What is the Best Commercial Real Estate Investment?

While residential real estate typically comes to mind when many hear “real estate investing,” commercial real estate is where many can find unique investment prospects. But which one is the best for your circumstances? Below, we demystify this landscape, explaining the types of properties available, their potential returns, and risk factors. Whether you’re a seasoned investor or new to the game, understanding the dynamics of commercial real estate is crucial to making informed decisions that align with your investment goals and risk tolerance.

Commercial real estate includes offices, retail locations, warehouses, and apartment or housing complexes with five or more units. Earning income in commercial real estate typically involves renting out these spaces to businesses, which can have advantages like longer leases, higher rental returns, and greater value appreciation than residential property. However, this sector ordinarily requires larger upfront investments, entails more intricate management tasks, and tends to be more vulnerable to economic shifts.

Types of Commercial Real Estate Investments

Before investing in commercial real estate, it’s important to understand the different types of commercial real estate out there. Typically, commercial real estate is broken down into four categories:

• Office
• Industrial
• Multifamily rental
• Retail

You can break down each category further. For example, retail includes stand-alone stores, strip malls, restaurants, big-box stores, fitness facilities, family entertainment centers, regional malls, and large shopping complexes.

Commercial real estate, especially with offices or residential units, can be assigned a class, which describes its age, location, and condition. There’s no governing body overseeing the classification of properties, so it’s more loosely done through a consensus among developers, brokers, agents, appraisers, and analysts in a local real estate market.

• Class A buildings are the newest, are in the best location, and require little maintenance. These are premium properties with high-quality design, construction, and finishes; amenities that come with the property; superior accessibility; and immediate marketability. Class A properties attract high-quality tenants and obtain the highest rents.
• Class B buildings are a bit older and may not be in the best locations. These are a step down from class A regarding location, amenities, design, and overall condition. While they are still good quality, these command lower rent rates than class-A properties, which makes them accessible to a broader range of tenants. They’re also popular with investors looking to improve a property they can sell for a profit.
• Class C buildings are the oldest, often over 20 years old. If they are newer, their design, construction, and amenities are average, at best. They are usually in far less attractive areas and may need major renovations and repairs. Vacancy rates may be high, and if the property contains multifamily housing, tenants may have lower credit scores or unstable income streams. These properties are often bought to raze, convert, or redevelop to improve their condition.

Office

Office real estate is largely self-explanatory. They include high-rises downtown, midrise buildings in suburban areas, medical offices, and single-tenant office buildings. Offices may be used for specialized purposes, such as a small laboratory, a remote distribution facility, or a dentist’s office.

The office real estate market has undergone a massive shift since the pandemic. The rise of remote work has led to major vacancies and declines in the value of office leases. According to a December 2023 study by Commercial Edge, a national commercial real estate consultancy, office utilization remains at about 50% to 60% of pre-pandemic levels. Instead of sales and rentals improving as we get further away from the pandemic’s peak, both Commercial Edge and McKinsey conclude the opposite in their 2023 studies of this market. At the end of 2023, office real estate sales were just 38% of 2022 year over year. The national office vacancy rate remains stubbornly at just over 18%.

More generally, McKinsey says, demand for office and retail space will remain below pre-pandemic levels. In its “moderate scenario,” the need for offices, even with expected increases in population, will be 13% lower in 2030 than in 2019. Its “severe” scenario could see it decline by more than 35%. This makes office space a risky investment. If remote work remains the norm, office real estate may not recover or must be repurposed, which can be costly. In the meantime, loans may come due before per-space leasing rates rebound, increasing foreclosures, further pushing up vacancy rates, and pushing down per-square-foot values.

Industrial

Industrial real estate refers to buildings and properties that are used for manufacturing, larger shipping facilities, or logistics. For example, warehouses, factories, and locations used for assembly would all qualify as industrial real estate.

A benefit of industrial real estate is that leases tend to be long-term and steady, making them more predictable for investors. However, many industrial properties need to be customized for specific uses. If a firm ends its lease, the property may need major updates to attract new tenants. The properties are also typically large and reliant on a single occupant, making it harder to diversify among multiple tenants.

Industrial real estate has been one of the better-performing classes of real estate in the early 2020s. The National Council of Real Estate Investment Fiduciaries (NCREIF) tracks the performance of different real estate investments. According to its index, industrial real estate fell 5.3% between the fourth quarter 2022, and the third quarter 2023, compared with a decline of 8.39% for all commercial real estate during that time. The National Association of Realtors, in an October 2023 report, notes similar findings but points out that there’s also been a 43% increase in square footage over the past year in the industrial real estate market, a far cry from other areas of commercial real estate seeing declines. Rent for warehouses and logistics facilities in 2023 had the strongest increase in recent years, though further growth could be tempered if the economy slows.

Multifamily Rental

Multifamily rental properties are apartment buildings, townhouses, and multiunit properties like high rises in urban areas. They are where people live for the long term (they count as residential only if there are four or fewer units), so they also include condominiums and mobile home parks. Multifamily homes, including duplexes, triplexes, and quadplexes, may be included in this type of property, though many lenders allow typical residential mortgages to purchase smaller multifamily homes.

According to the NCREIF’s property index, apartments have slightly outperformed other commercial properties, falling 7.55% compared with a fall of 8.39% for all commercial real estate between the fourth quarter of 2022 and the fourth quarter of 2023. This decline is in large part because of the national slide in rents. The median rent peaked in August 2022 at $2,054 and was $1,967 as of December 2023.

Retail

Retail properties are those used by companies that sell goods or services to consumers from a physical location. Retail includes supermarket shopping centers, strip malls, community centers, big-box locations, regional malls, restaurants, athletic clubs, and family entertainment centers.

