Commercial real estate investing includes making equity or debt investments in multi-family residential, land, office, industrial, retail, hotel properties and other more specialized assets. A significant advantage of commercial real estate is that investors can gain access to this segment through a number of different vehicles and structures that provide different types of opportunity at different points in the business cycle. It is important to remember that the commercial real estate market does not necessarily move in tandem with the residential housing market. It is driven more by economic factors such as economic growth, job creation, consumption and inflation.
These investments may utilize anywhere from 30% to 75% leverage, while traditional investments typically do not rely on leverage. Historically, commercial real estate has had a relatively low correlation with financial market indices. Over the long term, commercial real estate has also been less volatile when compared to traditional investments such as equities and fixed income. Also, real estate is a physical asset and is relatively illiquid, as opposed to traditional investments, which are financial assets and are highly liquid. Lastly, real estate is typically considered a better inflation hedge than traditional investments. This is because as inflation rises, the value of real estate usually increases in tandem, whereas traditional investments such as stocks are usually hurt by adverse inflation surprises.
Commercial Real Estate Strategies
- Private Debt: This includes whole loans, mezzanine loans and B notes. A whole loan is a term used to distinguish between an original mortgage loan and a pass-through security. A mezzanine loan is a hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. A B-Note refers to the tranche that is subordinate to the investment grade portion of mortgage debt. In addition, investing in commercial real estate through private debt typically produces steadier returns than equity investments as they are less sensitive to economic conditions. The disadvantages involved in private debt include limited upside potential and lower liquidity due to the mid-level structure, as well as difficulty in creating diversified portfolios due to the concentrated nature of debt positions.
- Public Real Estate Equity: Investors can gain exposure to commercial real estate through public equity markets in two ways; Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs). Both are types of companies that invest in real estate and whose shares are traded on exchanges. REITs invest in real estate directly, either through equity stakes in properties or through mortgages. They must distribute 90% of their taxable income to shareholders and thereby qualify for lower corporate tax treatment. REOCs are similar, except that they reinvest earnings into the business and do not enjoy preferential tax treatment. They engage in the development, management or financing of real estate. Both REITs and REOCs are often traded on a long-short basis by hedge funds.
- Private Real Estate Equity: This includes core, core plus, value-added and opportunistic strategies. Core usually involves investments in stable, fully-leased, multi-tenant properties within strong, diversified metropolitan areas, owned with little debt. Core funds also have highly predictable cash flows. Core plus refers to a low-risk/slightly higher potential return and leveraged strategy. Value-added refers to moderate risk/moderate return and higher leverage strategy. They usually involve redevelopment or re-leasing of a property to increase its potential value at a rate in excess of general market trends. Opportunistic refers to the highest risk/highest potential return and highest leverage strategy. Opportunistic funds are usually focused on "off-market" deals that have significantly higher risk profiles.
In summary, alternative investments in commercial real estate are negotiated private debt and equity investments in real estate assets with the objective of generating current income and/or reselling at a higher value in the future. Since commercial real estate historically has experienced significant fluctuations; cycles in value and local market conditions often influence investing outcomes. Most commercial real estate investments employ leverage, which has the effect of magnifying both gains and losses. It is important for advisors to remember that these investments are illiquid, are not listed on any exchange and are generally regarded as fixed and long term. Generally, there are no liquidity provisions, no standardized mechanisms in place to sell partial interests in non-realized funds, as well as significant restrictions on transfer.
Properly selected commercial real estate strategies have the potential to create current income along with capital appreciation. Commercial real estate is usually also considered a hedge against inflation. It offers direct ownership and can expand the efficient frontier in a portfolio. The flip side is that investors may have to accept illiquidity risk and advisors must help them understand the long-term potential trade-off of this type of investment vehicle. These factors should be taken into consideration when evaluating commercial real estate strategies and their related suitability requirements for specific clients.
Please be sure to check back in the coming weeks, as I will dive deeper into these durable income-producing investments.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.