Commercial real estate (CRE) refers to properties used for business purposes, such as retail spaces, office buildings, hospitals, and more. Unlike residential or industrial real estate, CRE is considered a more stable investment due to longer lease terms spanning five to 10 years.
This article guides you through the essentials of commercial real estate, including key definitions, the differences between commercial, residential, and industrial real estate, and tips for investing in CRE.
Whether you're looking to invest, lease, or work within the industry, this comprehensive overview will provide the foundational knowledge you need to succeed.
What are the main types of commercial real estate?
Commercial real estate (CRE) includes various property types, each serving different business needs and investment opportunities. The main categories are office spaces, multifamily buildings, retail properties, and industrial facilities.[1]
- Office spaces range from single-tenant buildings to large office parks.
- Multifamily properties, like apartment complexes, offer rental income from housing multiple families.
- Retail properties include shopping centers and standalone stores where businesses sell directly to consumers.
- Industrial properties, such as warehouses and factories, are used for manufacturing and storage.
- Hotels, from budget motels to luxury resorts, provide lodging for travelers
- Self-storage facilities offer rentable space for storing personal or business items.
- Land for future development, or agriculture, also falls under CRE.
Non-competitive CRE includes hospitals, schools, and government buildings operating under different market dynamics. Each type of CRE presents unique opportunities and challenges for investors.
How do investors value commercial real estate?
Investors value potential commercial real estate opportunities on several factors:
- Location: The importance of location varies by industry. For instance, multifamily properties should be near schools and supermarkets, while warehouses must be near highways, airports, and rail lines.
- Property condition: Older or poorly maintained buildings tend to have lower values than newer, well-maintained ones.
- Market demand: The demand for specific property types can influence values. High demand can offset some negative effects of a poor location or condition, while low demand can exacerbate these issues.
Location, condition, and market demand help investors classify investment properties into three broad categories: Class A, Class B, and Class C. Next, we'll examine each class in more detail.
Commercial Real Estate class types
Class A Real Estate
Class A real estate is the top tier of commercial real estate. It typically boasts the best locations, is in excellent condition, and enjoys high demand. These properties often attract excellent tenants willing to pay extra for the benefits of a premium property.
Class A real estate represents the least risk for investors since you’re less likely to worry about major maintenance or repair issues or tenants going illiquid. However, Class A properties require a significant amount of capital to invest due to their high entry cost.
Class B Real Estate
Class B real estate is the mid-tier for commercial properties. They don’t check all the boxes like Class A properties do, but they’re still overall good opportunities.
These properties may have minor maintenance issues but aren't extremely high-risk. With some updates, Class B properties have the potential to be upgraded to Class A.
Class B real estate offers a balance of risk and reward. They're more affordable than Class A properties, making them more accessible to a larger pool of investors. At the same time, they carry less risk than Class C properties and typically have sufficient demand to remain profitable.
Class C Real Estate
Class C real estate is the lowest tier of commercial properties. Typically, these buildings are at least 20 years old, have high maintenance costs, and are located in less desirable areas. They often attract industries with high tenant turnover, leading to unstable income.
While Class C real estate is higher-risk, it’s also the cheapest commercial real estate category. For experienced investors, Class C real estate can provide excellent returns on investment, as they require less upfront capital. Also, with strategic upgrades and renovations, a Class C property can be elevated to Class B, increasing its value and profitability.
What are the types of commercial real estate leases?
| Lease type | Tenant pays | Landlord pays |
|---|---|---|
| Single-Net Lease | Rent and property taxes | Repairs, maintenance, and insurance |
| Double-Net Lease | Rent, property taxes, and insurance | Repairs and maintenance |
| Triple-Net Lease | All expenses | None |
| Gross Lease | Rent only | Taxes, insurance, and maintenance |
Single-Net Lease (N)
In a single-net lease (N), the tenant pays the rent and property taxes while the landlord covers the other expenses, such as repairs, maintenance, and insurance. Compared to the different lease types, single-net leases are fairly rare in commercial real estate.
A single-net lease can appear unattractive for landlords since it puts much of the burden of maintaining the building on them. However, if demand is lukewarm, offering a single-net lease can be a good way to attract more potential tenants who would prefer a property without worrying about maintenance and insurance costs.
Double-Net Lease (NN)
In a double-net lease (NN), the tenant covers rent, property taxes, and insurance, while the landlord pays for repairs and maintenance.
