Major Commercial Real Estate Asset Classes
Assuming that all commercial real estate is the same is not only a much too simplistic approach, but it can also be a dangerous approach. In this article we’ll discuss the major types of commercial real estate and the differences amongst them. As you’ll see, each type of commercial real estate asset class has nuances that make the operation and analysis unique. Although some of the fundamental operational and valuation principles apply to all asset classes, the nuances of each asset class will lead to differences in the importance of different factors during the analysis.
For example, office, retail, and industrial properties often execute long-term leases of five to ten years while apartments are typically rented for terms of one year and hotels rent rooms by the day. Even within the major asset classes there exist subclasses of assets, such as office buildings in the Central Business District of major cities versus office buildings in the suburbs of secondary cities. The rest of this article will outline the most distinct characteristics and use cases of each of the major asset classes and describe a few of the more common subclasses within each category. The five major asset classes we’ll cover include:
Breaking Down the Major Real Estate Asset Classes
Office properties are those that lease space to companies from which those companies can operate their business. This includes space for employees to work, for meetings, for events, or other purposes. Office buildings can range from a single small building with a single employee to high-rise office buildings with hundreds of thousands of square feet and multiple tenants. Office properties typically involve long-term leases of at least five to ten years and are attractive to investors who look for more certainty around long-term cash flows than some of the other property types.
Retail properties can simplistically be described as a property used for marketing and selling goods and services to consumers. Retail properties range in use from a small medical office building or fast-food restaurant all the way to major shopping centers such as the 5.6 million square foot Mall of America in Bloomington, Minnesota. Retail properties are typically highly catered to the surrounding neighborhood and demographics and can vary widely in the look and feel of each property. Like office properties, leases for retail properties are usually in the five- to ten-year range, thus they provide a level of stability in cash flow that many investors are drawn to.
Industrial properties include those for uses such as manufacturing, warehouses, storage, distribution centers, or research and development. A large majority of industrial real estate is involved in the manufacturing and distribution of products and therefore needs easy access to transportation corridors, which is why these properties are often located next to shipping ports, airports, train stations, or major highway thoroughfares. Like office and retail properties, industrial properties usually have long-term leases and are often occupied by a single tenant or several large tenants rather than a highly diversified tenant mix.
Multifamily properties contain dwellings that are typically occupied by individuals or families and leased on an annual basis. Apartments, co-ops, and condos are all types of multifamily properties with small nuances in the legal and operational characteristics of each. Much like office properties, multifamily properties range from small properties (a duplex consisting of two units is the smallest type of multifamily) in rural or suburban areas to high-rise multifamily properties with hundreds of units in core urban areas.
Hospitality is the final property type we’ll look at and is a bit “odd” compared to the other four uses discussed above. Hospitality properties include hotels, motels, luxury resorts, and event centers, usually leased for a single night or for short blocks of time, such as a few days or a week. As you can imagine, this often allows hospitality-focused properties to increase rates quickly in periods of high demand, but also means that revenue could drop significantly during market downturns, natural disasters, or any number of other reasons. Hospitality properties are also often split between the real estate and the operation of the property, with an “operating partner” managing the day-to-day operations of the hotel or event space.
A Few Notes on Performance of Different Property Types
While office, retail, and industrial properties usually have long-term leases (five to ten years) and therefore offer a bit more stability/certainty in long-term cash flow, they are susceptible to a few common downsides:
- Often these property types have one or more tenants that occupy a large amount of space in the property. While that tenant may have agreed to a ten-year lease term, at some point the lease will expire. If the tenant decides to vacate the property at that point, the owner of the property could experience a major disruption in cash flow.
- Long-term leases often contain agreements as to how much the rent will increase each month. Common uses are a CPI (inflation index) or a set step-index (perhaps 3% increase each year). This does provide some certainty in cash flows, but it also exposes the owner of the property to risks if expenses increase faster than the stated rent increases or market rents rise much faster than the stated rent increases.
On the other end of the spectrum, multifamily and hospitality properties have much more flexibility to adapt to market changes due to their short-term lease agreements. This offers the ability to raise rental rates quickly in the case of market changes. However, it sometimes opens these uses up to the risk of lower demand. Recently, for example, we have seen how hard hospitality properties have been hit due to the COVID-19 pandemic.
Classes of Property
Not only are there different uses for each asset and sub-asset type, there are also differences in quality and functionality within each type of asset referred to as the “class” of the property. Classes are usually defined as a Class A, Class B, or Class C property with Class A representing the highest quality and Class C representing the lowest quality.
There is no universally agreed upon scoring system for determining the class of a property, but some generally accepted principles regard the physical condition and the level of modern functionality the property provides to tenants. For example, a brand-new office building developed with all the latest technology and conveniences would likely be classified as a Class A property while a building constructed 50 years ago with no internet access or elevator would likely be classified as a Class B or C property, depending on how well the property has been otherwise maintained. For more information on building class rating systems, companies like Costar and organizations like BOMA (Building Owners and Managers Association) provide some guidelines to help navigate the rating process.
This article has provided a very high-level look at some of the major asset classes and their subclasses in commercial real estate. However, our exploration of these asset classes was not exhaustive and an analyst should frame any analysis in the lens of the specific characteristics of the property under consideration. In the industry there are people who focus on one asset class and sometimes a single subclass of an asset type in a specific geographic area. This level of specialization often leads to an exceptional level of expertise and intuition for the fundamentals and performance of each type. An analyst should continue more deeply explore the nuances of property types you work on throughout your career.
About the Author
Josh Panknin is a Visiting Assistant Professor of Real Estate at New York University’s Schack Institute of Real Estate and an adjunct professor in the school of engineering at Columbia University. Prior to academics, Josh was Head of Credit Modeling and Analytics at Deutsche Bank’s secondary CMBS trading desk where he helped develop and implement automated models for valuing CMBS loans and bonds. He also spent time at the Ackman-Ziff Real Estate Group and in various other roles in research, acquisitions, and redevelopment. Josh has a master’s degree in finance from San Diego State University and a master’s degree in real estate finance from New York University’s Schack Institute of Real Estate.
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