Introduction:
What are the pros and cons of real estate investment? Get the answers here!
Pros and Cons of Five Types of Real Estate Investments
What are the Five Different Kinds of Commercial Real Estate Investments?
As stated by the National Council of Real Estate Investment Fiduciaries, there are five major real estate investment properties: multi-family, industrial, office, retail, and hotel (and sub-types in each group). Each property type has distinct characteristics, ranging from varied demand drivers to the underlying cash flow cycles. Furthermore, all are heavily influenced by market conditions; as economic headwinds move, so do each’s ups and downs. Office properties, for example, maybe an outstanding investment opportunity for one year and then face difficulties, or vice versa.
Real Estate
Real estate is considered a type of real property. Personal property, such as vehicles, boats, jewels, furniture, and farm equipment, is not permanently tied to the land. It contrasts with personal property, which is not permanently tied to the land and includes vehicles, boats, jewels, furniture, and farm equipment.
The term “land” refers to the earth’s surface, from the poles to the equator, and includes trees, minerals, and water. Land’s physical features are immobility, indestructibility, and uniqueness, as each parcel of land differs geographically.
Real estate includes any permanent artificial additions, such as houses and other structures. An improvement is any additions or alterations to the land that affect the property’s value.
When land is upgraded, the entire capital and labor utilized to construct the improvement reflect a significant fixed investment. While a building can be demolished, upgrades such as drainage, electricity, water, and sewer lines are usually permanent. The real property encompasses the land, its improvements, and the rights associated with its ownership and use.
A real estate agent arranges real estate transactions by matching buyers and sellers and representing them in discussions.
What Are the Various Types of Real Estate?
Residential real estate: Any property used for residential purposes. Examples include single-family homes, condos, cooperatives, duplexes, townhouses, and multi-family housing.
Commercial real estate: This type includes apartment complexes, gas stations, grocery shops, hospitals, hotels, offices, parking facilities, restaurants, shopping centers, stores, and theaters.
Industrial real estate: This type includes any property utilized for manufacturing, production, distribution, storage, or research and development. Land includes undeveloped property, vacant land, and agricultural lands such as farms, orchards, ranches, and forestry.
Cemeteries, government buildings, libraries, parks, houses of worship, and schools are examples of special purpose property.
Real estate is a crucial engine of economic growth in the United States. The report provides data on building permits, housing starts, and housing completions for single-family homes, residences with 2-4 units, and multi-family buildings with five or more units, such as apartment complexes 1.
Investors and analysts pay close attention to home starts since the figures might provide a general sense of economic direction. Furthermore, the types of new housing starts might provide insight into how the economy is evolving.
Overall, investors can purchase real estate directly or through private equity real estate funds or REITs. However, examining the potential for risk and reward with each type of property before investing in real estate is critical, and utilizing this knowledge to build a diversified portfolio. That is why it is beneficial to grasp the benefits and drawbacks of each type of real estate investment property and their forecast for the coming years.
Economic growth benefits real estate. You can expect more from your real estate investment when the economy recovers. Favorable economic conditions should boost property demand.
A failing water heater or a leaky roof are unanticipated maintenance concerns. Repair or replacement charges could deplete your savings. This situation is especially surprising if a recent house inspection missed the problem.
Multi-family: Stable Income but Expect Disruptions
Though “multi-family” often refers to apartment buildings, it encompasses many residential subtypes, including townhouses, single-family rental homes, student housing, and senior living developments. Demographic changes (age, income, and preferences of each generation establishing households) to employment growth and home ownership are all economic forces impacting multi-family housing.
Purchasing Multi-Family Real Estate
For investors seeking an additional source of monthly income and a slow but steady increase in the value of their portfolio, rental property investing is the favored investment method. There are two residential real estate properties in which one can invest: single-family and multi-family.
Multi-family properties, usually known as apartment complexes, are buildings with more than one rentable space. While developing a portfolio of tiny homes has lower entrance hurdles, investing in large residential complexes has various advantages. Here are three reasons to invest in multi-family real estate rather than single-family rental properties.
Millennials and baby boomers favor apartments, even as tax reform provides fewer incentives for these generations to purchase homes. Generation Z, born between 1998 and 2012 and expected to make up about one-third of the U.S. population this year, is also entering the rental market. Although demographic changes have increased multi-family demand, private equity investors see multi-family real estate as a lower-risk investment.
