Commercial Real Estate

Rental Income

Rental income includes the cash flows that investors in commercial real estate hope to receive. The credit quality of the underlying tenants influences the credit quality of a commercial property portfolio. The higher the credit quality of the tenants, the more likely they are to pay rent on time.

The Equity Component

Upon expiry of property lease, investors (landlords) may decide to redevelop the property for future sale, re-rent the property, or immediately sell the property. These decisions are dependent upon the value of the property at the time.

The value of a property is determined by its location and the prevailing state of the economy. Commercial real estate investments are vulnerable to such market forces as the possibility of either making a profit or a loss and the uncertainty related to the redevelopment or sale of commercial real estate. In this respect, commercial real estate investments are like equity investments. 

Liquidity

Commercial real estate investments are highly illiquid. This is because of the time and effort it takes to sell a property. Additionally, properties incur high transaction costs when liquidating, and it takes a long time to exit a commercial property investment.

Since illiquidity reduces commercial properties’ usefulness as a hedge against bad economic outcomes, investors demand a liquidity risk premium.

Cyclicality

Commercial property prices are pro-cyclical–positively correlated with the overall state of the economy. This implies that investors will demand a high-risk premium in return for investing in this asset class.

Question

Which of the following statements relating to commercial real estate is most likely correct?

1. The credit quality of the tenants does not affect the value of the property.
2. Commercial real estate ownership tends to be counter-cyclical.
3. The risk premium for illiquidity and the risk premium for uncertainty in future value is high in commercial real estate as compared to other asset classes.

Solution

The correct answer is C.

Commercial real estate investments are highly illiquid. Since illiquidity reduces a commercial property’s usefulness as a hedge against adverse economic outcomes, investors demand a liquidity risk premium. Moreover, as is the case with equities, commercial real estate investments are vulnerable to such market forces as the possibility of either making a profit or a loss and the uncertainty related to redevelopment or sale of a commercial real estate. Therefore, investors require a risk premium for this uncertainty.

A is incorrect. The credit quality of the underlying tenants influences the credit quality of a commercial property portfolio. The higher the credit quality of the tenants, the more likely they are to pay rent on time.

B is incorrect. Commercial property prices are pro-cyclical. This implies that investors will demand a high-risk premium in return for investing in this asset class.

Reading 43: Economics and Investment Markets

LOS 43 (l) Describe the economic factors affecting investment in commercial real estate.