Updated February 2017 — With 2017 bringing in a new administration, speculation about potential changes to regulations and the tax code has U.S. investors keeping a close eye on managing their portfolios. In the interest of diversification, many investors consider including real assets as part of their portfolio, and investing directly in commercial real estate continues to be a popular option due to potential for income generation.
It's a strategy that comes with its own set of risk factors — it wasn't long ago that the commercial real estate market tumbled along with residential real estate values. But, much like stocks, commercial real estate values have rebounded, and activity remains at high levels. And, unlike in the equity market, you can potentially make gains in real estate even if values are stagnant, given the potential for strong income and tax benefits.
So far, values continue to rise. After a record uptick in 2015, commercial property values continued to rise by 6 percent in 2016 according to a report on repeat sales from real estate research firm CoStar.
"Real estate today continues to provide a current return that is substantially better than most fixed income investment alternatives," says Bill Nimmo, Senior Vice President and National Director of Real Estate Asset Management for Wells Fargo Wealth Management. "Just as with other investments, it is extremely difficult to ‘time’ the commercial real estate market. But in our big picture view, adding commercial real estate to your portfolio offers a powerful combination of diversification plus potential for strong income, appreciation and total return."
Pros and cons
For an investor considering commercial real estate investing, Nimmo says there are some important factors to consider, as the sector has its pros and cons.
"The risks that go with direct real estate investing are different from other investment classes," he says. "The primary risk is that the underlying asset is illiquid and is not readily traded in the daily market," meaning it may not be as easy to sell an office building, for example, if you need to convert your investment to cash. If potential liquidity is a concern, you may want to learn about Real Estate Investment Trusts, or REITs, which are publicly traded. Another risk is the unpredictability of ongoing costs that can be associated with owning real estate, such as maintenance, capital improvements, and leasing costs for commercial buildings.
However, commercial real estate may produce steady income, as long as it's leased. As an owner, you receive monthly rent, while still also potentially enjoying the benefits of appreciation, along with potential tax benefits. And that's part of what makes real estate a potential boon for investors. Plus you can create equity by paying down any debt on the purchase, resulting in a potentially greater return when you do sell.
"Financing rates have trended up lately but only marginally. From a historic perspective, rates are still very low. You can get a very attractive fixed interest rate," says Bill White, Senior Vice President and Director of Commercial Real Estate Lending for The Private Bank. "That has our clients saying real estate is a good long-term investment. Even if the property doesn't appreciate in value at all, you're still paying down that debt and increasing your equity," while receiving monthly rental income, he adds.
"In our big picture view, adding commercial real estate to your portfolio offers a powerful combination of diversification plus potential for strong income, appreciation and total return." — Bill Nimmo, National Director of Real Estate Asset Management, Wells Fargo Wealth Management
An array of different commercial property types are available for investment today, including apartments, office, industrial, retail, and numerous special use asset classes. Residential properties and apartments are generally considered less risky plays in the real estate world and, in turn, sell at lower yields. Office and industrial buildings, as well as shopping centers, are riskier, because it typically takes longer to find tenants to fill vacancies, and it is more expensive to re-lease vacant space. Nimmo says. And vacancies not only mean less monthly rental income, but they also decrease the value of an asset when you decide to sell. Given more recent consumer trends and speculation around the future of department stores, investors and lenders are currently being more cautious when evaluating retail properties, but are still finding opportunities.
Location and markets
While the type of property you choose to invest in is critically important, so, too, is the market. This is especially true now, as more investors have jumped into the real estate market, driving prices upward. A real estate professional and your financial team can help you research information on markets and asset classes — office, retail, and industrial properties are often labeled "Class A," "Class B," and "Class C" based on when they were built, where they are located, and their condition.
"Location and submarket strength are significant factors," adds Nimmo. "Other factors include local economic strength and job growth trends, which impact demand for space, not to mention national market trends and conditions in the capital markets, both of which greatly impact the amount of liquidity in the market for real estate deals. Investors also need to pay attention to shifts in macro trends that can significantly impact real estate values such as population movement, other demographic shifts, technology changes and corporate streamlining. Understanding what affects cap rates (the multiple on cash flow to determine value) is also crucial. Our Real Estate Asset Management team helps clients work through these factors and focus on appropriate investment.”
With so much activity in what are deemed "top-tier" real estate markets, such as New York and San Francisco, competition for properties there is intense. But in secondary markets, such as smaller yet growing metropolitan areas, values may not have risen as sharply yet and it may be less competitive to buy in at good value, White says. “Keep in mind that current market size alone is not the only consideration. Before making a decision, investors should take into account all aspects of the potential opportunity, bringing in their financial team to help evaluate fit within their current portfolio and overall financial plan.”