An overlooked investment opportunity: Commercial real estate
Key takeaways
- Commercial real estate (CRE) is an asset class that includes investments in industrial, retail, office and multi-family residential properties.
- Annual returns on CRE can be as high as 6% to 12%, compared to 1% to 4% for single-family rental properties1.
- Going forward, the high cost of home ownership and the low supply of affordable rental units are projected – in our view – to keep supporting strong demand and high rental income for multi-family residential properties.
Commercial real estate offers a compelling investment opportunity, but it is often overlooked by investors. This is often due to a poor understanding of the asset class, which is identified as risky and less of a known quantity compared to residential real estate.
In general, commercial properties are intended to be a source of income generation for the property owners. There are four categories of commercial real estate: office space, industrial, retail, and multi-unit residential properties.
Commercial property categorization
Commercial properties can be categorized based on their price level, quality and amenities. Class A commercial real estate are high-end expensive properties in high-demand areas that are relatively new, and built to cater to tenants that can pay premium rents. Class B are generally older buildings, which can however generate high rental income if their owners are willing to invest in restoration and building updates. Class C are generally the oldest buildings, often located in less desirable areas for businesses, and in need of considerable maintenance.
Popular culture may be one of the reasons commercial real estate isn’t well understood. Real estate investing seminars offered to the public more commonly focus on single-family residences, and the “house flippers” and “fixer-upper” TV shows all feature single-family homes. Anyone can relate to getting a property ready for residential tenants, but renting a space for a company or store to use seems to require some specialized knowledge.
Commercial real estate also often requires a larger upfront investment, and the process of obtaining financing can be more cumbersome and technical. All this creates the misperception that commercial real estate is an investment opportunity reserved for the very wealthy.
Commercial real estate (CRE) benefits
Leases for industrial tenants, offices and retail stores may be as long as five years or more, considerably longer than a typical residential real estate rental contract. The lack of yearly and sometimes monthly turnovers can help investment performance by reducing costs. Multi-family residential rentals may experience turnover, but if they are filled at capacity, overall transition expenses tend to be minimal compared to what would happen in a single-family residential rental.
Depending on the lease arrangements, the owners may also be able to pass along all expenses, including property taxes and maintenance costs, to the tenants. In these cases, the mortgage on the property will be the only expense the owner has to meet.
Direct investments in properties are not the only way to gain exposure to commercial real estate as an asset class. CRE can be owned through investment vehicles such as Real Estate Investment Trusts and Commercial Real Estate Investment Funds, which can deliver some of the benefits of ownership without the costs of managing and maintaining them.
Current trends are supportive of multi-family rentals
Both structural and cyclical housing market trends appear to suggest that multi-family properties – among commercial real estate investments – will continue to experience a high demand for rental units. In the US, home ownership continues to be out of reach for many people. Over the past decade, the median price of a home in the United States increased by 30% while incomes rose only 11%2. The disparity is even more stark over longer periods, as home prices, after accounting for inflation, have soared 118% since 1965, while incomes rose only 15%3.
The sizable student debt that many Gen Z, Gen Y and even Gen X consumers are carrying contributes to making home ownership more difficult. Last, but not least, higher interest and thus mortgage rates in 20224 have added yet another reason why home ownership will become more challenging for many.
While demand for rent has increased, affordable rental units are becoming scarcer. In recent years, construction has focused mainly on high-end properties. In 2020, 80% of the new multi-family residential properties – both condominiums and rental buildings — were Class A5. This group of properties is too expensive for most families – according to agencies data, only 4% of the market-rate apartments (those without any rent controls) that were built in the past five years are affordable to households with yearly incomes of $40,000 or less, while 58% are affordable to households with annual income of $70,0006 or less.
Given the relatively inelastic demand for housing from middle- and lower-income consumers, Class B and C properties can be an appealing investment opportunity even in a recession. In addition, social distance habits and rules developed during COVID times have made garden-style apartments – among types of Class B multi-family residential properties – especially popular7, as they provide tenants with outdoor space.
For investors, the steady increases in rents have made owning commercial real estate relatively inflation proof. Since 2005, the average rent for multifamily properties has risen 86.4%, which was nearly double the rate of increase – 46.2% – for the U.S. Consumer Price Index, according to the Bureau of Labor Statistics and Axiometrics.
All these conditions suggest the demand for commercial real estate properties, and the benefits of owning them, may remain strong for the foreseeable future.
Investing in Class B properties through a fund or trust is also intuitively less cumbersome for individual investors than trying to buy the properties outright. Yieldstreet offers various types of commercial real estate exposure, through different products. Check out our offerings here.
Sources:
1 “Pros and Cons Of Investing In Commercial Real Estate,” Nolo.com,
2 “Home prices are now rising much faster than incomes,” CNBC.com, 11/10/21
3 Ibidem
4 https://www.businessinsider.com/personal-finance/best-mortgage-refinance-rates-today-tuesday-april-19-2022
5 Source: “Multifamily Economic and Market Commentary,” FannieMae, February 2020, drawing on data compiled by the real estate analytics firm CoStar
6 Ibidem
7 Source: “Suburban garden-style apartments are 2022’s comeback kid,” REJournals, 3/21/22, citing the commercial real estate broker Cushman & Wakefield to note that the garden-style apartments had a $60 billion influx of capital in 2021, constituting 28% more than in 2017-2019, while outdistancing other styles like suburban mid- and high-rises.
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2 Represents an net annualized return, using an internal rate of return (IRR) methodology, with respect to the matured investments shown in your Portfolio experience, utilizing the effective dates and amounts of subscriptions and distributions to and from the investments, net of management fees and all other expenses charged to the investments.[read more]