COMMERCIAL REAL ESTATE
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Commercial Real Estate is commonly defined as real estate with the potential to generate income for the owner of the property. Commercial real estate investments can be broken down into basic asset classes, each with unique set characteristics that address a wide range of investor needs.
Commercial properties are generally classified by type of use, such as Residential Rental, Office, Industrial, Hospitality, Land, and Retail.
Unlike stocks or bonds, investing in commercial real estate gives investors the opportunity to trade up and reposition a portfolio of investment properties while deferring capital gains taxes through the proper use of a 1031 exchange. This allows an investor to use their gains to build greater value over the course of their lifetime while taking advantage of changing markets.
Each classification of investment properties has specific set of qualities that dictate their potential risk and return. This article will focus on Residential Rental/Housing properties. While the specific details vary, the same approach can be used on all investment properties.
The basic appeal of Residential Rental or Multi Family properties is that we all need to live someplace, regardless of what the economy is doing. Performance of Multi Family investments is driven, as all markets ultimately are, by supply and demand.
Demand for Multi Family is sensitive to expansion or contractions of local population and affordability and desirability of other forms of housing, be it condominium or single family residences. As demographics change (the socio-economic climate of a location) both supply and demand for Multi Family is affected.
For example, over the last several years interest rates have been at historically low, making ownership in single family homes and condominiums attainable to many renters. This has put upward pressure on the supply of single family homes and condominiums while putting downward pressure on rents. As interest rates have risen we are seeing the opposite occur making Multi Family attractive commercial real estate investments because of potential future rent increases.
Some points for consideration in evaluation of a Multi Family investment are:
The type of neighborhood is a major factor; is it established or new? If the demographic includes children then proximity of schools is significant. Over all, access to churches, synagogues, and convenience of amenities such as shopping and entertainment are major considerations.
Who lives in a particular area and how likely are they to rent? The "who" in the equation is governed by the type and location (commute time) of jobs in the area. The level of income governs the propensity to rent. Generally, the more affluent the less likely renting will be the choice. However in areas such as New York and San Francisco where residential pricing has skyrocketed, many residents don't have an option and renting may be the only realistic choice.
Most Americans prefer to own and economic cycles clearly influence our ability to do so. Recent history illustrates this concept as low interest rates allowed those who traditionally rent to become home owners. Increased demand for ownership sparked a boom in converting apartments to condos (condo conversions), effectively decreasing the supply of Multi Family properties for investment. As interest rates increase, demand for ownership decreased, forcing the converted apartments back into the rental market.
Vacancy rates, competing projects, current projects under construction, zoning and possible future zone changes in addition to land available for future competing projects are major factors affecting market supply.
Characteristics of the Actual Site and Building:
Proximity to transportation, safety, noise factors, age of building and unit mix (demand factor) are also a significant part of an investor's evaluation.
Younger investors are attracted to Multi and Single Family investments for the simple reasons that they are most familiar with residential properties (we have all lived in some form of residential property) and the low financial barriers to entry (10% to 20% down payments with generally lower interest rates on debt).
When considering Residential Rental investments it is important to take into account the potential impact on the quality of life of the investor. Historically, successful investors have built their wealth with residential investments; adding value by managing the property themselves. While many younger investors welcome the opportunity to build their net worth by managing rental properties, older investors frequently find the management aspect of Residential Rental investments an unacceptable burden.
It is common for investors to accumulate significant wealth by investing in Multi Family properties in the first half of their lives and then switch to other, less management-intensive forms of commercial real estate as they grow older.
Examples of commercial real estate investments requiring little or no management are triple net lease single tenant properties (Walgreen Drug Stores for example) or Tenants in Common properties.
By using the 1031 exchange investors can diversify their commercial real estate holdings, thus reducing risk, eliminate management responsibility and not infrequently increase their cash flows.
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