Types of Commercial Real Estate
Commercial real estate encompasses a wide array of property types, including office buildings, apartment properties, malls, shopping centers, warehouses, distribution facilities, and research-and-development or research-laboratory properties. Buildings made up of a mix of office and industrial space are called “flex” properties. If 50% or more is office, the property is called “office/flex.” If less than 50% is office, it is called “industrial/flex.” Some flex properties include research-and-development or laboratory space.
Most investors also consider hotels to be commercial real estate, but some look at hotels as operating businesses, and lump them in with a subset of properties that include assisted-living facilities and casinos.
With the possible exception of raw land, all commercial properties, including the “niche” properties described below, have one trait in common: They are capable of producing income, either in the form of capital gains or rental income.
Niche Property Types
In recent years, an increasing number of investors have begun investing in so-called niche property types. These include specialty properties such as apartment complexes specifically for college or university students, age-restricted apartment complexes for older residents, self-storage facilities, and office buildings that cater to doctors and other medical-related tenants.
Other investors acquire raw land, with the goal of obtaining the appropriate permits so that, within zoning regulations, properties could be built on it.
Some investors are beginning to look at infrastructure as a possible niche real estate investment. Currently, infrastructure is often classified as a subset of private equity investing. Some companies invest in “social infrastructure” (prisons, courts, hospitals, municipal garages, municipal buildings and schools) or “transportation infrastructure” (airports, rail stations, ports, toll roads, bridges and tunnels) – areas that have some crossover with real estate. For example, there are already real estate investment trusts that invest in prisons, and investment funds that invest in hospitals or garages. And most airports and rail stations have a retail/restaurant component.
Private Equity Real Estate Investments
Some investors make private equity-style real estate investments. Such investors acquire real estate-owning companies or stakes in such companies, rather than invest in individual properties or real estate debt. Another form of private equity real estate investing is the creation of a company, which would then invest in real estate-owning companies, properties, debt or a combination of the three. Knoxville bankruptcy attorneys will help you obtain the debt relief you deserve in such cases.
Basic Terms to Know
Office, industrial and retail properties are measured in square feet. Buildings can be measured in “gross square feet” or “net square feet.” A 1987 article in the New York Times offered definitions of both terms: Gross square feet – “the sum of the areas at each floor level, including cellars, basements, mezzanines and …. Included are all stories or areas that have floor surfaces with clear standing head room (6 feet 6 inches minimum) regardless of their use.” Net square feet – “the sum of all areas within the perimeter walls of the unit measured to the inside faces of said walls and including all columns, shafts, ducts and risers whether separately enclosed or not.”
Apartments, hotels and self-storage facilities can be measured in square feet, but are more commonly measured in units or rooms. For example, an apartment complex may have 200,000 square feet, but would more commonly be described as having 1,500 units. A hotel may have 100,000 square feet, but it would be more common to identify it as having 500 rooms, or “Keys”.
Properties are often identified not only by their address, city or state, but by the submarket in which they are located. Some submarkets are essentially neighborhoods, such as in Manhattan, which identifies such places as Chelsea, Harlem and Times Square as submarkets. Other submarkets are regions, such as Northern New Jersey or Silicon Valley, in Northern California.
The cap rate is the initial annual return that a buyer can expect on his investment. You can read more on the source article for this article here to gain more knowledge on cap return. It is calculated by dividing the projected net operating income for the first year of the investment by the purchase price. If a building sells for $10 million and generates $1 million of projected net operating income, the cap rate is 10%. Investors can use cap rates to compare the returns of their real estate holdings to the performance of other types of investments, such as stocks and bonds. And sometimes, there are spells of high ROI for the investing companies. This has an affect on the general populace of the particular area, and it experiences a plethora of people moving to that area, specifically from NYC.
For some properties, it is important to consider the initial annual return. But for other properties, it is more appropriate to consider the stabilized return – ones that are either not well leased, have leases that are about to expire or are candidates for conversion to other uses. The stabilized yield is determined by calculating a projected yield after the building’s performance has been maximized.
Properties can have various types of leases. A traditional office lease is considered a gross lease – meaning the property owner is responsible for virtually all costs related to the leased space, ranging from taxes and insurance to water and power costs. By contrast, some office tenants, and most industrial and retail tenants, pay a net lease. In such a scenario, the tenant is responsible for the costs related to the space. Depending on how many of the costs are assumed by the tenant, a lease may be considered single-net, double-net or triple-net. The charges and payments of building expenses are also known as Common Area Maintenance (CAM) expenses. In a typical net-lease, the tenant shall reimburse the landlord for all expenses related to the maintenance of the property such as cleaning, gardening, snow-removal, lobby, lights and the like. In a double-net lease, the tenant also required to cover insurances, accounting, and certain legal expenses incurred by the landlord. In a triple-net lease, the tenant is also responsible for property taxes and certain improvements of the leased property.
The difference in rates of the various types of leases can be great. An office space could conceivably be advertised as having an annual rent of $50 per square foot as a gross lease, and $35 per square foot (annually) if the lease is triple-net.