According to the NCREIF Property Index, this has been a top-performing segment of the commercial real estate market, falling just 1.39% compared with an overall fall of 8.39% for commercial real estate between the fourth quarter of 2022 and the third quarter of 2023.

Special-Purpose Commercial Real Estate

Hospitality Commercial Real Estate: This sector includes hotels, motels, extended-stay hospitality, and resorts. The focus is on short-term stays, with amenities varying from basic in motels to luxurious in high-end hotels. The value of investments in hospitality real estate depends on location, tourism trends, brand affiliation, and operational management. The sector can be highly cyclical, with revenues fluctuating according to the season and macroeconomic factors. An October 2023 report by the National Association of Realtors says that the average daily rate for rooms is 17% above pre-pandemic figures, and revenues are up 13% over the same period.

Senior Living Housing: This heading captures very diverse forms of housing, from multi-unit residential complexes for communities of older adults, to assisted living and independent living communities designed with special amenities and services for older adult residents with disabilities and other needs, to skilled nursing facilities run more like hospitals than residences.

This sector, catering to the aging population, offers distinct prospects and challenges for investors. By 2030, all baby boomers will be older than 65, and one in five U.S. residents will be 65 or older. By 2034, older adults will outnumber children for the first time in U.S. history, according to U.S. census data. Properties that cater to this major demographic provide stable revenue streams, as the demand is driven by demographic trends rather than economic cycles. They can be especially attractive as investments in areas where the population is aging most.

Factors to Consider in Commercial Real Estate Investments

Investing in commercial real estate requires careful due diligence and a meticulous analysis of factors determining success or failure. A primary consideration in all commercial real estate is the property location, a quality that greatly impacts its value and utility.

For example, a plot in the middle of a major city might be well-suited for an apartment building or retail space but wouldn’t work well for industrial use. A property in an industrial neighborhood might be a good location for a warehouse.

Equally crucial is understanding the zoning laws, which dictate acceptable property uses and may place constraints on how many units can be put in an apartment complex or how many parking spaces per unit you must have.

An important undertaking to do would be a market trend analysis. A growing population in the targeted area suggests a rising demand for real estate, enhancing investment prospects. Alternatively, a declining demographic could pose challenges to achieving investment success.

A financial assessment should include calculating initial capital requirements, foreseeable ongoing expenses, and your choice of revenue strategies, whether capital appreciation or rental income. Consider the implications of tenant turnover and changes in interest rates. Detailed financial planning and commitment to a budget are important elements of a successful investment strategy.

Most Profitable Types of Real Estate Investment

As an investor, you aim to find the most profitable investment opportunities and take advantage of them. While there’s no single answer in each market for each person regarding which real estate investment will perform the best, there are some things that you can watch for.

Generally, the more tenants you can have, the more profit you can expect. Losing one tenant won’t impact your bottom line as significantly as having fewer tenants. You may also see greater profits from properties that require less investment and infrastructure. For example, residential vehicle parks and storage facilities offer high returns. Both allow many tenants but lack the infrastructure and maintenance requirements of a large apartment building.

Some types of retail and industrial real estate can also produce great returns. If you can find tenants who sign triple net leases, meaning that the tenant handles rent, real estate taxes, and property maintenance, you can avoid much of the cost of owning the property while still earning an income.

Some properties, like flex industrial space, are generally considered lower risk. This is because of tenants’ relative stability and the properties’ flexibility.

Recently, office buildings have been among the worst-performing types of real estate, largely because of changes in work habits during the pandemic. Nevertheless, many factors impact the real estate market, and the performance of different properties is likely to change over time.

Benefits and Risks of Commercial Real Estate Investing

Before you invest in commercial real estate, you should consider the pros and cons. Commercial real estate can offer consistent income and growth prospects but is subject to the whims of the real estate market and the economy.

Pros

• Consistent returns. Commercial real estate investors receive regular rent payments, meaning they can see consistent returns.
• Passive income. Commercial real estate investments can be passive, especially if you are relying on an investment fund or property management company.
• Capital appreciation. In addition to consistent rent payments, commercial properties can increase in value, offering two forms of return.
• Leverage. Many investors rely on loans to help fund their real estate investments. That use of leverage can increase return potential but can also increase risk.

Cons

• High costs. Commercial real estate can be costly. Many investors may need to pool funds with others or rely on debt to purchase a property.
• Market fluctuations. The real estate market can be highly volatile. Investors could face high vacancy rates, such as the currently high vacancy in office buildings and a drop in the value of the properties they own.
• Property management. Effective property management is essential for success. That means learning how to oversee and maintain the property and your tenant relationships or finding a trustworthy company to handle these tasks.

Tips for Successful Commercial Real Estate Investing

Tips for success in commercial real estate investing would include, first, seeking out diversification. If you only own a single property with a single tenant, you are relying entirely on that property and tenant for success. You could face financial setbacks if the building loses value or the tenant stops paying.

Diversifying by either investing in several properties or buying one with multiple tenants to reduce risk. You can also diversify by looking at other kinds of real estate investments, such as commercial real estate investment trusts (REITs), which are traded like stocks but must provide 90% of their taxable income in dividends annually.

Getting to know real estate investors and professionals in your area is also a good idea. You can leverage your network for knowledge of local opportunities and connections to contractors and others who can help with building upgrades and maintenance.

Finally, before committing to any deal, do your due diligence. Run the numbers on the deal to make sure there’s a good chance of turning a profit. Lastly, consider the worst-case scenario and how you would recover from it.

The Bottom Line

Commercial real estate includes office buildings, shopping malls, and apartment complexes. Like all real estate, it’s important to consider location and market trends before investing. Do your due diligence, have a plan for handling a downturn, and, finally, if need be, ensure your investment aligns with your financial goals and speak with a financial advisor before traversing further into this landscape.