When making investments in commercial real estate, there are numerous types to consider. Each of the commercial real estate types has its own unique attributes, risk-to-reward profiles, and economic drivers that provide investors insight into the qualities and risks the asset may or may not have. These attributes are based largely on the asset’s location, condition, and revenue-generating ability. Long ago, the industry adopted categories and classifications for these attributes that allow industry professionals to quickly communicate the quality and underlying risks using a few simple terms – Type, Category, and Class.
TYPE – In CRE, this term simply defines the property’s purpose. A simple example would be the distinction between commercial or residential.
CLASS – This term quickly defines the distinction between properties of the same type as it relates to their risk-to-reward profile.
CATEGORY – Most commonly used in the CRE investment sector, Categories provide quick insight to objectives pertaining to ROI.
TYPES OF COMMERCIAL REAL ESTATE
Hotels – Hotels are one of the most unique asset classes of CRE because they are the most operationally intensive and have the shortest lease duration of any property type. Unlike its residential counterparts which require lease agreements ranging from six months to multi-year, hotels operate on nightly leases. This asset class is dependent on the overall health of the economy and can react instantly to market conditions by increasing or decreasing their rates. They are often the first asset class to experience fluctuations in economic trends which lends to their ability to position offensively or defensively during these periods. Historically, hotels are the first to lead all other CRE types in performance coming out of a recession.
Multi-Family – Multi-family properties are any property with multiple tenants such as apartment complexes but also include smaller structures such as duplexes, townhomes and even condominiums in many cases. When compared to properties used for business purposes, multi-family residential properties have a shorter lease durations that can range from six months to one year. In similarity to hotels, the shorter lease agreements with multi-family properties can also adjust to market conditions quickly. For this reason, investments into multi-family assets are often considered defensive investments where the emphasis is placed more on avoiding losses rather than maximizing gains. Through economic cycles, these assets are mostly affected by homeownership trends, local employment, and demographic growth.
Office – Office properties can be single-tenant or multi-tenant buildings in urban or suburban environments. Unlike hotels and multi-family, office properties carry long lease terms of three to five years in most cases. The properties can range from smaller stand-alone or office-complex type buildings to massive skyscrapers dotting the horizon in downtown markets. Due to the longer-term cycles of occupancy and changes in supply and demand, office buildings are one of the most volatile classes of CRE and considered a higher risk investment. These assets are substantially driven and influenced by economic and employment growth.
Retail – Retail space can include anything from small shopping centers, strip malls, warehouse-style outlets, and expansive complexes with a large “anchor” tenant such as Target or Home Depot. In the vast majority of cases, all retail establishments lease the property from the owner. Leases are commonly five to ten years in length but can even be longer in certain situations. These properties are driven by the greater health of the economy and consumer confidence. Excluding the anomaly brought on by COVID-19, the majority of retail purchases are still made in person despite the abundance of online options these days. From choosing your new wardrobe or buying gardening supplies to swinging by your local pharmacy or grocery store, consumers still like prefer to see and feel what they are purchasing. For the retail sector, as it relates to investments if consumers are confident in the future state of the economy and their employment, they tend to spend more money. This translates into stabilized or increased demand for retail property.
Industrial – While the other types of CRE we’ve already discussed or more visible to the consumer, industrial real estate is literally the structural backbone of the global supply chain that keeps goods from across the globe flowing from those who make them to those who buy them. Industrial facilities consist of manufacturing, warehouse, storage/distribution, and research/development properties. They tend to have longer lease requirements and rely less on tenant improvements to attract occupants and are less affected by local economic drivers when compared to other CRE properties. While the new norm for industrial leases is five years, they can be much longer in some cases. As it relates to investments in industrial real estate, the stability of these properties is more heavily influenced by larger economic drivers such as global trade and consumer spending, or more simply put, supply and demand.
Other – The summaries above outline the major categories of CRE, but there are several others that fit into a more niche market. These types of properties include self-storage, student housing, mobile home parks which can also provide attractive investment opportunities.
CLASSES OF COMMERCIAL REAL ESTATE
As it relates to investments, the purpose of a classification system within a certain type of property is to help investors, brokers, and lenders quickly understand the quality of the investment based on a combination of factors. Each class has varying degrees of risk given their location and ability to generate revenue as well as their upside potential.
It is also important to note that there are no formal stipulations in CRE that universally classify a certain type of property across a vast geographical area. Classification of CRE is a very subjective process simply because what may be a certain class in one market might be a different class in another. Although there are many classifications and sub-categories, let’s discuss the highly common three-tiered classification system: Class A, Class B, and Class C.
Although there are many classifications and sub-categories, here we’ll discuss the highly common three-tiered classification system: Class A, Class B, and Class C.
Class A Property – Class A properties are considered lower risk by most real estate investors because they are located in top markets and often inside of downtown central business districts or the markets and submarkets with the highest demand. These buildings generally age from newly-built up to less than 10 to 15 years old and have little to no required improvement. They are commonly occupied with high-quality tenants, have very little or no vacancy, and have stable revenue. Examples of Class A properties would be high-rise condominiums, high-rise office buildings, skyscrapers, and multi-level to high-rise hotels, etc. Because of the size and nature of these assets, they require a large amount of capital. As such, these assets are mostly acquired, owned, and operated by larger corporations, publicly traded companies, or Real Estate Investment Trusts (REITs).
