“Landlords grow rich in their sleep without working, risking or economizing.”
-John Stuart Mill
There are many approaches individuals can take when it comes to investing one’s money, most markedly either investment in the stock market or through real estate. While the stock market has produced sizeable gains of late, recent history shows us that it is ripe with volatility. Although owning real estate does not come without risk, investing in real estate can add diversity to your portfolio and spread out the total risk in your portfolio of assets. What is more, you can guard against the uncertainties of the equities markets and benefit from the fact that real estate investments have historically been less susceptible to major market swings, although this is certainly not to say that real estate values cannot decline.
Real estate investments can be grouped into two broad categories – commercial and residential properties; both of which can be wonderful investment vehicles for accumulating long-term wealth. If you are new to investing in real estate, it is important to understand the differences between these two categories and the risks and benefits of each. Either avenue of real estate investing can boost your net worth, but most people typically look to residential real estate first, mostly because they are simply more comfortable dealing with residential property. However, the familiarity of residential investing does not necessarily make it the right route for every investor. Commercial real estate, slightly less familiar to most people, is defined as: properties that produce income, consisting of larger apartment complexes or office, retail, and industrial buildings. These buildings are primarily owned by investors, unlike single-family residential properties that are primarily owned for personal use. While commercial properties generally requires more up-front capital investment and can bring additional risk, such as a longer lease up runway or larger capital improvements as compared to a residential investment, the benefits outweigh the drawbacks in most circumstances.
One of the main reasons that private and institutional investors pursue real estate investments is to acquire yield. Real estate returns are attractive compared to alternative investments, such as equities, bonds or commodities; and generally, if you want the highest real estate returns, then commercial investing is where to look. Commercial properties generally have an annual return between 6% and 12% on the purchase price1, which is a higher range of returns than typically exists for single-family residential investments.
Long Term Tenants and Rent Increases
In most circumstances, residential leases are for a term of one year maximum with the tenant having the option to renew for another year. Commercial leases are much more favorable for the landlord due to the fact that most commercial leases are for a term longer than 2 years. In fact, some commercial leases can have initial lease terms of 15 years or longer. A long-term lease provides security for the landlord and the potential for increased yield if the property is taken to market for sale, due to the lowered risk associated with a stable tenant in place. Additionally, most if not all commercial leases provide for annual or bi-annual rent increases, which provide additional income to the landlord without the need for any additional capital improvement.
The Triple Net Lease
There are many types of leases in commercial real estate. The different types of leases indicate the landlord’s responsibility for upkeep and general expenses for the property. This range of responsibility has the “full service lease” on one end of the spectrum, in which the landlord is responsible for all expenses, to the “triple net lease (NNN)” on the other end of the spectrum. There are variations to triple net leases, but the general concept is that the property owner does not have to pay any expenses on the property, as would be the case with a residential real estate lease or even a full service lease. One of the larger fears people have about real estate investing is the uncertainly associated with costs of maintenance and upkeep, however the triple net lease alleviates those concerns. A triple net lease places most of the burdens of the property on the tenant, who is responsible for taxes, insurance, utilities, and, at times, even building maintenance. A triple net lease effectively eliminates the hassles of owning property and places all the responsibilities of ownership on the tenant, a luxury that investors usually cannot achieve with residential real estate.
Other Advantages of Commercial Real Estate
In addition to these enumerated benefits, there are numerous other benefits associated with commercial real estate investing. For example, there are fewer consumer protection laws in place governing commercial leases, unlike the numerous state laws that cover residential real estate ownership and leasing. This alleviates some of the headaches and burdens that can come as investors delve into residential real estate investing. Additionally, for local investors, buying commercial properties within your own community creates an intangible benefit of pride of ownership. There is great joy in knowing you own an income producing property that is a vital piece of local commerce.
Commercial investing is, however, not without risk. I am certainly not advocating for a “one size fits all” approach to investing. For some individuals, residential real estate may be preferable due to lower barriers to entry and less capital outlay. However, for many individuals I believe that commercial real estate is an undervalued form of investing that deserves further examination due to its many merits.