"Commercial Real Estate Has Historically Outperformed the Stock Market."
If you’re thinking of adding real estate to your investment portfolio, you’re not alone. Experienced investors know the importance of balancing fixed and equity investments with real estate assets. Not only does this diversity help to disperse risk, but it can also deliver long-term cash flow. For most investors, the idea of investing in real estate turns their minds to residential assets. However, few investors realize that commercial real estate has outpaced the stock market over the long term. If you’re wondering if you should invest in commercial real estate, we’ve got you covered.
Naturally, there are pros and cons to investing in both residential and commercial real estate. Deciding which makes more sense depends on your financial goals, investment timeline and risk tolerance.
Here, we’ll zero in on commercial real estate as an investment, how it compares to residential, when it makes sense to make the leap and a few things to think about.
What is Commercial Real Estate?
First, let’s look at commercial real estate and how it differs from residential. In broad strokes, commercial properties are those used for anything not residential. Commercial properties include vacant land, warehouses, offices, industrial, retail, motel/hotel properties, restaurants, hospitals, or multi-family residential buildings.
Even if you’re familiar with the residential market and feel ready to invest in commercial real estate, it’s important to understand the key differences between these two asset types. Commercial properties are often much larger and more complex in nature.
Other differences include the following. Commercial properties offer:
- Higher rental yields
- Longer lease arrangements – more stable, long-term income
- Lease variability – can arrange for the tenant to take on specific costs
Financing is another difference between these two types of assets. Many commercial properties are financed with adjustable-rate mortgages or specialized financing. While adjustable-rate mortgages are available for residential properties, their financing models are shorter-term and often more straightforward.
Perhaps the most significant difference between commercial and residential properties is how you make money from your investment. While residential assets can ultimately be rented out to one or a small number of tenants, commercial properties offer more significant income through lease arrangements.
So why are investors drawn to commercial properties if they are more cumbersome and complex? The answer comes down to return on investment (ROI).
ROI on Commercial Real Estate
If you’re wondering if you should invest in commercial real estate, you might be drawn to its potential ROI. When considering the possibility of making money on your investment, it’s essential to understand the variables.
Generally, the upfront investment for commercial real estate is more significant than it would be for a residential purchase, but the returns are also usually higher. The commercial real estate market offers higher rent yields than residential assets and longer lease arrangements. This guarantee of long-term rental income provides predictability and stability that is appealing to some investors.
Taxes can impact ROI directly. Although commercial assets are generally taxed at a slightly higher rate across the country, Michigan’s property tax laws are favorable to investors. When you purchase a commercial property in Michigan, your taxes are reassessed and capped, preventing most tax increases. Unless you make significant renovations or improvements to the building, your tax rate won’t increase beyond the rate of inflation.
In addition, if you own commercial property in Michigan and lose a major tenant, you can claim this and appeal for your taxes to be reassessed. If your case is approved, taxes will be capped at a lower rate.
Another factor that impacts commercial real estate ROI is the rate of depreciation. Commercial properties depreciate over 27 years, while most residential properties (except those built after 1986) depreciate over 39 years. In addition, straight-line depreciation can be used for commercial assets but not residential ones.
Market Sensitivity
At first glance, you might assume that commercial and residential real estate react to market influences in the same way. After all, macroeconomic forces such as interest rates, inflation and the state of the economy impact both. But there are key differences to note. If you’re wondering if you should invest in commercial real estate, it’s important not to assume that commercial and residential properties react to market forces similarly.
Generally, commercial real estate is more sensitive to economic cycles and pressures. It is highly sensitive to supply and demand, which can impact local lease rates and purchase prices quickly. The overall health of the economy impacts commercial real estate across the country.
If the unemployment rate rises, demand for many products and services decreases, and fewer businesses feel comfortable signing a long-term lease agreement. Considering this information, it’s important to be in tune with market forces if you plan to invest in commercial real estate.
This also means there are significant opportunities when the economy shifts towards productivity and growth. You can take advantage of these opportunities when you pay attention to economic news and data. Commercial real estate investors generally hold a long-term view of the market, making them less concerned about short term shifts in demand.
Better Payback Than the Stock Market
The long-term payback can be significant if you decide to invest in commercial real estate. You may wonder how investing in a commercial asset might compare if you invest the same money in the stock market.
Naturally, any investment comes with unique risks. According to Investopedia, commercial real estate (tracked through the Vanguard Real Estate ETF Total Return – VNQ) has outpaced the stock market (as tracked through the S&P 500 ETF – SPY) since 2005.
Although VNQ currently sits below SPY, it experienced higher floors when returns dropped in 2008 and 2020. Gains have also been significantly higher. With the current gap between the two benchmarks, savvy investors are looking for an opportunity to invest in commercial real estate.
Where do you Start?
As with any real estate purchase, it’s critical to do your research and find the right investment. Commercial real estate is not a passive source of income. Make sure you’re ready to respond to the needs of tenants and that you plan to remain invested over a
a longer period.
When exploring commercial investments, you’ll have your criteria for a given business or industry. A good commercial realtor can help you understand the local environment, infrastructure and laws. They can help you find an existing business or an ideal property, if you want to build. Starting fresh has several advantages, including the ability to make your property more enticing for businesses by introducing new technologies and making the space aesthetically pleasing.
If You Plan to Build, Find the Right Team
If you decide to invest in commercial real estate by building from the ground up, finding the right team is critical. Look for an experienced builder with a long track record in the industry that interests you. Whether you are ready to invest in commercial real estate or are simply exploring potential opportunities, finding a reliable build partner is a must.
At J.B. Donaldson, we are a premium design-build contractor with over 20 years of experience in a wide range of industries. With extensive in-house expertise, we collaborate with our clients, helping you navigate every aspect of your project, from pre-construction to final design.
We value quality, consistency, and predictability, which allows you to count on schedules, costs, and project integrity. Our commitment to excellence allows us to provide creative designs, practical solutions and innovative ideas while keeping your goals and objectives as top priorities.