Class B Property – In comparison to Class A properties, Class B properties are typically 15 to 20+ years old. They share similar qualities to Class A properties in that they have quality tenants, quality rents, and a good location. Many investors view Class B properties as value-add opportunities because they can often improve the value of the property through improvements and renovations that increase rent and attract higher quality tenants looking for longer-term leases. When value-add improvements are executed correctly, Class B properties can transform into Class A status and be sold for a greater profit.
Class C Property – This classification is for older buildings located in less desirable locations with high vacancy and lower rents. Many times, these buildings have engineering, architectural, and infrastructure issues as well as outdated technology. These are considered redevelopment opportunities that require extensive renovations. Most investors look at Class C properties as opportunistic investments with large upside potential through adaptive reuse or repositioning efforts.
CATEGORIES OF COMMERCIAL REAL ESTATE
As investors begin underwriting and reviewing asset types and classes, they then categorize them into one of four categories for risk/return assumptions: Core, Core+, Value-Add, or Opportunistic. This is where investors look at the income and appreciation aspects of the investment.
CORE – Core is considered the least risky asset class because these properties have little debt, predictable cash flow, and are located in the best markets. Do these CRE Category attributes sound familiar to a certain CRE Class? If you are thinking of Class A, you are correct! Like Class A, Core assets are newer and require little to no improvements on behalf of the new owner. These assets are generally your high-rise office buildings, luxury condominium high-rises, downtown luxury hotels, etc. Although these are relatively low risk because of their stable cash flow, it’s important to note that they also have less upside for investors upon sale. Larger well-capitalized institutions such as public REITs commonly own these assets.
CORE+ – Core+ is a step up in the risk category but still considered a lower risk asset class due to the similarities in characteristics they share with their CORE counterpart. These assets are still your large assets in major metropolitan markets but have an added risk component to them such as age, condition of the asset, location just outside the Central Business District, etc.
VALUE-ADD – Value-add is the term in commercial real estate used to describe a property that has in-place cash flow but also has unlocked potential and upside through focused management, renovations, and added improvements and/or repositioning efforts. These kinds of assets are considered riskier because they aren’t operating at their fullest potential at acquisition. Reasons for subpar performance typically include the fact that the properties have been poorly maintained and/or managed, which means they are leasing below market rates and/or have lost market share. Value-add investors, such as the Sponsors PERI primarily partner with, will seek investments where they can address deferred maintenance, upgrade a key aspect of the property, replace property management, drive satisfaction, and/or secure higher quality tenants. Through successful execution, these efforts will result in increasing rates/rents thereby increasing value. Value-add investors seek these opportunities because these assets often have existing cash flow at the time of acquisition along with the potential for upside as the property appreciates in value due to repositioning efforts.
OPPORTUNISTIC – Opportunistic investments are often referred to as “distressed assets.” Though this asset category is considered higher risk, opportunistic assets generally have the potential for the greatest returns. Because they require a more extensive and impactful turn-around, these properties require an investment/property management team with greater subject matter expertise, wherewithal, and skillset to achieve success. This is largely due to most opportunistic assets having little to no cash flow, are struggling to overcome major problems such as financial distress (significant drops in occupancy, inability to refinance, etc.), deferred maintenance, foreclosures, Chapter 11 bankruptcies, etc. Often, these properties require partial or complete overhauls and in extreme cases can be renewed into a property where very few visual traces of its past remain.
In the immediate years following the Great Financial Recession, there were plenty of opportunistic assets out there offering desirable upside. CRE investors who possessed the expertise for turn-around situations were able to acquire assets at massive discounts to current value, restructure their financing, and reposition the assets for significant upside. Many seasoned CRE investors prefer the opportunistic approach because have discovered how to unlock value on assets that were mismanaged. In fact, many private equity real estate investment companies begin aggregating capital in mature real estate cycles in the hopes that a recession will present the opportunity to buy assets at significant discounts.
Though the opportunistic asset category is considered higher risk, these assets generally have the potential for the greatest returns.
It’s important for investors to understand the types, classes, and categories of property they are investing in because each will have their own dynamic risk-to-reward profiles. At PERI Capital Group, we evaluate investments in all property types but tend to focus on the value-add and opportunistic categories for investment. When partnered with the right Sponsor that has the right balance of expertise and a proven track record, market downturns become ripe with opportunities to buy great assets at substantial discounts thus providing the opportunity for much higher returns.
We hope that you have enjoyed this segment of our CRE 101 Series and invite you to contact us with any thoughts or questions.
The views expressed herein are exclusively those of PERI Capital Group, are not meant as investment advice, and are subject to change. This information is prepared for general information only does not consider the specific investment objectives, financial situation, and the particular needs of any specific person or entity. We recommend that you seek financial, tax and legal advice regarding the appropriateness of investing in any investment strategy discussed or recommended in this article.