Commercial Property Types

Given the real estate cycle and its impact on portfolios, we now examine specific demand and supply factors influencing the risk and return of commercial real estate subsegments, including residential and non-residential properties like office, industrial, retail, and hospitality spaces.

Residential Property Investment Characteristics

Residential properties encompass single-family homes and multi-family units such as apartments. Multi-family properties, typically in urban or suburban locations, may be owned by individual or separate investors. Demand for residential rentals is driven by local economic conditions, income growth, and the availability of affordable owner-occupied housing. Leases are often short-term, and tenant protections can impact cash flow analysis, typically based on gross potential rental income (GPRI). Various factors like market rents, tenant turnover, and vacancies affect net operating income.
$$\text{Gross potential rental income}=\text{Market rent} \times \text{ Rentable space}$$

Commercial Real Estate Properties can be classified as follows:

• Offices
• Industrial and Warehouse
• Retail and Multi-family Occupancy Units
• Hospitality, i.e., Hotels and Restaurants
• Land

The above commercial property types are mainly used is to create a low-risk portfolio, taking into account relevant factors such as prime locations, agreed leases, e.g., financially wide-ranging and accountable occupiers, low vacancies, and noble leasing terms.

Common types of leases include:

• Net lease: In a net lease, the tenant is responsible for operating expense payments
• Gross lease: The owner pays for the operating expenses.
• Triple-net leases: common in Canada and USA, each tenant must pay their share of; property taxes, common area maintenance, and operating expenses.
• Sale-leaseback: in this type of lease, a company sells a building it occupies and owns and signs an agreement with the new owner to allow the company to continue occupying the building.

Offices

Offices form a hefty portion of commercial properties. They are usually maintained by real estate asset businesses that rent office spaces to occupants in varying terms, either monthly, quarterly, biannually, or annual tenancy agreements.

The existing lease agreements make it relatively easy to determine the income associated with office rents, which are normally adjusted for inflation. This makes investing in office rental space relatively appealing to many investors.

Investing in office rental space is largely determined by the following factors:

• Economic state: The economic state greatly determines growth and demand for office spaces. High demand in office rental space positively correlates with a high economic growth rate and vice versa.
• Technology: Technological advancements have led to remote working, which, in retrospect, has led to a decline in the demand for office space.
• Length of lease: Terms on a lease contract have an overall impact on the investor’s risk-return appetite. On average, lease contracts vary from one country to another. They may be determined by several factors, e.g., the attractiveness and location of the office space, the financial status of the lessee, future changes in the lease agreements, etc. A 20-year lease contract can have a five-year fixed rental clause with agreeable annual increments; after that, it may appear attractive to a tenant instead of a lesser-year agreement.  
• Operating expenses: When signing the tenancy contract, both parties need to be very aware of how to cater for recurrent utility bills, which has a definite outcome on whether a lease agreement will be net or gross. Generally, it is cheaper to operate a net lease than a gross lease as the occupant has the discretion of mitigating recurrent expenses regarding their operations.

Industrial and Warehouse

These include properties such as manufacturing services, research and development units, and distribution outlets.

Returns on investments for industrial and warehouse properties are affected by:

• State of the economy: Strong economic growth is a good catalyst for manufacturing activities and, in return, increases the demand for such units.
• Import and export businesses: Most import and export businesses demand mass storage facilities to drive their business ventures.
• Lease terms: Lease contracts for such commercial properties normally run on net leases as the operating expenses are quite hefty.

Retail

This sector includes properties such as shopping malls, supermarkets, etc.

The demand for retail units depends on the following:

• Purchaser spending behaviors
• Economic growth
• Employment status
• Population growth
• Lease contract terms

Multifamily Occupancy Units

Multi-family occupancy units can take apartments, bungalows, and mansions, constituting a significant proportion of the commercial real estate investment market.

These appeal more to family units as opposed to single occupancy, which again becomes a determining factor alongside the following when investing in such properties:

• Population demographics: High population growth is a driver for increased demand for rental apartments.
• Rental vs. homeownership costs: The comparison of rental costs versus ownership costs has an indirect correlation as an increase in home rates affected by interest rates, debt financing costs, etc., may increase rental units’ demand.

Land

Landforms one of the most sought-after commercial properties by investors as the rest of the other real estate investments listed above pragmatically depend on it.

Varied investors purchase land mainly for speculative motives depending on the following factors:

• Infrastructural improvements: Road constructions, social amenity installations, etc., have a favorable outcome on land prices.
• Location: Accessible land can fetch higher prices instead of remotely located parcels of land, which may result in a rapid loss in value if left undeveloped.

Question

Which of the following is the most speculative as far as real estate investment is concerned?

1. Raw land
2. Warehouses
3. Land with infrastructural developments

Solution

The correct answer is A.

The success of an investment in raw land heavily depends on developing the land to yield marginal returns. The land is highly likely to appreciate over time.

B is incorrect. Warehouses are rarely speculative since they are characteristically rented, and warehouse rents guarantee imminent income streams.

C is incorrect. Land with amenities indicates a predetermined profitable worth centered on a predictable stream of future cash flows.

Reading 36: Overview of Types of Real Estate Investment

LOS 36 (c) Discuss the distinctive investment characteristics of commercial property types.