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We won’t tell you that investing in commercial real estate is a guaranteed path to wealth. But we can say that property ownership is a proven and time-tested way to make money. Consider this: The Forbes 400 list of billionaires includes more than a few commercial real estate tycoons.
There’s a good reason for that.
The property sector offers generous rewards for those who are willing to put capital at risk. Through positive cash flow, healthy value gains and favorable tax treatment, commercial real estate investors can reap life-altering gains.
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Commercial real estate is a broad category that includes any type of real property used for business purposes. Office, retail, and hotels are among the largest and best-known categories of commercial real estate. In other words, if you go to a workplace, shop, and take vacations, you’re a customer of commercial real estate space.
Other commercial real estate property types include industrial and warehouse space, apartments, medical offices, self-storage, and data centers. Some users of commercial real estate occupy buildings that they own. But in most cases, the businesses operating in commercial properties are tenants who pay rent to the investors who own the property.
Commercial real estate ownership varies. The largest, most expensive properties typically are owned by institutional investors, such as real estate investment trusts or pension funds. Smaller properties tend to be owned by individual investors. There are many methods investors can use to create exposure to commercial real estate.
An investor can make a direct purchase of an office building, a retail property, a warehouse, or a multifamily project. Investors also can take a smaller stake in a single property via crowdfunding. Or, an investor might purchase shares of a real estate investment trust, which pools a portfolio of properties and then sells the portfolio to investors.
An investment in commercial real estate involves purchasing a physical property or taking an ownership stake in one or many pieces of real estate. Buying into commercial real estate gives investors an opportunity to make an educated bet and, ideally, to share in some of the gains generated by the overall economy. Here are five persuasive reasons to consider adding commercial real estate to your portfolio:
Successful property investors do very well for themselves. They can make money in two primary ways – by collecting monthly rents and by selling the property for a gain. Let’s take a look at the first way of making money: So long as your rent collections exceed your costs of ownership, you’ll have what’s known as positive cash flow.
In other words, the property is bringing in enough money to pay the mortgage and any other monthly and annual expenses. And if your tenants have triple-net leases, they pay the costs of property taxes, utilities, and insurance themselves.
Commercial tenants typically sign leases for a period of years – often five years, but sometimes 10 years or even longer. These long-term commitments from tenants provide peace of mind to property owners. If your tenant roster is filled with companies that boast extended track records and healthy business models, chances are they’ll keep making their rent payments for years to come.
A landlord who has built a strong roster of tenants – companies with stellar credit histories and stable track records – can reap steady rental revenues over a period of years.
Leasing space to multiple tenants creates diversification and mitigates risk. In other words, even if one or two tenants move out at the end of their leases, or if a tenant suffers a business failure and stops paying rent, the investor has a reliable rental stream from the remaining tenants at the property.
The brief but dramatic recession of 2020 underscored the stability of rental incomes for landlords: Even as government lockdowns temporarily closed many offices and retail locations, tenants kept paying their monthly rent.
One of the beauties of triple net leases is that landlords can transfer nearly all of the costs and uncertainty onto tenants. A well-maintained property filled with thriving tenants makes life easy for the investor who owns the building.
The landlord makes sure everything continues to run smoothly at the property, but in these dream scenarios, there’s not much for the owner to do beyond collecting rent checks and building equity as the property value appreciates.
That brings us to the second way commercial real estate investors make money. Value gains can be a dramatic way to create wealth. In most property types and in many markets, commercial property values have surged in recent years. An investor who holds a property for several years builds equity as tenants’ rent payments cover the mortgage payments. If the landlord believes values are peaking, the owner can exit the asset and roll the proceeds over into another investment.
Savvy investors cash in on the value of leverage. Here’s a simplified example: Say you pay $2 million for commercial property and resell it five years later for $4 million. Sounds like a 100% return. But if you made a down payment of $500,000 for the property and took a mortgage for the rest, your return is magnified to 300%.
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Rising prices are officially back as an economic challenge. Inflation has risen to its highest levels since the early 1980s. In January 2022, the official rate of inflation in the U.S. surged to 7.5%. Commercial real estate is considered a reliable hedge against inflation.
In a period of rising prices, owners can command higher rents when negotiating leases, and they can get higher prices when it’s time to sell. But inflationary periods typically correspond with higher interest rates for commercial mortgages, a reality that increases an investor’s cost of borrowing.