Some property owners prefer to deal only with credit tenants (see example), which have investment-grade credit ratings, as rated by a third-party agency such as Moody’s, Standard & Poor’s and Fitch. Any rating above BBB-minus is considered investment grade. Properties with investment-grade tenants are often considered more valuable by investors.
Types of Investments
There are a variety of investment types, depending on the level of risk an investor is willing to accept.
The safest investments are called “core” properties. These generally seek an internal rate of return of less than 10%. Buyers of core properties use a limited amount of debt debt — usually less than 50% of a property’s value. An example of a core investment would be a retail property with a solid tenant locked into a net-lease of 10 or more years. Another core investment would be a fully leased office building in a historically strong market with a high occupancy rate, such as Midtown Manhattan.
The next-safest investments are called “core-plus.” These generally seek an internal rate of return of 10% to 13%. Buyers of core-plus properties often use slightly more debt than core investors — usually from 50% to 75% of a property’s value. Core-plus investments are relatively safe, but provide the owner with the opportunity to increase the internal rate of return, in exchange for taking on slightly more risk. For example, a buyer may acquire an office building that is well occupied, but which has several leases expiring over several years. If the building is located in an office market that averages 90% occupancy, a property owner could reasonably assume that his/her building could consistently achieve that level. Core-plus investments also include the need for minor renovations — such as upgraded lobbies, common areas, bathrooms or exteriors. After completing such upgrades, a property owner could eventually raise rates, and in turn, increase the investment’s yield.
The “value-added” category is next on the real estate market’s risk-reward ladder. Value-added properties generally seek internal rates of return of 14% to 17%. Buyers of value-added properties often use debt equal to more than 60% of a property’s value. Value-added investments carry some risk, and often rely on a buyer’s understanding of market trends, demographics and potential tenant needs to be successful. For example, a buyer may acquire an older single-tenant office building with a short-term lease, in an office market with an average occupancy rate of 90% and with limited office construction. The buyer would allow the lease to lapse, and then spend several million dollars on renovations, raising the building’s quality to Class-A status, while making the building suitable for multiple tenants. Under that scenario, the building would likely gain at least 90% occupancy, and at much higher rents than before. That would increase net operating income, which in turn would increase the buyer’s internal rate of return. Some value-added investors concentrate on higher-yielding debt opportunities, such as mezzanine debt.
The riskiest investments are in the “opportunistic” category. These generally seek an internal rate of return of 18% or more. Buyers of opportunistic properties often use debt equal to more than 70% of a property’s value. Opportunistic investments, which carry the most risk, would include properties that have been foreclosed or which are about to be foreclosed, properties bought from distressed sellers (such as companies that have sought bankruptcy protection), or the underlying debt on properties owned by distressed sellers.
Other opportunistic investments entail large construction projects, and so-called property repositionings. For example, an investor may buy a large abandoned warehouse in a well-populated area and spend tens of millions converting it into a mixed-use property — perhaps with retail and restaurants on the street level, office space on the lower floors, and residential condominiums on the top floor.
Increasingly, U.S. value-added and opportunistic investors are seeking higher internal rates of return by investing overseas. Value-added and opportunistic investments are also referred to as high-yield investments.
On March 21, 2007, the trade publication Real Estate Alert published a review of the 385 funds investing, raising capital or planning to raise capital later in 2007. Of those, “90 funds were targeting only non-U.S. investments, up from 44 a year ago. Another 55 funds plan to put at least some of the equity to work outside the U.S. American investors are increasingly plowing capital into emerging markets. For example, Real Estate Alert found that 15 funds are targeting India, up from just one in the survey two years ago. Other venues attracting interest: China, Brazil, Russia, Argentina and Vietnam.
Some investors provide only debt for developers and other property owners, including ones that specialize in higher-yielding debt opportunities, such as mezzanine debt.
Types of Investors
A variety of investor types target a wide range of real estate investment opportunities.
Institutional investors can include banks, insurers, pension systems, endowments and foundations.
Foreign institutions are also buyers of U.S. properties. Dutch pensions, for example, have invested in the U.S. for more than two decades. Since the 1990s, German institutions have been active buyers, either working independently or by pooling money into special partnerships. In the 1980s, Japanese financial institutions were big buyers of U.S. properties, especially on the West Coast.
Many institutional players contract with third-party advisory firms to help them build real estate portfolios. Advisors can have discretionary or non-discretionary relationships with their investor clients. An advisor with a discretionary arrangement can buy or sell properties within certain pre-arranged guidelines regarding yield, property type and geography. A non-discretionary relationship means the advisor must first obtain approval from the client. Such advisory contracts generally last three or more years, although many institutions have the ability to fire an advisor with limited notice. Advisors don’t usually hold equity stakes in the properties they buy on behalf of clients and manage. They earn fees based on the performance of the properties and may also collect bonuses based on gains produced by the sale of the properties.
Some corporations also own the real estate they occupy.
