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Evaluating Real Estate Investments by Asset Type

And the Best Real Estate Investment is…

One question I am often asked about with regards to real estate is: What is the “best” type of property to invest in?

Obviously, there is no right or wrong answer. Your ability to risk the money you invest, the returns you might expect, time horizons, and your overall investment goals all impact what investment might be right for you.

The following factors impact the success of all real estate investments:

1) Location

2) Financing

3) Tenancy

4) Necessity for capital improvements

Additionally, the terms of any existing leases will affect a property’s performance. There are, however, some benefits and challenges inherent in various asset classes. Understanding these details can help you assess what type of investment is best to help you meet your goals.

This column addresses the risks and rewards generally associated with residential, retail, office, industrial, and operational real estate investments.

Residential Investment Properties

Residential investment properties are attractive because there are a broad range of choices in a wide variety of price points. You can invest in a single-family home, a condominium unit, or a multi-tenant building.

Furthermore, there is a comparatively strong supply of possible residential tenants compared to other asset types. Everyone needs to live somewhere.

Perhaps the biggest challenge with residential property is that it tends to be management-intensive in terms of maintaining the property and collecting rent. If you are not handy, or if the property is not near you, you will likely need to hire someone to handle operational matters for you.

The biggest challenge with residential property is that it tends to be management-intensive in terms of maintaining the property and collecting rent

In addition, units in multi-tenant buildings may be negatively affected by neighboring owners. Residential renters’ appetites for amenities change more quickly than do commercial tenants. On top of that, pricing may be competitive, as you must bid against both prospective investors and prospective residents. [Editor’s Note: The Financial Poise webinar, “Investing in Residential Real Estate” will provide a deeper look into this specific type of investment.]

The following are specific risk factors for residential properties:

  • Individuals do not typically have pockets as deep as commercial businesses. You will need to check the credit of your tenant(s) and any lease guarantors.
  • The neighborhood — or demand for rental housing in the area  — may change significantly in a relatively short period of time. The proximity of the property to public transportation and neighborhood amenities (including grocers, dining and entertainment, parks and recreation, and quality schools) can also impact the desirability of apartments.
  • The demand for property-level amenities is always evolving. This is particularly important for a multi-tenant building where common areas must be maintained as well as individual units.
  • Residential leases tend to be shorter term than commercial leases, so you may need to find new tenants on an annual basis. Turnover costs might include leasing commissions or referral fees in addition to normal cleaning expenses. On the upside, changes in tenancy also provide an opportunity to increase rents more quickly if market conditions improve.
  • Government subsidies or tax incentives may be available for some types of low-income housing.
  • When reviewing the rent roll, note that rent concessions can boost occupancy. However, they will decrease revenue on a per-square-foot basis.

Retail Investment Properties and Office Investments

Retail and office investments share several similar features. Both can be single- or multi-tenant properties. The tenants may include global, national, or regional firms, as well as “mom and pop” businesses.

The number of tenants and the tenants’ credit and sophistication, as well as the extent of common areas maintained by the landlord will impact the ease of managing both types of properties.

Recent market trends for both sectors include a general reduction in square footage desired by tenants. In retail, this is largely due to internet sales and better distribution channels  — resulting in less inventory stored on-site. In office buildings, the need for storage areas for paper files has been reduced significantly by electronic records. Additionally, the footprint of offices has waned as companies have become more open to telecommuting, and have shifted from fewer single-user areas in favor of collaborative common spaces. [Editor’s Note: Learn the ins and outs of  this type of investment with the Financial Poise webinar “Investing in Commercial Real Estate]

As a by-product of telecommuting, space requirements have also been affected by hoteling. This happens when employees reserve desks or offices on a daily or hourly basis when they are physically in the office, using lockers or other designated storage space for files and personal items when they are working remotely.

One of the biggest challenges faced by the retail sector is the impact of e-commerce. While 91.6% of retail sales still arise from brick-and-mortar stores, the future of large retail spaces (such as department and big box stores) is unclear.

One of the biggest challenges faced by the retail sector is the impact of e-commerce.

Some retailers have moved to a showroom model. At the store, customers can see and touch sample products, and then have the goods shipped from a distribution center. In contrast, Amazon has now opened brick-and-mortar stores to supplement its online presence. Learning how to Leverage Real Estate Investments to your advantage could really pay off depending on the timing.

E-fairness legislation is currently being deliberated by Congress to require online retailers to collect sales tax for all customers regardless of whether they have a physical presence in the state. This would eliminate price distinctions due to state and local taxes.

