Commercial Real Estate 101- Asset Classes and Investment Hypotheses
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Commercial real estate is broadly defined as any property that generates a profit through income in addition to capital appreciation. Income is earned through the leasing out of the property, while appreciation is captured at disposition. Millions of people have invested in commercial real estate over the years – and not everyone is an expert.
Before you decide to invest in commercial real estate, it’s important that you have a grasp on the basics. In this article, we’re going to give you a better understanding of commercial real estate 101, so you can make smart investments in your financial future.
Asset Classes, when used in the commercial real estate context, are not referring to things like stocks and bonds like in traditional finance. Instead, when CRE professionals discuss asset classes they’re referring to the different types of commercial property. There are four main asset classes in CRE: multifamily, retail, office, and industrial. Beyond that, there is also hospitality, self-storage, healthcare, and a near limitless supply of specialty buildings. Below, we’ll focus on the four big ones.
- Multifamily— Commonly known as apartment complexes, multifamily properties also include smaller properties like duplexes and walkups that are designed to be leased out to residents.
- Retail— Both single and multi-tenant buildings that are used as stores to sell consumer products fall under the retail property category. Restaurants are also considered a retail property type but fall under a specialty subset.
- Office— Office property types can be buildings fully leased by one company or a group of offices that belong to different companies in a single building. Unlike retail properties, the main purpose of an office building is not to sell merchandise. Office buildings like dentists and medical offices are a special subgroup of the office property type.
- Industrial— Buildings like warehouse facilities, distribution, manufacturing, plants, and factories, are all included in the industrial property type. Industrial property types can be large or small properties from “Flex” to “Big Box” industrial complexes.
An investment hypothesis is simply a shorthand explanation of what the buyer intends to do with the asset. In commercial real estate, there are three basic investment hypotheses:
- Buy and Hold— The buyer will make minimal changes to the property and plans to hold the asset “as is” for a reasonable period of time, collecting the income it produces. The buyer may do things like lower management fees, fix broken fixtures, or create a more efficient capital structure but they will not fundamentally alter the building.
- Value Add— The buyer will invest significant money into improving the existing building and/or land through renovations, but will not alter its basic use.
- Development— The buyer purchases a property and fundamentally alters the current building, land, or both. This could be by building a new structure on vacant land or by converting an existing property from one use to another, say from a hotel to a multifamily complex.
Commercial real estate investors will often create pro forma forecasts for several investment hypotheses when considering an investment, to see which option will give them the best return. Savvy firms unlock hidden value by modeling several scenarios and by thinking of creative ways to structure their deals.