A real estate investment trust, or REIT, is a corporation that receives a [tax] designation to invest in real estate. In exchange for the designation, which reduces or eliminates [corporate income taxes], a REIT must distribute 90% of its income, which may be taxable in the hands of the investors. Many REITs are listed on stock exchanges. Others are private held.
Most REITs acquire or develop offices, apartments, malls, shopping centers or industrial properties. In recent years, some REITs have invested in niche or alternative property types, including prisons and self-storage properties.
Types of Private Investors
Real estate is often owned by private investors, including individuals, families and family trusts. Occasionally, a family or family trust may own the land beneath a building. This is most common in older cities, such as New York or Boston. A family or family trust leases the land, generally for 99 years, to the owner of the building. Conceivably, when a so-called ground lease expires, the lease holder could claim ownership of the building – but in practice, leases are renewed long before they expire. Churches and foundations are also frequent common owners of ground leases.
Some investors pool their money into special partnerships, such as a group of doctors that collectively invests in an office building they would occupy. Some investments are held in syndicates, in which an investor buys a property and then raises equity by offering stakes in the building.
Some investors pool money in tenancy-in-common vehicles, in which the investors don’t know one another. Such vehicles pool up to 35 investors seeking to make tax-deferred investments. According to a Dec. 15, 2004, article in Real Estate Alert, “While TICs are not new, they have become more common since March 2002, when the IRS ruled that such interests can qualify for tax deferrals. Under Section 1031 of the Internal Revenue Code, owners, under certain circumstances, can defer capital-gains taxes when selling a property if the proceeds are used to purchase another property within 180 days. The 2002 ruling said that proceeds can be plowed into TICs, fueling interest in the structure.”
Real Estate Funds
Real estate funds are the opposite of syndicates. Rather than finding a property and then raising equity, fund operators raise capital from institutions and private investors and then invest in properties, development projects, debt or real estate companies.
Funds can be closed-end or open-end. While closed-end funds stop raising money after reaching their targets and usually have fixed life cycles, open-end vehicles can continue to raise capital over time and operate indefinitely. Funds can seek core, core-plus, value-added or opportunistic internal rates of return. Most open-end funds seek core returns, although the number of non-core open-end funds has increased since the late 1990s.
Fund operators, which often invest in their own vehicles, earn money through a mix of fees and profit sharing. A fund operator may charge some combination of annual management, acquisition or disposition fees – generally totaling no more than an annual 2% of assets managed. In other words, if a fund operator raised $500 million, it could receive $10 million of fees annually. In addition, fund operators receive a share of profits (often 20%) after a minimum rate of return is achieved.
Some funds invest in other funds. These “fund-of-funds” vehicles often seek internal rate of returns of 10% or greater. Some fund of funds concentrate on funds that invest in the U.S., while others target vehicles that invest in Europe or Asia.
Funds are often operated by private companies, but some are operated by divisions of banks or other large financial companies. Some REITs have established affiliates to operate real estate funds – but in those cases, the fund is targeting a different yield or geography than the REIT.
Many operators of real estate funds also manage hedge funds or private equity funds. Occasionally, real estate fund managers also operate mutual funds. Sometimes, people confuse real estate mutual funds with private real estate funds. The difference is that real estate mutual funds invest in the stocks of real estate companies, and private real estate funds do not.
Real Estate Fund Fees
Fund operators, which often invest in their own vehicles, earn money through a mix of fees and profit sharing. A fund operator may charge some combination of annual management, acquisition or disposition fees – generally totaling no more than an annual 2% of assets managed. In other words, if a fund operator raised $500 million, it could receive $10 million of fees annually. In addition, fund operators receive a share of profits (often 20%) after a minimum rate of return is achieved.
A typical real estate fund charges an incentive fee — a way to split profits — which generally includes the following:
1) Investors receive a “preferred return” — usually between 8 and 12%. In other words, initially, fund investors receive all of the profits until a “preferred” return on equity is reached – to insure that limited partners receive a base profit before the operator shares in the profits.
2) After the preferred return is achieved, some funds split profits thereafter, often with 20% of distributed profits going to the operator, and 80% going to the fund investors. However, most larger real estate funds employ a “catch-up.” In this scenario, the operator receives a disproportionately large share of the profits in order to “catch up” to a 20% split of total distributions on a running basis. Catch-ups can range from 25 to 100% of distributed profits. Once the fund operator achieves a 20% split, it is entitled to 20% of additional profits.
For example, a fund’s incentive fee structure may read like this: After investors receive a 9% preferred return, the fund operator receives half of the profits until it has accumulated 20% of total profit distributions. After that, it gets 20% of additional profits.
Developers
Some companies only develop properties, either to sell at completion or to amass a portfolio. Developers may construct a building to be sold immediately to an owner-occupant. Such arrangements are known as “build to suit,” and require construction of a buildings that meeting size and use specifications. Other developers are backed by equity partners — frequently institutions or fund operators. Some developers operate their own funds.