Understanding Commercial Real Estate Asset Classes
Real estate has historically been a preferred asset class because of its tremendous capabilities to build wealth. This is achieved through property value accumulation combined with debt reduction. At the same time, passive income can be generated by rental income. You may not realize, however, that there are many different property classes available for you to consider.
Why Property Classes Matter
As a passive investor, you understandably may plan to let an experienced property management company deal with maintenance, operations, and other aspects of running a tenant-occupied property. However, asset classes directly impact exposure to various types of risks, financing opportunities, and other factors. A greater understanding of the property classes will support your decision about which passive investing opportunity is right for you to pursue.
A multi-family property has five or more residential units. A one to four-family home is considered a residential property and would qualify for residential financing. There are several important benefits of a multi-family property, and this begins with financing. Generally, lenders offer the most competitive rates, the longest loan terms, and the highest loan-to-value for these properties. For a passive investor who wants to benefit from maximum leverage, this is a popular option.
One of the reasons why a multi-family property is viewed as one of the least risky types of commercial properties to invest in is because everyone needs a place to live. Compared to other types of leases on commercial properties, a multi-family property generally has the shortest lease terms. This ranges between six to 12 months in many markets. Shorter leases work in the property owner’s favor when market rental rates are increasing steadily or rapidly.
Office buildings generally have longer leases than multi-family properties have, but there is some variation in this. You can find some buildings with 12-month leases or with even shorter terms. When an office building has multiple tenants on long-term leases, it is considered to be much less risky than a building with only one tenant. However, when you are looking at the income potential of office buildings and related exposure to risk, the quality of the tenant must be considered.
From a financing perspective, lenders generally offer terms that are slightly less favorable than multi-family property financing for a multi-tenant office building. For a single-tenant office building, the lender usually will review the tenant and the lease terms carefully before giving a loan quote.
Compared to a multifamily apartment building, an office building may be more challenging to find tenants for. Because of this, units often remain vacant for longer periods of time. When a single-tenant office building is vacant, the unit is not generating any income until a new lease is signed.
Retail properties are comparable to office buildings in many ways. They can have one, several, or dozens of tenants. The leases are generally longer in length, but this is not always the case. Financing terms are more favorable when there is a reputable, secure anchor tenant as well as multiple smaller tenants. Likewise, the financial risk of investing in retail properties is moderated by the quality and number of tenants.
Whether you are investing in retail or office buildings, always analyze the lease end dates carefully. Ideally, the lease end dates would be fairly spread apart so that occupancy and income generation are not significant concerns.
Mobile Home Parks
From the vantage point of a passive investor, a mobile home park is initially viewed as being comparable to an apartment complex. The property is occupied by multiple residential tenants who have relatively short-term leases. With this type of property, however, the mobile homes may be owned by the property owner or by the tenants. Therefore, the rental rate may only include lot rent or lot rent plus mobile home rent. This dramatically impacts the property’s income potential. It also affects property maintenance expenses and other related aspects of upkeep.
From a financial standpoint, manufactured or mobile homes are not considered to be real estate. Instead, they are classified as personal property, and they cannot usually be collateralized by a commercial loan. The commercial loan would cover the land and site-built improvements. If you purchase a mobile home park with park-owned homes, you would need to obtain a secondary loan for the homes or place a much larger amount of money down with your purchase. In addition, the value of park-owned homes would generally depreciate. Wealth building is affected by the number of mobile homes owned by the park.
A mixed-use property is usually considered to be a combination of residential units with office or retail units on the same lot. These properties are common in urban areas, such as with a retail store on the street level and a few apartment units in the upper levels of the building. One of the benefits of a mixed-use building is that the property’s income is derived from a wider mix of tenants. Generally, however, you must still analyze risk based on the number of tenants, the lease terms, and the quality of the commercial tenants.
Commercial financing available varies considerably based on the overall unit mix. You may find more attractive financing terms when the majority of the square footage or the majority of the monthly rents are linked to multifamily occupancy.
The last major class of real estate is industrial. Industrial properties include distribution warehouses and manufacturing facilities. Long-term leases are common with these properties. One of the challenges associated with industrial properties is rooted in finding new tenants to fill vacancies. In many cases, these buildings are customized to meet the operational needs of the tenant. Because of this, considerable updates may be needed before the property can accommodate a new tenant.
Financing terms for industrial properties generally include a significant down payment, a higher interest rate, and a shorter-term length. These terms reflect the increased risk to the lender and to the investor. However, with the right long-term tenant, the owner of an industrial property may enjoy a healthy source of passive income and may never deal with a vacancy throughout the entire period of ownership.
Other Property Types
As you explore the many passive investing opportunities to build wealth, be aware that there are other commercial property types that fall outside of these four primary classes. Some of the more common types are self-storage properties, hospitality properties, stand-alone restaurants, and gas stations.
Self-storage properties are popular among those who are focused on wealth building because the income stream is diversified across many tenants. As is the case with other multi-tenant properties, a few vacancies will not generally create financial hardship for the owner. The lease terms commonly range from month-to-month to 12 months. In addition, upkeep on self-storage properties is relatively low because these are essentially warehouse-like structures. Financing terms on self-storage facilities may be aligned with those for a multi-family office or retail building in many cases.
Hospitality properties are generally viewed as a riskier yet potentially lucrative type of property to invest in. The income is analyzed by multiplying the average daily room rate and the hotel’s occupancy rate over a specific time period. Income potential from these properties is vulnerable to economic conditions. Furthermore, operational costs and property upkeep can be significant. Because of these factors, lenders often require a substantial down payment and may issue a loan with a shorter term and a higher interest rate.
Special Purpose Properties
Many other commercial properties do not fall into these more significant classifications, and they could present excellent passive investing opportunities. These include amusement parks, golf courses, assisted living facilities, gas stations, stand-alone dry cleaners, stand-alone restaurants, and others. Notably, these property types are highly customized and may only be suitable for a specific type of business. Some of them, such as gas stations and dry cleaners, have potential environmental concerns. These may increase the cost of property insurance and dictate the need for an environmental impact report to be completed periodically. All of these property types may require significant renovations in order to be converted to a different use when the current occupant vacates.
As you continue to explore the many investment opportunities available that can generate passive income, keep in mind that the risk and the income potential for each of these property types are dependent on multiple factors. These include area demographics, the quality of the tenants, the local economy, and more. To maximize the opportunity to build wealth while mitigating risk, consider working with a skilled advisor who has a deep understanding of the local market and of property investing.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.