Buying an investment property is the first step to building a real estate empire. The good news? If you own your house, you’re already an investor. But that doesn’t necessarily mean residential real estate is the best way to start.
If you’re dipping a toe in the commercial real estate pool for the first time (or thinking about diversifying your portfolio with a different type of property), here’s what you need to know about how to determine which commercial property will give you the best return.
What’s the Rate of Return?
The average return on investment (ROI) for commercial real estate is 9.5%. It’s difficult to parse this number across separate categories, so it’s essential to consider a few factors when determining which commercial property type offers the best potential for your portfolio.
The Golden Rule Still Applies: Location, Location, Location
Office spaces in business districts within easy commuting distance (or proximity to reliable public transportation or other amenities) are in high demand. Even during pandemic-era remote work, office space that pivoted to coworking space in urban areas had more utility than a standalone building in the middle of nowhere.
Retail properties can offer high returns if they’re well located, such as in a shopping center or other location with high foot traffic. However, spaces in busy urban areas with no accessible parking and no foot traffic are generally suboptimal.
Industrial real estate has a different set of considerations. These spaces, such as warehouses and distribution centers, need access to major highways and enough square footage to suit the building’s purpose inside and outside. This land (and the necessary zoning to utilize it) can be nonexistent in urban settings and scarce in the suburbs.
Demands Are Changing
Office space has dramatically shifted
In 2020, news outlets reported on empty office buildings in downtowns in major cities as some residents fled a global virus and switched to remote work. Office buildings are slowly seeing an uptick in tenancy, but not fast enough for some landlords, who are offloading their investments.
It is safe to say that a global pandemic will not be an annual event. But some companies have permanently shifted to remote or hybrid work, marking a seemingly persistent reduction in footprint demand for urban office spaces. However, hybrid models are asking tenants to become more creative, adopting suburban space or smaller business center locations with better amenities.
Ecommerce is growing
Consumers got used to doing business online during the pandemic, getting everything from booze to groceries delivered with just one click. In-person shopping has bounced back with a vengeance, but we’re still observing the impact of easy shopping from the comfort of one’s couch.
As a result, those investing in retail spaces need to adjust their expectations when dreaming of pre-pandemic returns with their eyes open. Despite this, retail has been one of the post-pandemic winners in terms of consistent rent growth and resilient performance amid interest rate hikes.
Industrial space became more valuable
Where are businesses storing all this new merchandise that consumers are snapping up online? Large industrial warehouses are hot and in high demand. Even as retail giants such as Amazon begin to scale back their fulfillment centers, other businesses recognize the value of having their own space to design, build, and ship their products.
However, overbuilding in the industrial space has resulted in some demand gluts; many believe this to be temporary and not high-impact on the space’s long-term outlook.
Is the Risk Worth the Reward?
Office properties are among the riskiest investments. They are very vulnerable to economic downturns and changes in the business landscape. However, investors who select their locations wisely and focus on delivering impeccable service to high-quality tenants have the best chance of a good return on their investment.
In most cases, it’s best to view an office property the same way you would an investment in the stock market. While making substantial short-term gains is difficult, office space becomes profitable over time. It has about the same ROI as other properties — or more in areas that see a boom in revitalization.
Investing in retail property can be risky, but the better your location, the better the chances you’ll see a high rate of return. In many cases, tenants pay the lease on their store and a prorated share of maintenance, property taxes, and insurance. Additionally, a retail center with a mix of businesses that include established anchors and smaller businesses can generate long-term, steady income.
However, the demand for the in-person retail experience changed during the pandemic and is still in recovery. Some retailers have responded by incorporating “phygital” retail into their stores, a technological shift that combines the best features of physical and digital retail experiences.
Retail spaces also have higher tenant turnover, and ongoing maintenance can be costly. Ongoing shortages and a lack of employees also affect consumers’ desire to go to a physical location.
Industrial properties are having a moment right now. The per-square-foot rental price averages just over $7.50, and industrial spaces have a vacancy rate below 5%. Contrast that with office buildings, which, despite a bounce back from the pandemic (and a higher rental price), still have vacancy rates that are 18% or more.
Industrial properties are also easier to manage remotely. Tenants generally take care of maintenance, their own insurance, and keeping properties safe and up to code. Additionally, tenant leases are usually lengthier and more stable than retail and office space.
However, certain industrial spaces are non-starters for most investors. Single-use industrial spaces for businesses like car dealerships or supermarkets remain an incredibly risky investment. If the company goes out of business, you’re out of a tenant.
Which Property Is Best for You?
The investment property you select depends on financial considerations and your investment goals.
Commercial mortgage rates are generally higher than residential rates and come with similar fees associated with purchasing a home, so you’ll need a plan or a lot of cash.
And the entry price varies wildly, depending on where and what you buy. For example, the per-square-foot price may be lower for an industrial building, but you’ll be investing in a much larger building. And the cost of large buildings in urban areas will be out of reach for many investors.
Suburban office space generally comes at lower prices and has another good thing: it’s located where the workers are, so there is solid potential for immediate occupancy. But you’ll be starting with a smaller space, and the fees for purchase are still in place.
Investing in a well-established retail center can be costly, but the risk of investing in a newly built, vacant retail space might cost even more.
The most critical consideration when deciding which commercial real estate investment is best for you is simple: What are your investment goals?
Are you looking to invest in a large warehouse and build to suit your tenants, or do you want a turnkey property with tenants in place? Is your goal hands-off management, or would you prefer to be involved in the day-to-day operations? Do you need space of your own on your property?
These answers can help you decide which property is best for you. Talk to your financial advisor and carefully investigate all possible properties before deciding.
Get more insights into office, retail, and industrial trends with Crexi Intelligence.
Ben Mizes is the Co-Founder and CEO at Clever Real Estate, the nation’s leading real estate education platform for home buyers, sellers, and investors.