5 Types of Commercial Real Estate

Commercial real estate is a popular alternative asset class with a wide range of property types available for investment. Each comes with specific risks and accompanying potential returns. Investors who add commercial real estate to their portfolios may benefit from dual return streams: income in the form of rent and appreciation from any increase in property value over time. They may also benefit from diversification, reduced volatility, and the ability to hedge inflation.

Here are some topics we’ll discuss:

• Defining characteristics of commercial real estate
• Types of commercial real estate
• Residential
• Offices
• Hotels
• Industrial
• Retail
• Which property type should I choose?

Defining Characteristics of Commercial Real Estate

The commercial real estate market is broadly differentiated by three characteristics: the quality of the assets (expressed as a classification, e.g., Class A, B, C), lease profile, and location. These attributes help determine the risk and return potential of a specific commercial real estate investment.

Asset Quality (Classification): Each building’s classification provides information about its age, aesthetics, quality, amenities, and location—all of which can influence rental yields. There is no definitive way to classify different buildings, but we’ve provided a general guideline below.

• Class A buildings are best-in-class properties with modern amenities, typically located in prime areas and constructed within the last 15 years. Class A assets usually provide investors with the highest and most stable rents.
• Class B consists of buildings that are 10-20 years old, which require some capital expenditure to upgrade and modernize in order to attract top-tier tenants.
• Class C are generally 20-year-old buildings that need significant repair and refurbishments. These assets generally command below-average market rents.

Lease profile: The duration of a commercial real estate lease could be as short as 12 months or as long as 99 years. Leases also determine who pays for which expenses. In a gross lease, the tenant pays a fixed rental amount while the landlord pays all of the operating expenses of the building. In a net-lease scenario, the tenant bears the responsibility for the maintenance charges, either in full or at a pre-agreed percentage.

Location: Assets located in prime cities, downtown districts, and bustling tourist spots typically have the potential to generate higher returns than assets located in suburban locations. During economic downturns, however, these assets face greater occupancy risks and rental pressures.

Types of Commercial Real Estate

Investors can choose to invest in one of the five major types of commercial real estate by picking individual deals or by investing in a fund specific to a sector. Opportunities are also available to invest in diversified funds that combine multiple property types. Each option comes with its own risk profile and can be affected to a greater or lesser degree by broader macroeconomic trends.

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Residential assets are properties people can live in. Residential asset prices are influenced by the local supply of housing, GDP, employment, income levels, wage growth, inflation, interest rates, mortgage financing opportunities, and both regulatory and demographic trends. Residential assets are typically less affected by market conditions than other property types, as housing is consistently in high demand, irrespective of fluctuations in the economy.

These assets can be leased to multiple tenants across income groups, so the credit risk is well-diversified. However, residential leases are typically short (12-18 months on average), which creates more leasing pressure on the investor.

Sub-categories of residential properties available for investment include:

• Traditional multifamily: Residential buildings with five or more units are considered multifamily housing. These assets are typically more expensive than other residential assets, but investors in multifamily assets can benefit from tax incentives and easier bank financing. Examples of commercial properties in this category include garden apartments (low-rise apartment complexes with shared outdoor space), five to 12-story mid-rise apartments, and high-rises (12+ stories) in sprawling urban centers.
• Single-family residential (SFR): Residential properties with one to four units, ranging from a single house to a quadruplex, are included in the single-family residential category. Single-family complexes are generally larger in size than multifamily apartments, and they are commonly found in suburban locations. These assets typically require less property maintenance and capital expenditure.
• Niche housing: Student housing, senior housing, assisted living facilities, and other small but fast-growing residential sectors that benefit from long-term demographic trends are considered niche housing. The nature of the tenant base typically leads to higher occupancy levels—and therefore higher yields—compared to traditional multifamily assets. For instance, due to limited on-campus housing options, full-time students, especially the growing cohort of internationally mobile students, typically seek affordable accommodations close to their universities for the entire academic year. This surging demand coupled with limited supply of beds around the world creates a positive rental growth outlook.

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Office real estate is leased to companies for operating their businesses. Demand for office space is strongly influenced by macro fundamentals like GDP and job growth, as well as structural trends, including the rise in hybrid working, urbanization, and changes in living, working, and commuting patterns. Traditional office leases are long-duration, ranging from three to 10 years, which reduces leasing risk. At the same time, these assets may also require heavy capital expenditure to prevent obsolescence.

Sub-categories of office properties available for investment include:

• Central business district (CBD) offices: Prime offices located in downtown city centers can command premium rents. Central business district offices may consist of glossy skyscrapers and the corporate headquarters of some of the world’s largest companies. They are typically characterized as Class A with modern amenities and may also be environmentally friendly.
• Suburban offices: High-rise, mid-rise and low-rise buildings located outside downtown areas are included in this category. While suburban offices have historically generated rent in line with the market average, their investment appeal has grown in recent years due to factors like larger floor space plans and shorter commutes.
• Co-working spaces: This category includes office space leased to workers from different companies as well as self-employed professionals, generally on an as-needed basis. Tenants using these shared workspaces typically sign shorter-term leases, ranging from monthly to annually, which increases occupancy and credit risk.
• Niche offices: Office buildings leased to tenants in specific, fast-growing industries are considered niche offices. Popular examples include life science companies like biotech pharmaceutical companies and medical facilities. Properties outfitted for specific use cases like these have been in high demand, commanding premium rent in many markets. For example, life sciences has a strong foothold in the D.C. metro area, and biotech has deep roots in Boston.

