When investors review any shortlist of investments, commercial real estate alternatives are likely to be included. The primary example of non-commercial real estate is represented by home ownership — especially owner-occupied single-family homes and individually owned apartments such as condominiums. Most other real property examples are usually classified as commercial real estate.
Commercial property comes in all shapes and sizes — ranging from a small retail shop or restaurant to massive shopping centers and office buildings. As with most investments, long-term success with commercial real estate depends on a combination of factors such as purchase price, proper timing, financing terms and economic conditions. For example, a New York skyscraper located at 666 Fifth Avenue in Midtown Manhattan has recently been in the news due to its purchase price and growing debt problems. This commercial building is one of the priciest in US history — the current owners (Kushner Companies) paid $1.8 billion in 2006 (just before the financial crisis). A balloon mortgage payment of $1.2 billion is due in February 2019.
The visibility of the 666 Fifth Avenue property provides an educational illustration of both risk and reward opportunities for commercial real estate investments. With a $1.2 billion mortgage, a modest appreciation of 10 percent in the property value can produce a 30 percent profit. However, with the vacancy and debt issues now facing the owners, a forced liquidation below the initial purchase price would result in a capital loss.
Commercial Real Estate Categories — 6 of Primary Interest to Most Investors
Commercial real property can be categorized as follows:
- Raw land
- Office buildings
- Retail businesses
- Multifamily housing
- Industrial facilities and warehouses
- Specialized businesses such as golf courses, self storage and funeral homes
- Hybrid combinations such as mixed-use properties: office/retail/multifamily housing
Most professional investment activity involves the last six categories (excluding raw land and construction). Categories like those shown above can be subject to variations due to tax and financing guidelines. For example, multifamily apartment buildings with fewer than four units (duplexes and triplexes) in the United States are often considered to be “non-commercial” by tax jurisdictions and lenders. But for investment purposes, all apartments are usually classified as commercial real estate.
Active and Passive Roles — Commercial Real Estate Ownership and Investing
A key decision for any potential commercial real estate investor is whether a passive or active role is desired. With a passive role, investors do not make decisions about running the business that occupies commercial property. With an active role, an owner and manager of a business needs to worry about increasing sales and making payroll.
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Even with a passive role, an investor must not lose sight of external issues — especially vacancy and occupancy rates. Vacant offices and apartments do not produce any passive income. Many investors remove the need for day-to-day decisions by delegating this task to a property manager. Popular forms of commercial real estate investment such as limited partnerships and real estate investment trusts (REITs) provide additional mechanisms for maintaining a passive investment role.
Commercial Real Estate Advantages and Risks — Due Diligence Is Always Required
The potential advantages of commercial real estate investing include financial leverage, tax benefits such as depreciation, long-term capital appreciation and equity build-up. However, the potential risks are also significant — as demonstrated by the 666 Fifth Avenue example.
One of the earliest opportunities for investors to minimize the potential risks is completing a thorough due diligence review before completing the initial purchase. When an investor is buying a commercial property, the due diligence process includes a detailed examination of expenses and current lease agreements. In the due diligence phase, buyers should review all available information about the properties before completing the purchase transaction.
For buyers interested in contrarian investing for commercial real estate, pay attention to prevailing market sentiment. In order to “buy low and sell high” with commercial real estate investments, it may be necessary to buy when the prevailing sentiment is to sell — and similarly to sell when crowd behavior is to buy. With the 666 Fifth Avenue property, a successful contrarian investor would probably have been the seller rather than the buyer.
About Agora Financial — Independent Market and Economic Insights
Agora Financial provides independent commentary, education and analysis via multiple media outlets — including online and print publications, online seminars, conference calls, videos and international conferences. The company was founded in 1984 and is a subsidiary of The Agora (based on the Greek word for marketplace), a foundation of entrepreneurs and contrarians established in 1979 by Bill Bonner.
Agora Financial is based in the historic Mount Vernon district of Baltimore, Maryland. The company never accepts money from investors or companies in exchange for coverage — the editors of Agora Financial provide unbiased economic and market insights that are regularly featured in national and international news forums. The executive publisher is Addison Wiggin, a best-selling author.