The 6 Types of Commercial Real Estate Property
A successful commercial property career starts with a solid understanding of commercial real estate — specifically, knowing the definition of commercial real estate, why it might be a good investment alternative to residential real estate and the different types of commercial properties.
What is commercial real estate?
The simplest way to define commercial real estate is a property that has the potential to generate profit through either capital gain or rental income. Examples of commercial property spaces include office buildings, residential duplexes, restaurants, or even a warehouse. If you can make money from leasing it out or holding it and reselling it, it can be classified as a commercial property.
How is commercial real estate different from residential property?
Commercial real estate is different from residential property in four significant ways:
- Purpose: With the exception of residential rental properties like apartment buildings, commercial real estate property typically functions as a place of business, not a residence. The purpose of commercial spaces is to serve as workspaces that create income for owners and investors.
- Price: Because commercial properties are often larger buildings on substantial plots of land in highly-trafficked commercial areas, they are much more expensive than residential properties, and are therefore more likely to be owned by a group of investors rather than an individual.
- Occupants: Residential property is often owner-occupied, whereas commercial properties are usually occupied by business tenants who lease the property from the owner or a group of investors.
- Lease terms: Commercial real estate properties typically have longer lease terms than rental residential properties, with retail and office spaces having the longest leases averaging 5-10 years, compared to typical residential apartments or homes that may be leased for six months to a year.
How does investing in commercial property compare to investing in residential property?
While commercial property often requires a larger upfront investment than a residential property, the potential rate of return is often higher as well–but you may also run a higher risk, especially with retail or industrial tenants in an iffy economic climate. On the plus side, as a commercial real estate owner or investor, you can take advantage of triple net leases, which place the financial responsibility for costs like real estate taxes, maintenance, and insurance in the hands of the leasing tenant.
Unlike residential real estate, you usually can’t live in the property when you invest in most commercial real estate. But the upside is that you’re usually working with business owners (a B2B relationship) rather than directly with renters (a B2C relationship). And with income-producing businesses as property tenants, they’re more likely to stick to lease terms and pay rent reliably. The longer lease lengths in commercial real estate can give you a more stable cash flow, and tenants like government agencies and healthcare providers can offer certainty even in an unstable economy.
On the downside, Investing in commercial real estate properties can be more complicated than investing in residential properties. Most commercial investors either have a background in commercial property law or have a team of commercial property experts on hand to cut through the red tape that comes with the business of commercial real estate.
What are the different types of commercial real estate?
CRE property runs the gamut of everything from industrial space to hotels and open land, but it usually falls under one of six categories.
1. Office
Office buildings are generally categorized into two types: urban or suburban. Urban office buildings are found in cities and include skyscrapers and high-rise properties — some may even total as much as a few million square feet in size. Suburban office buildings are usually smaller in stature and sometimes grouped in office parks.
Office buildings can be multi-tenanted or single-tenanted, and many are build-to-suit. They’re also ranked in three tiers: Class A, Class B, and Class C. The Building Owners and Managers Association International (BOMA) explains:
Class A
- Most prestigious buildings competing for premier office users, with rent above average for the area. Buildings have high-quality standard finishes, state-of-the-art systems, exceptional accessibility and a definite market presence.
Class B
- Buildings competing for a wide range of users with office spaces renting in the average range for the area. Building finishes are fair to good for the area. Building finishes are fair to good for the area and systems are adequate, but the building does not compete with Class A at the same price.
Class C
- Buildings competing for tenants requiring functional space at rents below the average for the area. Medical office buildings are a specialty sub-sector in this space.
Learn more about the 3 office building classes.
2. Retail
Retail comprises the commercial spaces that host the retailers and restaurants we frequent. They can be multi-tenant (often with an anchor, or lead tenant, that serves to drive traffic to the leased property) or single-use, standalone buildings.
The retail sector is complicated, as the type of shopping center is dictated by many metrics, including the size, concept, types, and number of tenants, and trade area.
Single-tenant buildings include big-box centers (usually with a national chain like Target, Walmart, Best Buy, or Dick’s Sporting Goods) or pad sites (single-tenant buildings within a shopping center, often a bank, restaurant, or drug store).
Learn more about the 8 types of retail real estate.
3. Industrial
Industrial buildings accommodate industrial operations for a variety of tenants and are mostly located outside of urban areas, especially along major transportation routes. The low-rise buildings can also be grouped into industrial parks. The properties are categorized into four types:
- Heavy manufacturing: These buildings are heavily customized and house machinery manufacturers need to operate and produce goods and services.
- Light assembly: These aren’t as customized and may be used for product assembly or storage.
- Bulk warehouse: These properties are usually large and are used as distribution centers.
- Flex industrial: These properties contain a mix of both industrial and office spaces.
Keep in mind that industrial land use has its own subset of zoning laws, with things like research and development (R&D) facilities having a specialized type of industrial zoning.
Learn more about the 8 types of industrial real estate.
4. Multifamily
Any time you have five or more residential units owned by a single entity, they’re classified as commercial real estate. The multifamily sector covers all types of residential real estate outside of single-family, including apartments, condos, co-ops, and townhomes. Like office buildings, multifamily property is often classified into Class A, Class B, and Class C.
