents may also be quoted monthly.
Market RentMarket rent is the rental rate that a specific location could achieve if it were available to lease today. Like the contract rent, market rent is quoted per square foot. Investors compare market rent to contract rent to see if there is an opportunity to increase rental rates once a suite becomes available.
Net Operating Income (NOI)The net operating income is the total rental income from all of the tenants, parking revenue, and other revenues minus operating expenses (taxes, insurance, management, maintenance, utilities). The net operating income is one of the first metrics and investor will review/verify because the cash return to investors is paid from the net operating income. Net operating income does not take into consideration financing nor does it include capital improvement costs.
OccupancyOccupancy is the percentage of occupied suites in a commercial real estate property or market. For example, if a 100,000 square foot building is leased and occupied by 95,000 square feet of tenants, the building’s occupancy is simply 95%. Occupancy can be measured in buildings and in entire markets.
VacancyVacancy is the percentage of unoccupied suites in a commercial real estate property or market. For example, if a 100,000 square foot building is leased and occupied by 95,000 square feet of tenants, the building’s vacancy is 5%. Like occupancy, vacancy can be measured in buildings and in entire markets.
Now that you have the broad fundamentals, an understanding of the basic “hows and whys” of commercial real estate investing, and a few key terms at your disposal, you’re ready to move up the line to more advanced topics.
CRE201: Start With Risk is the first entry in RealCrowd’s Valuation Series and your next step in learning how to assess the real estate market and investment opportunities.
Specifically, it will teach you how to think about risk and return—a pair of concepts foundational to the analysis of real estate assets—and cover the following topics:• Risk/return profiles of CRE investment strategies• Factors affecting real estate values• Assessing the value of a CRE asset• Quicksnap analysis of multiple opportunities