Commercial Real Estate Asset Classes (or Property Types) explained
| January 24, 2019
The real estate industry is divided into residential and commercial sectors.
The residential sector focuses on properties used as homes or non-business purposes. Residential properties are usually valuated in square feet or meters.
Commercial real estate can be broken down into four main categories, also called “asset classes” or “property types”: multifamily, office, retail and industrial assets but also smaller categories such as hospitality, land or mixed use with specific characteristics. Each one having pros and cons for both investors and tenants.
Multi-family properties consist of residential properties with at least 5 units such as properties used by multiple family groups. Leases are usually short-term (1 or 2 years), which benefits the landlord as he can adjust rent with the market rate at the end of the lease. Multi-family properties are defined by their location, either urban or suburban but also their size, and category. This can be either A, B or C according to the quality of the building and the services included. This market is driven by economic factors such as demographic trends and local employment growth. Investing in multi-family properties is called a defensive investment as it aims to minimize risk, which is in this case low since having a place to live is a primary need for everyone.
Office properties cover a wide range of buildings, from single tenant properties designed for offices to multi-tenant buildings. Leases are typically negotiated for a long-term period and can include a building purchase option. In long-term leases, the total rent is often locked at the initial negotiated rate for the whole period and doesn’t consider market changes. Significant adjustments can therefore occur when leases expire. Economic drivers are employment growth, as well as local economy state (some industries are concentrated in one region). Commercial real estate investments in office buildings present a risk: an economic crisis may lead to the bankruptcy of the businesses. To avoid such a disaster, investors can rent their office to multiple tenants, so that the risk is split amongst them and one single tenant cannot therefore endanger the whole investment if he remains unable to pay.
Industrial properties include all properties designed for industrial purposes. They go from small buildings of 1 unit to big warehouses. Usually, the smaller ones (used for R&D for instance) are difficult to re-tenant as they have been built according to the needs of the first tenant. Big warehouses, in comparison are used for distribution or manufacturing, and are easier to adapt to. As for the retail and office sectors, leases are held for a long period, which can lead to potential underappreciated lease payments. The driving factors are more macroeconomic than local, such as the global trade economy (import & export), the population growth and the cost of ownership. To avoid the risk, investors tend to rent to multiple tenants instead of one.
Retail properties include everything between a little grocery to a large regional mall. The driving factors are both global and local. Indeed, the market can be impacted by the consumer trends and confidence levels, the employment growth and the economy cycles, as well as the location and the traffic flow. Leases are also for long term periods but can take different forms. Triple net leases, also called NNN are usual in the retail industry. With this lease of 10-25 years duration, the tenant must pay all the fees related to the property: the maintenance and repairs fees, the insurance of the property and the real estate taxes, in addition to the basis rent. The advantages for the investors are that he doesn’t have to deal with daily management responsibilities, he can expect a predictable income, and the tenants who sign for this long-term commitment are usually trustworthy. Many tenants are also required to pay a percentage of the sales that is within 4⁄8% of the sales above the level of sales predetermined by the landlord and the tenant, in addition to the base rent. Long-term leases are a security for investors looking for stable incomes but also a risk since they are not able to adapt the rent with the current market rate.
The hospitality sector is defined by a large range of products including hotels, amusement facilities, travel centres, student accommodations, senior housing and all other types of buildings people pay to take advantage of the services offered in them (stays, food and beverage, leisure). Hotels are the main properties within the hospitality sector. They are establishments providing accommodation, food and other services for tourists and travellers. Hotels can be independent, called a boutique, or being part of a larger chain. Usually, hotel chains develop and manage the lodging properties owned by outside investors. The hotelier sector can be broken down into different segments which are Deluxe, Luxury, Upscale, Midscale, Economy and Extended Stay. Midscale hotels represent the larger part of the market. Hotelier real estate is driven by both national and worldwide factors but also unpredictable conditions such as terrorism, natural disasters and politics issues. Hotels’ profitability depends on both occupancy and room revenues, with the main performance indicator being the Revenue per Available Room (RevPAR=average daily room rate x occupancy rate).
As an asset, land includes anything that is on its ground (wood, source of water…). Land can remain a very lucrative asset for investors when it is well understood. Investing in a raw land presents different options: • Renting out the land to farmers • Selling the wood located on the land • Selling out to a real estate developer at the right time and at the right price
7. Mixed use
A mixed-use property is a commercial property, which includes commercial and residential spaces (for example apartment buildings with retail or medical offices on the lower floors). Investing in mixed use property has the advantage of diversifying assets and as a result splitting risk. However, when purchasing such assets, investors must be aware of the nature of the building as changing it can be difficult, long and laborious.
Each of these categories has its own characteristics, advantages and risks. In order to spread the overall risk, a prudent investor will tend to diversify the types of properties he invests in.