Commercial real estate investing can produce significant returns for investors while providing the security of a physical asset; however, it’s important to distinguish between the types of real commercial real estate as they carry different benefits and strategic considerations. Different property types – or “sub-asset classes” – present their own unique set of risk/reward profiles, which will vary somewhat based on macroeconomic factors and the market cycle. As such, the underlying property types you invest in should be considered with respect to your portfolio objectives and, as with other attributes of your real estate portfolio, diversification of property types will make for a stronger portfolio.

The commercial real estate market is primarily divided into six different asset categories: multifamily, office, industrial, retail, hospitality and development. Macroeconomic factors and shocks impact each category of underlying asset in a different way; each has benefits and drawbacks.

Multifamily

Once lumped in with single-family residential, multifamily is now firmly entrenched as one of the four major commercial real estate asset classes – alongside office, retail and industrial. The asset class now accounts for around one quarter of all U.S. commercial real estate investment, and is occupying a growing share of institutional investor’s portfolios. In this article we take a look at the major advantages to investing in multifamily commercial real estate, and why it is a particularly favorable time for the asset class.

Why Invest in Multifamily Real Estate?

Provides build-in hedge against inflation while reducing risk

While office space, industrial and retail properties typically have only one or a small handful of tenants locked into long-term leases, multifamily properties can have tens or even hundreds of diversely-structured rental agreements, with tenants turning over on a rolling basis. This arrangement provides downside-protection by minimizing vacancy exposure during economic downturns. On the other hand, consistent turnover of leases in a multifamily property allows management to gradually ratchet up average rents in accordance with prevailing market rates and commensurate with the rate of inflation.

Multifamily exhibits low volatility

Multifamily has historically been the least volatile of commercial real estate asset classes. The main reasons are fairly straightforward: whereas markets for office, industrial and retail most closely align with micro and macroeconomic trends, multifamily most closely mirrors demographic trends: where people live, how many, and the demographic makeup of populations within a given market or neighborhood. Clearly economic trends and demographic trends are related, but since residential dwelling is the most essential function of the built environment, multifamily will be less impacted by fluctuations or structural shifts in the economy. As a corollary, we could say that multifamily is more resilient through market cycles.

This holds true empirically: over the past few decades multifamily has exhibited less volatility  – as expressed by standard deviation from mean return – of any major commercial real estate asset class, while yielding the best risk-adjusted return.

Performance of real estate asset classes

Office

The office sector of the institutional U.S. commercial real estate market consistently exceeds $100 billion annually, and attracts capital from both private investors and institutional investors.

Why Invest in Office Real Estate

The asset class provides some of the most stable returns available within the real estate spectrum. The long-term nature of underlying leases (often 5-10 years) provides office owners predictable, stable cash flows. Demand for office space moves alongside employment trends, with job growth typically driving greater absorption rates of office space. This is particularly true with respect to professional services and knowledge-based sectors of the economy, such as legal services, finance, and information technology.

Contemporary Factors in Office Real Estate Investing

The sector has performed well recently, with the NCREIF estimating a 10.3% average annual return from 1995-2015. In the office sector, the preferences of millennials toward office space and the physical setting for work are shaping the thinking of real estate developers and investors. The advent of telecommuting and co-working has introduced fluidity into the space needs of many companies, and reflects demand from young professionals for more workplace flexibility and geographic latitude. Meanwhile, demand for modern amenities and hip, creative spaces dominates design considerations as real estate developers build and renovate existing spaces.  

Industrial

Easily the least sexy of commercial real estate sub-asset classes, industrial real estate is utilitarian and developed largely without design considerations. Industrial assets tend to perform reliably, with tenants often signing long-term leases, and engaged in more tangible, space-intensive activity than the industries that occupy space in the office sector. Whereas office tenants look for things like exposed brick, accessibility to boutique retail and living, and attractive facades, industrial tenants look for sufficient clear heights for storage, modern fire suppression systems, and access to shipping routes.

Opportunity in the industrial sector is created by demand for physical products, agglomerative economies of scale in manufacturing, R&D, and production of raw materials. Often, favorable tax conditions in local jurisdictions create favorable conditions for industrial space, stoking demand among tenants who are expanding warehousing or manufacturing operations. In some cases, macroeconomic policy, such as adoption of protectionist or liberal trade policy, can impact demand for industrial space, impacting the flow of goods and materials produced and stored in industrial space.

Contemporary Factors in Industrial Real Estate Investing

Much like other sectors of the commercial real estate market, Industrial is impacted by technological advancements and shifting preferences.

Ecommerce – While ecommerce presents a real challenge to traditional retail, it has been a boon for investors and developers of industrial space. As online shopping supplants traditional retail across almost every retail subsector, traditional retailers who have modernized, and the tech upstarts who have disrupted the space, all require greater industrial space for storage and distribution.  