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Hotel assets are inextricably tied to the health of the economy. Depending on the hotel type, demand is highly correlated to either business travel or tourism. Hotels are also complex assets to manage, involving high operating costs. The right management team is a crucial driver of performance across a range of metrics, including occupancies and RevPar (revenue per available room). Hotels typically turn their rooms over daily. This requires more work to maintain high levels of occupancy, which may also be subject to seasonal demand trends.

Sub-categories of hotel properties available for investment include:

• Full-service hotels: Hotels offering a range of services and amenities like meeting rooms, gyms, spas, and restaurants are full-service hotels. Luxury, upscale, and mid-priced hotels fall under this category.
• Limited-service hotels: Budget-friendly hotels that typically do not include restaurants and room service are considered limited service. As such, they have the lowest operating costs among all hotel sub-categories.
• Extended-stay hotels: Hotels offering long-term accommodation, with basic amenities like laundry and kitchens, are suitable for extended stays. They typically cater to business travelers or to families relocating between cities.

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Industrial real estate includes factories, warehouses, shipping and distribution centers, and large buildings for other types of industrial activities, such as manufacturing, production, and storage. Due to technological evolution, the digitization of nearly every aspect of our lives, and high demand for last-mile delivery, industrial real estate is one of the highest performing sectors today. Industrial lease duration is anywhere from three to 10 years.

Sub-categories of industrial properties available for investment include:

• Bulk warehouses: The largest category of industrial assets in terms of square footage typically functions as a regional distribution center for a single or multi-tenant base.
• Flex warehouses: Also known as infill industrial, flex warehouse assets are single-story buildings with a combination of warehouse and office space.
• Heavy manufacturing: As the name suggests, heavy-manufacturing industrial assets are highly customizable spaces built to accommodate heavy machinery and large manufacturing plants. They are typically leased to tenants such as chemicals and power companies.
• Mixed-use and light assembly warehouses: Industrial facilities in the mixed-use and light assembly warehouse categories cater to specific storage and distribution needs, such as cold storage, self storage, and data centers. They are intensive assets to manage and operate, due to specific requirements, such as climate control, uninterrupted power, secure access, and data connectivity.

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The retail sector closely follows consumer spending behavior. For example, low footfall and sales for a brick and mortar retailer, due to higher e-commerce spending by consumers, directly impacts the retail bottom line, resulting in higher cash-flow risk for the landlord. The average lease term for retail assets has historically been between three to seven years.

Sub-categories of industrial properties available for investment include:

• Malls: Malls are large retail properties that include a range of tenants, often with a prominent department store anchoring the asset.
• Neighborhood shopping centers: Neighborhood shopping centers are typically smaller than malls. Their anchor tenant profile is also comparatively low-risk, often featuring supermarkets, convenience stores, and/or drugstores.
• Single tenant: Assets located in a city’s prime tourist or business hotspots typically benefit from a high volume of shoppers. Single tenant buildings may include ultra luxury brands as well as mass urban brands, and they often pay steep rents. The average asking rent on New York’s Fifth Avenue—one of the world’s most glamorous shopping corridors—is around $2,775, for example.

Which Property Type Should I Choose?

The allocation strategy for investors eyeing the commercial real estate market ultimately depends on their risk-return appetite. Investors looking for a bond substitute would do well to invest in Class A conventional real estate sectors (property types) and sub-sectors benefiting from strong growth tailwinds. For example, rapid growth in e-commerce has accelerated demand for industrial assets, while the de-urbanization trend is driving interest in suburban residential and office assets. On the other hand, investors who are more open to taking risk—and have the right operational expertise and capital spending abilities—could benefit from opportunities emerging in niche, fast-growing sectors, such as mixed-use and light assembly warehouses, co-working spaces, and life sciences buildings.

Here are a few questions that may help you determine the right property type to choose:

• What is the overall composition of your portfolio?
• What is your budget?
• What is your ideal risk profile for investments?
• What is your target rate of return?
• How long do you want to/can you hold the asset?
• How much operational work are you willing to do?

Conclusion

Despite the inherent risks, commercial real estate is generally considered a stable investment that generates steady annualized cash flows and solid returns over a long period of time. Over the years, it has become an integral part of a well-diversified and balanced investment portfolio, comprising stocks, bonds, and other alternative assets. As with any investment, however, developing a sound understanding of commercial real estate investing and all its parameters will ultimately determine success and profitability.

No securities commission or regulatory authority has recommended or approved any investment or the accuracy or completeness of any of the information or materials provided by or through us

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