Here’s a thought exercise you can try the next time you’re visiting a new city: take a deliberate look at the urban landscape and compare it to where you live now or even where you grew up. Do you see distinct districts of office space and residential? Or, do you find small houses peppered in among the retail shops and attractions? Is the city divided into pockets, each with their own balance of commercial properties?
There are countless ways that cities can develop all over the world. Domestically, a city’s zoning authority has a lot to do with what gets built where. But if you look closely, you can see the pattern of development that occurred before that authority was created. Historic building preservation, landscape, industry, and geology affect the city’s layout regardless of any zoning restrictions.
Now, think about how you would invest in commercial real estate if you lived in that city. How is it different from the strategy you’d apply in your own? It may seem like a silly suggestion, but exercises like these can stimulate outside-of-the-box thinking and lead to a stronger, more diversified portfolio. If you’re thinking of adding to your CRE investments or moving forward with your first commercial property, read on. We’ll review the four main commercial categories and take a look at how applying various investment strategies can create very different opportunities for return.
Although commercial properties come in many shapes and sizes, they break down into four essential categories. If you’ve been looking into CRE, these will already be familiar, but let’s focus on each category’s potential and challenges. Keep in mind that an individual category will have tiers of property classes (A, B, C, and D) that will alter its opportunities for return within that category.
The downtown business district highrise, the suburban office park, and the Victorian three-story now housing the local law office are very different examples that fit into the same category. The value of an office property, when you’re looking at financing, is based on its earning opportunity and occupancy rates. When you invest in offices, it’s important to understand projected job growth in the area to help you determine occupancy potential.
Industrial properties are usually clustered together away from residential spaces. Because of their potential for noise, volume of waste, and need for access to major thoroughfares (including highways, waterways, and railways) you’ll find them on the outskirts of town. Warehouses, factories, R&D, distribution centers, and other industrial properties can be harder to lease out, but require less overhead and capital investment. You don’t need the amenities you would expect in an apartment building, for example.
It’s not always clear where the boundary lies between what is residential property and what is commercial when it comes to housing. As a general rule, multifamily rentals are any properties where the owner handles maintenance, finding tenants, and general leasing duties. This is a good category for beginning investors as multifamily rentals are easier to finance and faster to close.
Retail properties work a lot like offices but are typically open to commercial foot traffic. This category includes restaurants, strip malls, grocery stores, boutiques, and big box stores. Retail spaces are leased from the owner, just like offices and multifamily rentals. They offer a high return rate, but are less stable investments.
The Four Strategies
CRE investors are always concerned with two things: risk and return. Finding the right balance between them is a matter of preference, but ultimately decides how successful the investment will be. Risk and return have a positive correlation, meaning that the higher risk properties also offer the highest potential returns. These investment strategies can be used for any CRE category and one company can (and should) use a different one for each property in its portfolio.
The core strategy (a.k.a. “buy and hold”) favors yield over appreciation. It’s the most stable strategy with the lowest gains. This strategy is a good go-to for investors with short to medium timelines. The higher tier, Class A properties represent a low ongoing capital investment, but any vacancies will suck revenue due to the intense repayment schedule over the first decade or more in operation. From a lender’s perspective, core investments are low risk, which means interest rates can stay low as well. Expect 10% or less annual ROI when you use this strategy.
The core plus strategy involves slightly more risk than core. This is the strategy to use with properties that need some minor capital investment before they reach peak profitability. Think upgraded amenities, repairs, and maintenance. Investors who are in a rush shouldn’t go with the core plus strategy as it’s more suited to a medium-term timeline. Typical annual ROI is around 10%-12% and lenders will want to see that you have the means to bump up the quality of the property to make it profitable.
Again, this strategy is a step up from the last one with respect to risk and return. It applies to properties that will need five to seven years of capital investment. However, they can provide a foot in the door to richer markets. Value added property investment requires bringing a property up in asset class by making renovations and boosting vacancy rates. These are significantly more impactful improvements over what you’d see with a core plus strategy. It can be harder to secure funding for value-added properties but the annual ROI goes up to 13-20%.
CRE investors looking for the highest rewards and who can tolerate the most risk will choose the opportunistic strategy. It’s not typically a go-to for beginning investors. If the core strategy can be described as “buy and hold” then the opportunistic strategy is “fix and flip.” On top of procurement capital, investors will need construction or property improvement funding as well. This can mean financial products like term-to-perm loans and bridge loans. An average annual ROI for the opportunistic strategy is above 20% but it will require a game plan for growth and expansion, given that a hot market can quickly gobble up properties that are ready for redevelopment.
In any given market, the opportunities in the four categories may be unique from other markets. Housing could be opportunistic while retail could be core. Alternately, a trend in redevelopment could mean that an opportunistic business could operate across residential and commercial properties in multiple districts. Financing is based on the viability of the strategy in the market your business is targeting.
Investors who don’t see the opportunities they want in a chosen strategy can tap into developers and property managers to create them. Selecting a location for development requires data-driven market research of primary and secondary markets, infrastructure assessment, sophisticated GIS mapping, and cost analysis. Lenders will want to see evidence of thorough planning before they’ll agree to fund construction. However, it can be worth the time and investment in planning to have more control in high-cost CRE markets.
Regardless of which investment strategy you use from core to opportunistic, you’ll need financing. As you can see from the summaries in this article, getting that financing will vary between the strategies. Unless you’re an expert in financing strategic deals, you’ll want someone on your team who is. A commercial loan broker brings the market experience and financing network to help you close deals fast, at the right cost, and with the right terms to advance your business based on your goals and objectives. Building a relationship with a loan broker is instrumental in finding the right financing for each strategy you choose to take on. Compare terms across lenders, get insights and professional packaging so that you can close with confidence. Contact our team today.