Commercial real estate (CRE) has been a popular asset class for investors for quite a while. It encompasses office buildings, shopping centers, distribution centers, and multi-family properties. CRE offers investors the potential to generate income, appreciate in value over time, and diversify their portfolio. With rising interest rates, remote work trends, and a variety of economic conditions, many investors are asking, “Is it still worth the risk?”
CRE’s Appeal
Unlike residential real estate, which is targeting individuals and families, commercial real estate targets businesses. This can lead to greater rental yields, longer leases, and the opportunity for professional management. Benefits:
- Consistent cash flow from long-term leases
- Potential hedge against inflation by leasing an asset to a business that will increase rents as their market rates are increasing
- Diverse types of commercial real estate properties (office, retail, industrial, mixed-use, etc.)
- Tax treatments (1031 exchange and depreciation (in the U.S.))
Dangers in the Current Market
1. Office Space Decrease
The pandemic provided impetuousness towards the remote and hybrid work model, resulting in a substantial decrease in demand for traditional office space. Even in major cities, vacancy and availabilities increased while companies shrank their office space footprint.
2. Interest Rate Increases
Central banks worldwide recently raised interest rates in order to combat inflation, which may impact:
- the ability to get loans
- the valuation of property, and
- the return for investors in the property
- Higher borrowing costs will result in higher costs when financing acquisitions, and lower profit margins.
3. Retail Itself
E-commerce continues to disrupt brick and mortar, especially for the non-essential. While some of these segments remain strong, such as discount stores or experiential retail, others will not survive.
4. Tenant Risk and Market Disruption
Commercial tenants may default or go out of business, which is even more likely in an economic downturn. As compared to residential leases, it often takes longer to replace a commercial tenant, and when one is transitioning from the previous tenant to the new tenant, there are often significant build-out costs and tenant concessions.
Opportunity Remains
Despite the risks, many sectors to be involved in commercial real estate are holding up, and in fact thriving:
- Industrial Estate: Due to logistics and e-commerce, there is a significant demand for warehouses and fulfillment centers.
- Multifamily: The demand for rental housing will be strong because of homeownership costs.
- Medical and Life Sciences Buildings: Some segments of healthcare infrastructure provide long-term reliability with consistent demand.
- Data Centers: Cloud computing and AI is driving the demand for real estate which is tech infrastructure.
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Should You Invest?
Here are a few things to consider:
- Level of Experience: Commercial real estate is not an indicative as a beginner-particularly when you consider due diligence, vetting tenants, structuring leases, and managing property. These activities are much more complex than in residential real estate.
- Risk Factors: Market cycles, tenant turnover, and unplanned expenses can affect your returns. Are you sensitive to these types of risks?
- Access to Capital: Commercial real estate usually requires a large capital expenditure and financing arrangement. Be confident your cash flow can service interruptions before you make a decision.
- Investment Horizon: A long-hold strategy tends to win in commercial real estate. If you are seeking to flip something quickly… this is likely not the asset for you.
Other Options for Investing in Commercial Real Estate
- Real Estate Investment Trusts (REITs) – A publicly traded entity investing predominantly in commercial real estate that can liquidate quickly and provide investment in commercial assets.
- Crowdfunding Platforms – These platforms allow investors to pool money and participate in large developments with a smaller minimum investment than direct participation.
- Private Equity Real Estate Funds – These funds seek only accredited investors for institutional or institutional-grade investments.
Final thoughts
Commercial real estate investing can be a very high reward but, also, a very high-risk form of investment. It can provide benefits like cash flow stability and diversification of your portfolio but the risks of economic cycles, industry demand or need changes, and rising costs still apply. Success requires research, knowing your market, knowing and selecting the right asset, and long-term thinking. If you can accept change and complexity and can manage the risk, commercial real estate may provide you a legitimate investment option. As always, please seek professional financial and legal advice before engaging in commercial real estate.
Written by Pranjal Data
