What is Commercial Real Estate (CRE)?

Commercial real estate is like setting up a lemonade stand in your driveway. . .

Your kids set up a lemonade stand in your driveway. That site is commercial real estate, because its purpose is business - to sell lemonade. But your home itself is residential - its purpose is to be lived in. Sometimes, there’s overlap: People live in apartment buildings, but their main purpose is the business of housing people; the owner collects rental payments. If a property’s primary purpose is to facilitate money-making, it’s commercial.

The real estate market is typically divided into two categories: residential and commercial real estate.

• Residential real estate is comprised of properties specifically designed to be lived in, such as houses, individual apartments, and condominiums. Residential properties cannot be used to conduct business because of zoning laws - you can hold a yard sale in your backyard once in a while, but you can’t run a restaurant out of your basement.
• Commercial real estate is comprised of properties whose primary purpose is to make money or provide a place for others to make money. Examples include office buildings, restaurants, shopping centers, and apartment buildings.

The distinctions between the two can get murky, especially when it comes to apartment buildings. People live in apartment buildings, but no one buys an entire high-rise just to live there — they seek to make a profit by renting individual units out to other people. The units themselves are considered residential properties; the building as a whole is considered a commercial property.

Commercial real estate is traditionally divided into four categories:

• Multi-family: These are apartment complexes and other properties that have multiple living units. To be considered a commercial property, a multi-family building must have five or more living units.
• Office: Companies purchase or rent office space to provide places for their employees to work and collaborate. Office buildings often provide stable income for their investors because companies don’t move their offices very frequently. Office buildings are loosely divided into the following classes:
  • Class A buildings: The highest-quality buildings in the most desirable locations with the most extensive amenities like fitness centers, gardens, rooftops, etc.
  • Class B buildings: Average, older office buildings with fewer amenities and a less luxurious feel. These buildings are typically in locations that are in less demand, such as suburbs or small towns.
  • Class C buildings: Low-quality office buildings in undesirable locations. These buildings are generally at least 20 years old and may require extensive renovation before they can become practical choices for office space.
• Retail: This category includes all properties used for businesses that sell products to consumers, such as stores and restaurants. Retail property includes shopping centers, strip malls, single-unit storefronts, and restaurant spaces.
• Industrial: Industrial property includes all real estate that is used for manufacturing or large-scale commercial storage, such as a warehouse or manufacturing plant. Industrial properties are typically located outside of residential, shopping, and business areas and must follow strict zoning regulations. They are typically occupied by a single tenant or business owner.

Some buildings don’t fit neatly into one category. Hospitals and self-storage facilities, for example, don’t fall under any of these categories but are still considered commercial real estate properties because they are used to conduct business, not to house people.

Similarly, mixed-use developments combine different types of properties into one. For example: a combined apartment building and shopping center that provides tenants with a self-contained living area with easy access to shopping and restaurants.

Compared to investing in the stock market, investing in real estate of any kind offers one major advantage: you’re buying physical property.

When you invest in stocks, there’s always the risk that the company you’re investing in will go out of business, and the value of your stock will drop to zero. With real estate, even if the market changes, the property you own is still tangible and will always be worth something. That means real estate can be a good way to diversify your investment portfolio and spread out your risk over different types of assets.

Compared to residential real estate, however, commercial real estate offers a few unique advantages:

• Longer lease terms: Unlike residential properties, tenants in commercial properties, like office buildings or shopping centers, tend to be there for the long haul, which leads to more stable cash flow for investors. Many leases have a term of decades.
• Higher return on investment: Compared to residential real estate investments, commercial investments tend to have higher returns, largely because of their longer lease terms and the greater number of tenants that can occupy them. Returns are affected by the market for commercial space in a given area, however, such as how much space is available compared to the demand for space, and how the overall economy is doing.
• Capital gains: When you purchase a commercial property, you own a building that can go up or down in value. Historically, the real estate market grows year over year, despite intermittent downturns. If that trend persists, the value of the building will increase, and you can sell it for a profit.

But commercial real estate is not without its disadvantages:

• Higher upfront cost: Purchasing a multi-family building is significantly more expensive than buying a single-family home.
• Higher risk: Commercial real estate is often considered a riskier investment not only because it costs more upfront, but because there’s a smaller pool of potential tenants. This can make it harder to rent out the space and recoup the costs. Plus, businesses may not be as financially stable as residential renters with steady income, leading to an increased risk of tenant turnover, despite the longer lease terms. This is especially true during economic crises, which may hit retailers and other businesses first and acutely, but residential tenants will still need a place to live.

There are two ways aspiring moguls can invest in commercial real estate:

• Direct investment: If you can afford it, you can purchase a commercial property outright, or finance the purchase through a loan. Since commercial real estate is a higher-risk investment, this route is best suited for investors who have considerable experience in the industry.
• Indirect investment: Most people who invest in CRE do so through real estate investment trusts, or REITs. These companies are portfolios of real estate properties, which generate profits through rent payments and then distribute those profits to shareholders. Most REITs are publicly traded, like stocks, and that makes them easier for investors to buy and sell.

No single type of commercial property is best for all investors. Each type of property has its pros and cons, and the best CRE investment may vary depending on the area, market trends, and a particular investor’s knowledge, experience and resources.

For instance, since real estate is a highly localized market, investing in industrial property might make sense in one part of the country, but would be a relatively bad investment in another.