The pandemic-era bout of inflation presents a novel scenario – during the last period of inflation, such factors as commercial mortgage-backed securities, real estate investment trusts, and crowdfunding weren’t major factors in real estate markets. In the modern era of property investment, it’s anyone’s guess how inflation will affect the real estate industry. Still, history provides a guide. Here’s an overview:
This is especially true if the inflationary cycle is being driven by burgeoning demand and a booming economy. If, however, rising prices are spurred by a jump in the underlying cost of goods, landlords might not have as much leverage to negotiate higher rents. Standard inflation clauses typically are written into leases in a way that protects landlords’ interests by automatically tying rent to the consumer price index.
Tenants will accept rent increases only to the extent that demand for space exceeds supply. In an economically moribund geographic area, rents are unlikely to soar. The same goes for property types. Since the start of the pandemic in 2020, shopping malls have experienced an ongoing decline in demand amid the rise of e-commerce. Office space is a mixed bag -- some employers insist they’ll continue to occupy offices after the pandemic, while others eagerly embrace permanent work-from-home arrangements.
Medical office space is an exception – it has proven quite stable across real estate cycles. Other property sectors have experienced more demand than supply. These include warehouse and distribution space, multifamily properties, and grocery-anchored shopping centers.
In this self-perpetuating cycle, more money chases properties than there are properties available to buy, and prices move higher. Inflation creates a common-sense reason for property prices to rise: If building materials cost more today than they did a year ago, the replacement value of any existing building is climbing. This is another reason inflationary conditions push property prices higher.
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Savvy real estate investors know there are a number of perfectly legal tax benefits that reward property owners, and they make these incentives part of their calculations. Real estate investors can take advantage of numerous tax breaks and deductions.
Owners generally can deduct the reasonable costs of owning, operating, and managing a property. Depreciation is another tax consideration – the IRS allows commercial property owners to write down the value of commercial buildings over a period of 39 years. By counting depreciation as an expense against taxable income, real estate investors reduce their tax liabilities. The tax benefits continue even if you sell a property for a hefty gain.
You can defer capital gains taxes through a 1031 exchange, an IRS-approved tactic that lets an investor delay the tax bill related to sales of commercial real estate, so long as they roll any proceeds into a similar property within a given period of time. It’s important to remember that the U.S. tax code is endlessly complicated, so be sure to consult with a tax professional about how these tax breaks apply to your unique situation.
At the most basic level, diversification means spreading your bets across asset classes – so if stocks fall, commodities tank or cryptocurrency grows frothy, your portfolio includes other investments that don’t move in lockstep.
As an asset class, commercial property returns don’t necessarily follow other asset classes. Real estate’s correlation with stocks and bonds is low—and, in some cases, it’s an inverse relationship.
Allocating real estate to a portfolio of diversified assets can mitigate overall volatility, and ultimately generate a higher return per unit of risk. Real estate ownership also is atypical in that it gives you direct ownership and control of an asset.
While stocks, bonds, and commodities are worthy asset classes, commercial real estate adds a different type of ownership to your holdings. What’s more, well-managed real estate in a steady sector such as medical office space can provide stability to a portfolio.
It might sound too good to be true, but tenants willingly will foot a large chunk of the costs of maintaining and improving your property.
The most common form of a lease agreement is the triple net lease, which allows the landlord to pass on to tenants the costs associated with the property. Taxes, insurance, and maintenance become the financial burden of the tenants occupying the property. If local authorities increase property taxes, the additional cost is the tenant’s responsibility. If insurance premiums rise in response to weather events or other factors, tenants are on the hook.
And if the costs of routine maintenance and building repairs rise, the tenant bears the increase. In an inflationary environment such as that of 2021 and 2022, triple net leases allow landlords to shift some or all of the risk of rising prices to tenants.
By passing variable expenses onto tenants, the investor gains some protection from unexpected increases in the costs of operating commercial real estate. And most tenants really don’t want to be in the real estate business, so they’re happy to let you bear that responsibility.
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Whether you’re worried about the corrosive effects of inflation or just want to add some diversification to your portfolio, commercial property is a smart bet. Commercial real estate mints many millionaires, and a few billionaires: It’s a solid way to generate healthy returns.
That’s not to say that any of this is easy. Commercial real estate is a highly competitive marketplace, one that poses plenty of risks to go along with the rewards.
However, by tapping into the combination of positive cash flow, robust appreciation, and favorable tax treatment, savvy, experienced investors can enjoy consistent gains.
Are you looking to learn more about investing in commercial real estate? Contact us today!
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