Multiple units produce a diverse and consistent passive revenue stream. Landlords can adjust rents for inflation and switch tenants or refurbish flats with minimum downtime between leases by using annual lease periods. According to the most recent National Apartment Association (NAA) annual study, turnover is at its lowest point this century.
Financing that is appealing to investors is easily available. Freddie Mac, Fannie Mae, and the Federal Housing Administration complement multi-family financing from banks and life insurance companies, resulting in fierce rivalry amongst the various lending sources. Because of this competition and lowering Treasury yields, developers and investors have been able to borrow at low-interest record rates. When these low rates are combined with reliable underlying cash flows, they produce appealing yearly cash flows.
Multi-family real estate is also ideal for property investors looking to establish a big portfolio of rental units. Acquiring a 20-unit apartment building is significantly easier and faster than purchasing 20 separate single-family homes. With the second approach, one would have to communicate with 20 separate sellers and undertake inspections on 20 residences, each at a different address.
Furthermore, this strategy would have an investor opening 20 separate loans for each property in some situations. This trouble might be avoided by purchasing a single property with 20 apartments.
Both landlords and tenants are concerned about affordability. New construction costs are continuously rising, limiting development to projects that can command top-of-market rates. Some submarkets are concerned about overbuilding compared to the number of residents with high enough salaries to support the new supply. Other impediments to activity exist: According to the NAA, labor costs, regulation, approval delays, and community opposition are holding down new licenses.
As costs rise, urban supply networks are already contracting. To stay within budget, builders are experimenting with prefabricated, panelized, and modular systems. Further disruption is on the way. A 3D printed house built as a third-world housing solution for this year’s South by Southwest conference may represent the future of urban multi-family development. Meanwhile, the driverless automobile can potentially convert the parking garage into a white elephant.
Office: Don’t Underestimate the Complexities
The complexities of office properties are easily underestimated. Office real estate has numerous sub-categories since some tenants have particular demands, such as medical offices with highly technical requirements. They range from tiny, single-tenant buildings or multiple similar structures clustered into office parks to massive multitenant skyscrapers. The demand for office space is strongly linked to regional economic activity and job growth.
Office Pros
Low unemployment indicates that demand for office space will remain robust, particularly in fast-growing areas where jobs in technology, finance, and healthcare are concentrated. Demand is highest where amenities are nearby, giving metropolitan centers an advantage. However, when millennials settle down, communities with good schools and parks will benefit in the next three to five years since they prefer to work close to home.
Neglected places have become potential in markets where the character is a differentiation. Downtown high-rises are transformed into mixed-use attractions, with ground-level dining halls and boutique penthouse hotels. Google’s headquarters in the Chicago region retains its character as a former cold storage facility. The American Tobacco Campus near Durham, North Carolina, is characterized by water mains, train lines, and other production relics. Tenants will give a premium for an awesome workplace that aids in the recruitment and retention of talent.
Office leases are often long-term (five, seven, or ten years) and include annual rent increases, which serve as an excellent inflation hedge. A long-term lease to a tenant with good credit is beneficial for various reasons, not the least of which is that it can assist owners weather economic downturns.
The office market is expected to become more competitive as job growth slows, increasing the need to fund costly renovations, and the expenses to accomplish this work rapidly rise. Co-working spaces like WeWork, Spaces, and Industrious will compete with traditional landlords for smaller tenants since their business models provide economies that traditional office landlords cannot match.
The new creative offices will be smaller: Space planning seeks to increase productivity by cramming more personnel into the same space. Businesses used to permit 400 square feet of space per employee, but today only 150 to 250 square feet are required. According to real estate consultancy Cushman & Wakefield, job growth has spurred the need to densify. Each employee now receives 194 square feet on the average floor design.
Compared to multi-family, vacancy risk and re-tenanting expenses rise when the number of office leaseholders in a property decreases, and credit risk rises as landlords lease to startups. An early-stage company can deplete its private equity or venture capital funds and declare bankruptcy in the middle of a lease term. Revenue is lost when renters leave, and the cost of re-tenanting might entail large capital expenditures.
Retail: High Highs and Low Lows
The retail industry encompasses everything from small neighborhood shopping centers to massive super-malls that pull people from miles away. Still, each category is experiencing explosive disruption as a result of e-commerce. But it is not yet dead. People still need to go grocery shopping, try on clothes, and enjoy the community experience that experiencing retail provides.