Apartment rental buildings, in particular, are split into multiple property types. Freddie Mac has separated them into six different buckets:
- High-rise: A building with nine or more floors and at least one elevator.
- Mid-rise: A multistory building with an elevator, typically in an urban area.
- Garden-style: A one-, two-, or three-story apartment development built in a garden-like setting in a suburban, rural, or urban location; buildings may or may not have elevators
- Walk-up: A four- to six-story building without an elevator.
- Manufactured housing community: A community in which the operator leases ground sites to owners of manufactured homes.
- Special-purpose housing: A multifamily property of any style that targets a particular population segment, including student housing, seniors housing, and subsidized (either low income or special need) housing.
5. Hotel
The hotel sector covers establishments providing accommodations, meals, and other services for travelers and tourists. The hotels may be independent (boutique) or flagged—the latter means it’s part of a major hotel chain, such as a Marriott or Sheraton. Real Capital Analytics splits them into six separate categories:
- Limited-service: Does not have room service, on-site restaurant, or concierge.
- Full-service: Includes room service and has on-site restaurant.
- Boutique: Located in an urban or resort location, has full-service amenities, is not part of a national chain, and has fewer rooms.
- Casino: Has a gaming component, such as video poker or slot machines.
- Extended-stay: Limited-service with fully equipped kitchens in guest rooms and larger rooms for long stays.
- Resort: Full-service, large amount of land, in a typical resort location (such as Hawaii or Orlando), and has an attached golf course, water park, or amusement facility.
6. Special Purpose
Special purpose real estate may be owned by commercial real estate investors, but doesn’t fall into any of the sectors mentioned above. For instance, open land for fairs, amusement parks, churches, self-storage, and bowling alleys are special-purpose facilities.
What is the best way to get started in the commercial real estate industry?
If you’re interested in diversifying your portfolio by investing in commercial real estate, it’s important to first understand the different types of investment opportunities.
Direct investment: Direct investment is the most straightforward way to invest in commercial real estate–if you have access to plenty of cash and plenty of knowledge. With a direct investment, you’ll work with a real estate agent or broker to find a property to purchase, and then you can choose to lease out and manage it yourself as the landlord or hire a property manager.
Indirect investment: If you aren’t flush with cash and you’re not CRE-savvy, you can invest in commercial real estate through indirect investment. REITs, crowdfunding, and ETFs all allow you to invest without taking on the full burden of responsibility for the leased property. Rather than buying a property yourself, you can purchase stock in a company that buys, sells, and leases out commercial properties. As a limited partner, you’ll enjoy a portion of the investment returns without having to be involved in day-to-day commercial property operations and decisions.
Types of indirect commercial real estate investment
Real Estate Investment Trust (REIT): REITs are companies that buy commercial real estate properties and then leases them out to tenants. REIT offers shares to qualified investors (like mutual fund managers and other professional investors) and then distributes 90% of profits to investors as dividends. Because REIT shares are easily bought and sold, REIT investment is a more liquid form of property ownership.
Crowdfunding: Just like traditional crowdfunding, commercial real estate crowdfunding allows a collective group of individuals to contribute funds to finance a large project, like the purchase of a commercial property. Crowdfunding requires a lower initial investment than other types of CRE investing, but it is not tightly regulated, so investors must be accredited by the Securities Exchange Commission (SEC).
Exchange Traded Funds (ETFs):An REIT ETF operates much like a mutual fund, but it can be publicly traded in the stock market, so its value changes more frequently than a mutual fund. An REIT ETF typically contains a grouping of REIT securities rather than stocks and has fewer overhead fees because the securities aren’t being traded individually.
Whether you’re buying, selling, or investing, the easiest way to get started in commercial real estate is to read commercial property blogs, listen to CRE podcasts, and start learning more about your local market through social media groups and market research.
Pros and cons of investing in commercial real estate
Weighing the pros and cons of investing in commercial real estate can help you decide if it’s the right move for you.
Pros of investing in commercial real estate:
- Traditionally provides a strong return on investment, especially in areas of high demand and low inventory
- Offers longer lease terms than residential real estate for greater cash flow stability
- Can provide the benefits of both short-term cash flow through leasing and long-term returns due to capital gains over time
- Provides a more diversified portfolio and may give you more control over ROI
- Spaces like government and healthcare can provide more stability during an economic downturn
Cons of investing in commercial real estate:
- Buying and selling are lengthy processes, making it less liquid than other investment vehicles
- May require more money upfront, especially if you’re choosing to buy a property outside of a partnership or publicly traded REIT
- Can be highly susceptible to economic downturns, especially retail space and small businesses
- Because different commercial tenants have different space layout needs, tenant turnover can be time-consuming and costly
- Direct investing requires an understanding of commercial real estate laws, regulations, and best practices
The bottom line
Commercial real estate offers a wide variety of profitable opportunities, for owners, investors, and tenants, but it’s not for everyone. Learning more about the CRE industry can give you a better understanding of its ins and outs and open up new possibilities for diversifying your portfolio or growing your business.
Stay in touch with what’s going on in the commercial real estate world by reading the latest CRE news on the VTS Blog.