Double-net leases can help attract a large pool of tenants who want to avoid maintenance costs but aren’t intimidated by property tax and insurance payments.
However, as the landlord, you must be fairly closely involved in managing the property to address repairs and maintenance. For Class C real estate and some Class B properties, maintenance costs can be high and may quickly eat into your profits.
Triple-Net Lease (NNN)
In a triple-net lease (NNN), the tenant pays for all expenses in addition to rent. This includes property taxes, insurance, and maintenance.
Since the expenses are the tenant’s responsibility, a triple-net lease offers substantial benefits to landlords, who don’t need to be as directly involved in the day-to-day management of the property and can rely on a more steady income.
However, you may find less demand for triple-net leases than other net lease types. Especially in slower markets, tenants may have more options for double-net or even single-net leases where they won’t have to worry about maintenance costs.
Gross Lease
In a gross lease, the tenant is only responsible for the rent, while the landlord handles all other expenses.
With a gross lease, you can charge a higher rent to cover the costs of taxes, insurance, and maintenance. Tenants are also often easier to find since a gross lease is more convenient for them.
However, as a landlord, you will have to be more involved in the daily operation of the property. There is also the risk that an unexpected repair or maintenance issue could cost more than the rent covers.
How can I invest in commercial real estate?
You have several options for investing in commercial real estate. While simply buying a commercial property has the potential for high returns and tax benefits, it also involves the greatest commitment in terms of capital and time.
For more passive income, you may consider real estate investment trusts (REITs) and investing platforms. Here's a run-through of your options.
Buy a commercial property
Pros
- Built equity
- Passive income through long-term leases
- Potential returns up to 12% or greater
Cons
- Big upfront investment
- You may be responsible for repairs, maintenance
You can buy a commercial property outright, alone or with other investors. Types of commercial properties include office buildings, multifamily properties, retail spaces, and industrial properties. Working with an experienced commercial real estate agent is crucial.
Owning commercial property lets you gain equity over time (just as you would with residential real estate) and generate passive income through leases. Commercial leases often extend for 10 years or more, which makes them fairly stable. While the return on investment for a commercial property varies depending on the area, industry, and local economy, an annual return of between 6% and 12% is typical.
However, purchasing commercial property requires substantial capital upfront, or you’ll need to partner with other investors (which will mean a smaller share of the profits). Also, you could be responsible for maintaining the building, and you may have to prepare for periods without tenants, especially during economic downturns.
Real estate investment trusts (REITs)
Pros
- Low capital requirements
- Property diversification
- Generates passive income
- No landlord responsibilities
Cons
- Lower returns
- No equity buildup
- Risk of investment loss
Real estate investment trusts (REITs) own and collect rent on real estate, distributing that income to investors as dividends. Listed on stock exchanges, REITs can be invested like any other stock.
This makes REITs highly accessible to investors with limited capital, allowing them to benefit from regular dividend payments and any REIT's value appreciation without purchasing property directly. As a result, investors don't have to worry about maintenance, vacancies, or problem tenants.
In addition, REITs often give investors exposure to a diversified portfolio of properties located in multiple markets, providing added diversification. For example, Realty Income Corp., a REIT traded on the New York Stock Exchange, invests in a wide range of commercial real estate and has a portfolio of over 15,450 properties across all 50 U.S. states, the U.K., and six other European countries.[2]
While REITs are lower risk than purchasing commercial property outright, the rewards are also significantly reduced. You won’t benefit from any of the equity you’d have built as an owner. Plus, the return on investment may be lower. For example, the average annual dividend for REITs in 2023 was just 4.09%.[3]
As with any equity, you also risk losing some or all of your investment if the value of the REIT declines.
Real estate investing platforms
Pros
- Low minimum investment amounts
- No property management required
Cons
- Higher risk than REITs
- May charge high fees
- May only be available to wealthy investors
Real estate investing platforms (also called real estate crowdfunding) pool capital from a large group of investors to buy and operate income-generating real estate. Popular platforms include Fundrise, CrowdStreet, YieldStreet, and RealtyMogul.
Like REITs, you’re not responsible for the daily management of the properties, such as maintenance and collecting rent, and you can invest with a small amount of money.
Unlike REITs, these platforms are often tied to just one property, which opens up the potential to make even greater returns.
However, the fact that your investment may be tied to just one or a handful of properties exposes you to more risk if the project fails. Also, platforms often charge fees for investing and some are only open to accredited investors.