Regarding single-tenant retail and office properties, the investor should focus on the following:

  • The tenant’s credit. Obviously, the success of the investment hinges on the ability of the tenant to perform its obligations under the lease. This includes both paying rent and performing maintenance and other obligations. A guarantee from a deep pocket may provide a backstop in the event of a default of a subsidiary. But enforcing that promise may be expensive and time-consuming  — and perhaps impossible if the tenant ends up bankrupt.
  • The length and terms of the lease. A long-term lease provides predictable income and a basis to acquire financing. But it also means little opportunity to capture upside potential if market rents increase. The lease will designate landlord and tenant responsibilities (both for normal operations and in case something goes wrong) and may also include rental concessions or allowances for tenant improvements.
  • The location. Look at the market demand for space and the supply of tenants, as well as accessible parking, transportation and amenities. Downtown hubs and larger metropolitan areas provide a bigger tenant base to draw from if the economy falters.
  • The age of the property. What is the likelihood that significant capital repairs will be needed, and when? How long has the tenant been operating in the location?

If there are multiple tenants, you may also consider the following  additional factors:

  • When reviewing the rent roll, do several leases expire at the same time? This presents both a danger of high vacancy and an opportunity to redevelop larger portions of the property at once. Rent concessions (as well as tenant improvement costs) paid over the lease term and then burned off will affect the true rental revenue stream.
  • Each tenant may have specific parking requirements, but tenants may not all have the same hours of operation. This may provide flexibility if parking space is at a premium.
  • Pay attention to what items are included and excluded from common-area maintenance charges (CAM), and how — and when  — CAM charges are passed through to the tenants and reconciled.

Some issues specific to shopping centers include:

  • Shopping center leases may have use or radius restrictions limiting the type of businesses the landlord can add to the shopping center. These “non-compete” clauses can be narrowly tailored (e.g., to exclude a specific competitor), but are frequently broadly worded (e.g., sellers of women’s shoes).
  • Some shopping center leases include provisions that allow other stores, including smaller tenants, to pay less rent or even terminate their leases if anchor tenants “go dark” or leave the center.

Industrial Property Investments

Industrial properties include warehouses, distribution centers, manufacturing facilities and flex buildings. Access to transportation is more important for industrial assets than other property types; tenants will need to be able to easily transport materials and goods to and from the facility. Features that warrant special attention when considering an industrial building include:

  • Number of dock doors and the type of dock equipment (for example, bumpers, drive-in or dock high doors);
  • Size and security of the truck court, which should be separate for each tenant (as well as separated from passenger vehicle parking areas);
  • Clear height of storage and operational (non-office) areas;
  • Drainage, sprinkler, lighting, and ventilation systems, especially for manufacturing and production areas;
  • Size of the office areas, which often require a higher degree of finishes to be provided by the landlord.

Operational Real Estate Investments

Operational properties do not get leased to specific tenants. They are instead used by paying customers on a daily, weekly, or monthly basis. Hotels, parking garages, self-storage facilities and some assisted/senior living centers are examples of this asset class.

Unlike residential, retail, office, and industrial properties, the success of an operational property is largely dependent on the underlying business at the property. Income from such assets will change due to seasonal and other variances in business. 

No asset class is necessarily “better” than any other for investment. However, some types of properties will need more time and expertise than others to keep cash flowing.

For operational assets, therefore, it is important to have property management with specific expertise in the field who can 1) handle the business on a day-to-day basis, and 2) optimize use while controlling costs. Accordingly, these properties do not make good “armchair” investments without the help of an experienced operator to take on these efforts.

Operational assets are also more dependent on the local economy than other property types. The occupants do not need to ask for rent reductions from the landlord if business is slow; the income adjusts itself based on the market. On the other hand, a strong demand for the property’s services or reduced competition can mean quicker income for the landlord.

The Overall Picture

No asset class is necessarily “better” than any other for investment. However, some types of properties will need more time and expertise than others to keep cash flowing. Having multiple tenants may increase the operational complexity of a property, but it may also afford more flexibility to adjust rents or repurpose space if needed.

You should always obtain your own market research and conduct due diligence before investing in a property. Reviewing existing leases is a key to understanding the potential benefits and pitfalls of a given asset.

Ideally, passive investors should strive for diversity in their investment portfolios, and rely on knowledgeable property management if issues arise. Mixed-use properties, such as storefronts with apartments or offices located above them, may have both advantages and disadvantages of their component asset types. They also offer a degree of diversification within a single building.

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