Cannabis – As more and more states legalize or partially legalize marijuana use, demand grows for industrial spaces devoted to the production, curing and distribution of cannabis, often with accompanying onsite business administration. These tenants require modernized fire suppression, watering, climate control, and security systems. Because cannabis products remain illegal at the federal level, and due to interstate commerce laws, many traditional lenders and even institutional investors are unable to or are uninterested in investing in industrial spaces tenanted by cannabis companies. As such, there is substantial opportunity in the space.    

Retail

Demand for retail space is driven by consumer spending, which accounts for around 70% of U.S. GDP (gross domestic product). Hence, the retail sector of the CRE market moves closely with the overall economy, with consumer confidence as a powerful leading indicator of performance. While consumer spending tends to move fairly uniformly over the economy, savvy real estate investors in the retail space will look to diversify tenant mix, to mitigate the effect of reduced demand in any one retail vertical.

You can’t talk about retail commercial real estate without talking about the vast impact ecommerce has had on the sector. News of ecommerce’s ascent – and the consequent demise of physical, brick-and-mortar retail – dominate industry headlines. However, reports of the death of traditional retail remain greatly exaggerated: ecommerce transactions still hover around just 10% of total retail activity in the U.S.. While retail-focused REITs have exhibited sub-par performance lately, the sector overall continues to perform in line with other CRE sub-asset classes. Rather than destroying the market for physical retail space, ecommerce has rather altered demand for retail space in more qualitative ways. Consumers now demand more omnichannel, integrated shopping experiences, where price comparison, in-store pickup, returns, and checkout are all facilitated by technology (particularly mobile devices). While the car-dominated retail paradigm of malls and big-box stores has suffered in recent years, boutique storefronts in urban areas have thrived. This aligns with changing preferences in the multifamily market, where urban walkability and accessibility has been favored more and more by affluent millennials. Still, as ecommerce grows as a percentage of overall shopping transactions, retailers and investors in retail space must be mindful of changing consumer preferences.

Hotel/Hospitality

This sub-asset class is subject to far and away the most fluid leasing environment of any in commercial real estate. Whereas industrial, office or retail tenants typically sign 5 or 10 year leases, and multifamily tenants are locked in for at least a year at a time, hotel rooms are booked by the night, with two-night minimums and non-refundable time periods the only protections for the hotel operator as lessor. As such, the NOI and profitability of hotels are very sensitive to local demand shocks. In many areas the hotel business is seasonal, with demand waxing and waning alongside the weather, recreational opportunities, college campus activity, and industry conferences or other events.

As with other sub-asset classes, technology has created opportunity for savvy investors and developers. Opportunities for more streamlined operations, better marketing, and dynamic room pricing can all create lucrative value-add situations.  

Demand in the market for hotel rooms is driven primarily by business travel and tourism. Opportunistic hotel investors may find yield by acquiring hotel assets as a metro area is transforming; the arrival of new, large businesses, the emergence of foodie or art scenes, and demand for single-family homes (and subsequent increase in out-of-town visitors) may all drive greater demand for hotel rooms over time. However, like all other assets, the preferences of millennial professionals is upending the traditional hospitality paradigm in many markets. Boutique hotels have emerged in some markets not just as a place to sleep while traveling, but as a major impetus for travel in and of itself, with hip bars, restaurants and common areas, and tastefully-appointed interiors. The Ace Hotel in Palm Springs and the Doug Fir Hotel in Portland, OR (adjacent to the eponymous music venue) are two examples.

While cap rate and NOI still apply, the return metrics associated with hotel investing are unique:

Price Per Key is the purchase price divided by number of active rooms.

Average Daily Rates (ADR) measures the average per-room income for a given period of time, calculated as “room revenue earned” divided by total rooms sold over the time period.

Revenue Per Active Room (RevPar) measures total revenue per rented room, calculated as Occupancy Rate x ADR.  

Conclusion

All sectors of the commercial real estate market in the United States are being transformed by technology, and heavily influenced by the particular preferences of the millennial generation. On a basic level, all are driven by macroeconomic trends and local demand drivers. The long-term aggregate prospects of all real estate classes are inextricably linked to the performance of the U.S. economy at large. However, savvy, experienced real estate developers and investors can find opportunity with the right asset in the right place at the right time, regardless of position in the market cycle.

As an individual investor, look for Sponsors and developers to co-invest with who are experienced within the sub-asset class and market.

 

By EQUITYMULTIPLE Staff
EquityMultiple's team features real estate industry veterans, technology-driven analysts, and dedicated armchair economists.
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