What is Commercial Property?
Commercial property is real estate that is used for business activities. The designation usually refers to buildings that house businesses. But, it can also refer to land used to generate a profit. Also, it includes large residential rental properties. The designation of a property as a commercial property has financial implications. It can influence how it is financed, how it is taxed, and how laws are applied to it.
Any property that is zoned or used solely for business purposes is a commercial property. This may include shopping centers, strip malls, hotels, retail stores, warehouses, restaurants, industrial spaces, farms, office buildings. Even vacant lots can be commercial property if they have been zoned as such by a local government.
Commercial Property – A Closer Look
In most municipalities, an individual cannot build a business on a residential property. On the other hand, they can’t build a home on a commercial property either. This is because commercial properties have certain standards. The owner or builder must observe these regulations when constructing a business. They can range from the style of building or a minimum number of parking spaces. In many cases, commercial properties are located next to each other. This is to prevent the disruption of residential communities. Commercial properties also may have different tax rates compared to other types of properties.
Commercial property includes malls, grocery stores, offices, industrial estates, manufacturing shops, and more. The performance of commercial property—including sales prices, new building rates, and occupancy rates—is often used as a measure for business activity in a given region or economy. For example, the RCA Commercial Property Price Indices measure the price changes in commercial real estate across the United States. (Source:investopedia)
Commercial Property Examples
Often, commercial properties are broken down into specific categories. These include:
- Industrial — Industrial properties usually include heavy manufacturing, light assembly, and warehouses. These types of properties are typically large, have been reconfigured to accommodate heavy machinery, have easy highway access, and may include office space.
- Retail — Retail properties are some of the most common commercial properties, and they may include strip malls, community centers, and regional shopping malls. They range in size and contain from one to hundreds of individual stores and businesses.
- Office — Office properties are typically located in urban and suburban areas. In large cities like Los Angeles, Atlanta, or Jacksonville, these properties are usually high-rise buildings. Outside of major cities, they may be office parks, mid-rise buildings, or office campuses.
- Multifamily — Apartment buildings may seem like residential properties, but they are actually commercial. This is true for the garden, mid-rise, and high-rise apartments.
- Hotels — Hotels are considered commercial property, no matter the size or type. This includes extended stay hotels, full-service hotels, and limited-service hotels.
- Land — Land zoned for commercial property typically fall into three categories. Brownfield land was once zoned for industrial use and may be impaired. Infill land is land that has been developed but is now vacant. Greenfield land is undeveloped land.
- Special purpose — Most other types of commercial property fall into the special purpose category. This might include places like car washes, self-storage buildings, theme parks, nursing homes, churches, and marinas.
Investing in Commercial Property vs. Residential Property
Commercial property has traditionally been seen as a sound investment. Initial investment costs for the building are higher than residential real estate. So are the costs associated with customization for tenants. However, overall returns can be higher. Also, some common headaches that come with residential tenants aren’t present when dealing with a company and clear leases. Commercial property investors can utilize the triple net lease. This allows expenses such as real estate taxes, building insurance, and maintenance to be borne by the company leasing the premises. This advantage is not available to residential real estate investors.
In addition to favorable leasing terms, commercial property tends to benefit from more straightforward pricing. A residential property investor must look at a number of factors. High on the list is the emotional appeal of a property to prospective tenants. In contrast, a commercial property investor can rely on the income statement. It shows the value of current leases. Value can then be compared against the capitalization rate of other commercial property in the area.
Commercial Building Classifications
Commercial buildings are separated into three classes. These classifications mean different things to different types of investors.
Class A Building:
Class A buildings are the newest and highest quality, with the best location and highest rents. They are beautiful buildings in beautiful neighborhoods and attract the highest quality tenants. They are typically downtown with commercial on the main level and residential units on the top. As a beginner investor, Class A is not for you. The reason is that the price is too high, with low returns and you get steep competition from institutional buyers and funds. They can pay all cash and are okay with the low returns.
Class B Building:
Class B buildings are usually a little older, but they are still of good quality and attract average, working-class tenants. Oftentimes value-added investors target these types of buildings as investments since well-located Class B buildings can be returned to their A-class glory. These are the most stable properties. As a commercial real estate investor, your goal is to find a B class building in an A-class neighborhood and then renovate that building to get A class rents.
Class C Building:
Class C is the lowest official classification and the buildings are older and need updating. They have the lowest rents and you’ll find lower to middle-income tenants in them. If you are an apartment investor, class C is the way to go because the ratio between the price per unit and the rents are still good and you can get the highest returns. There will always be a demand for them because they are the most affordable, especially with the rising rents of Class A and B apartments. However, you need to be careful because the buildings tend to need a lot of maintenance and the neighborhoods and tenants could be challenging. Managing these properties requires skill.
Class D Building:
There is also another class but it is not an official class. The buildings are often vacant and in need of extensive renovation. Class D properties are for experts who have deep pockets. If you’re a beginner, don’t even consider a class D building.
Commercial Property – Types of Leases
Leases are the lifeline and the lifeblood of a commercial property. They keep the money flowing, thus protecting you from foreclosure. They are legally binding written agreements between the property owner and the tenant.
For apartment buildings, the lease could be a one year lease, a 9-month lease, or a month to month lease. Leases give you the legal right to collect rent, evict people and take them to court if they don’t pay. If you don’t have a strong legal instrument your tenants can take advantage of you. They can stay in your apartments without paying rent. So, having a strong lease is really important.
3 Types of Leases for Office Buildings and Shopping Centers:
- Full-Service Lease: The tenant pays a flat fee and the landlord pays for everything, including insurance, taxes, repairs, and utilities.
- Triple Net Lease: The tenant pays for everything. This is a passive option, where the landlord only has to pay the mortgage.
- Modified Gross Lease: The tenant and landlord split certain expenses.
Investing in Commercial Property through REITs
Real estate investment trusts (REITs) are an option if you want to invest in commercial property. Most investors lack the capital or desire to buy a whole building. However, REITs operate like mutual funds. They pool investment dollars to buy assets. Each share in a REIT represents the company’s underlying assets. Buying shares in a REIT that specializes in commercial property gives you exposure to this sector without requiring you to buy a building on your own. REITs own or finance income-producing real estate across a range of property sectors. However, these real estate companies have to meet a number of requirements to qualify as REITs. Most REITs trade on major stock exchanges, and they offer a number of benefits to investors.
What are the different types of REITs?
- Equity REITs – The majority of REITs are publicly traded equity REITs. Equity REITs own or operate income-producing real estate. The market and Nareit often refer to equity REITs simply as REITs.
- mREITs – mREITs (or mortgage REITs) provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities and earning income from the interest on these investments.
- Public Non-listed REITs – Public, non-listed REITs (PNLRs) are registered with the SEC but do not trade on national stock exchanges.
- Private REITs – Private REITs are offerings that are exempt from SEC registration and whose shares do not trade on national stock exchanges.
Up Next: What Is a Forward Contract?
Forward contracts are private agreements between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation. However, its specific nature makes it particularly suitable for hedging. The forward contract refers to the underlying asset that will be delivered on the specified date. For this reason, it is considered a type of derivative. Forward contracts can be used to lock in a specific price to avoid volatility in pricing. The party who buys a forward contract is entering into a long position. The party selling a forward contract enters into a short position. If the price of the underlying asset increases, the long position benefits. If the underlying asset price decreases, the short position benefits.