When office tenants discuss amenities, they refer to places nearby where they may dine, drink, exercise, and go for entertainment. This “experiential” retail is alive and strong, infilling well-positioned premises and backing empty big boxes and malls with higher quality tenants—often with inventive concepts—replacing failed enterprises. Experiential retail offers strong tenant demand and low capitalization rates.
Lifestyle malls are gaining popularity as value-added investments: Luxury retail has done well recently but is beginning to suffer headwinds due to the Asian and European economic slowdowns.
There’s experiential retail (grocery-anchored centers), super-regional malls in primary markets, and everything else. Many transactions, particularly those in over-retailed and tertiary markets, have weak demand on both the buyer’s and seller’s sides, putting significant downward pressure on valuations. As national retail chains continue to close locations, evaluating the future risk in specific retail real estate assets can be tricky.
Industrial: Online Retail Demands the Whole Package
Warehouses, distribution hubs, manufacturing, research, and development facilities are examples of industrial properties. However, some of these sites are leased to a single tenant due to the complicated machinery and technology. Single-tenant leases are often long-term and provide a bond-like cash flow stream as long as the tenant continues in occupancy. However, because of the customization required, these buildings may be difficult to lease without considerable changes when a tenant quits, increasing the risk even more.
E-commerce and its near-instantaneous delivery have altered the warehouse’s appearance. Amazon is leasing multistory distribution complexes in metro areas and Amazon Hub city stores to get closer to customers. Warehouses are in great demand across all market groups, particularly in marine port areas, as mega-ships transiting the Panama Canal alter import distribution procedures. Rents for cannabis production are increasing even in older warehouses. Because of today’s favorable supply and demand fundamentals, which will likely continue in balance for the foreseeable future, industrial has become the most coveted property sector among institutional and private investors.
Industrial Cons
Because low capitalization rates do not justify the borrowing costs, warehouses sometimes require all-cash finance to acquire. Data centers require fiber optic networks, low-cost power, and redundant generating and cooling systems. The more specialized an industrial facility, the more difficult it is to change for a new tenant.
Hotel: Lower End Slow; Upper-End Busy
Hotels are defined by their amenities and services, ranging from no-frills budget motels with only necessities to limited service facilities that may lack room service or an on-site restaurant to full-service hotels with 24-hour concierge and spa amenities. And there are many variants on the accommodation theme within these levels—at every pricing bracket. Property types span from independent boutique hotels to huge chain businesses to extended stay housing and resorts, all with features geared to a specific population. Hotels linked to a well-known lifestyle mall, a big medical center, a prominent casino, or even an acclaimed restaurant, for example, function as the principal demand generators for the targeted guest.
Unlike landlords with long-term leases, hotels and short-term rentals are more adaptable and may endure economic change by fast responding to occupancy rates, guest preferences, and amenity trends. They can change their pricing, refurbish, conduct promotions, and update their offerings, among other things. These strategies can prevent vacancies if the competition is not keeping up. Delinquencies (and evictions) aren’t an issue because hotel customers must pay in advance.
According to JLL’s Hotel Investment Outlook 2019, luxury and high-end hotels are in great demand since guests seek unique experiences. According to research, luxury hotel transactions in the United States surged by 76% in 2018. Businesses are responding by acquiring one-of-a-kind luxury properties and adding luxury components to previously existing ideas.
If a hotel is not located in a desirable region, does not provide adequate amenities compared to competitors, is poorly managed, or does not respond to market changes in real-time. Whether a no-frills or a luxury hotel, every aspect, from the rooms to the amenities, requires daily cleaning, refilling, and continual updating. This necessitates a healthy operational budget; keeping customers pleased and their needs met is critical, as reviews on websites such as Trip Advisor or Yelp significantly impact a hotel’s reputation and occupancy rate (or lack thereof). This necessitates a competent, talented, and extremely proactive management team, as well as extensive due diligence on the part of investors before investing in any hotel. Furthermore, in most hotel chains, the owner is expected to execute a property improvement plan (PIP) regularly to bring a hotel into accordance with brand standards. Upgrades may include new furniture, fixtures, carpeting, and lighting, which can be fairly costly to perform and significantly reduce net cash flows.
A diversified portfolio of private equity real estate, public REITs, and direct acquisitions can help investors limit the risk of any particular type of property. With such a wide range of risk profiles, real estate investors must carefully consider the possibility of setbacks and the prospects for better profits.
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