Commercial Investment Property: Stores and Office Buildings

The term commercial investment property refers to any type of improved real estate (other than residential investment property) where some form of business or commerce is conducted. Shopping centers and malls, office buildings, manufacturing plants, warehouses and public storage facilities, restaurants, gas stations, movie theaters, and other enterprise locations have their place in this category. For the purpose of brevity, this discussion will focus primarily on the first two entries of that list: shopping centers (both anchored centers and strip malls) and office buildings.

The "anchored" shopping center is typically characterized by an indoor or outdoor mall complex that also houses one or more major tenants, such as a "big-name" supermarket or department store, which occupies the largest portion or heart of the shopping area. The anchor is the main draw and, as such, indirectly generates business for other tenants of the complex. The four main anchor types – in best-to-last order of investment return potential – are these: supermarkets, drugstore chains, department stores, and movie theaters.

Anchored shopping centers are relatively easy to manage, at least when compared to residential properties. The landlord's responsibilities are generally limited to management, grounds and structural maintenance, insurance, and real estate taxes. The individual tenants are typically responsible for interior construction, upkeep, and repairs. Additionally, the presence of an anchor store usually makes financing easier to obtain, and affords better investment security. Because of these factors, anchored shopping centers can be an excellent investment for even novice investors. But due to the relatively large down payment requirements, inexperienced or small investors should typically only buy as part a group. The centers are usually located in well-studied, heavily trafficked areas on large lots. As communities grow, the use of the underlying land can often be upgraded, thereby increasing its value (this, of course, after the expiration of any net leases).

However, anchor tenants are known to be fairly tough negotiators with original builder-developers. Although they pre-approve the site after market studies, demographic analyses, and traffic counts, they never lose sight of the fact that the developer usually needs their lease for financing and to attract other tenants. Potential investors should therefore carefully review all long-term lease clauses before acquiring anchored shopping centers.

Furthermore, most of the income can be expected to come from the dominant tenant; in other words, the anchor. If the anchor should fail or move out at the end of its lease, the center as a whole may require restructuring and retrofitting or, at a minimum, some downtime until a new anchor tenant can be found.

Strip malls are usually comprised of a series of retail stores whose average size approximates about 1,000 square feet each. As such, most strip malls total less than 20,000 square feet in size. They typically have good visibility due to being generally located on the perimeters of densely populated neighborhoods, heavily trafficked commercial streets that have easy access, or on or near corners.

These shopping centers are relatively easy to manage, in part because of their smaller size. As such, they also represent a smaller investment than larger anchored shopping centers, and are not subject to the risk of losing a major-draw tenant. Leases tend to be of shorter duration, so renewals have the advantage of inflationary increases and supply-and-demand factors brought about by improvements to the surrounding areas.

Strip malls are a great way to invest in commercial real estate with a relatively low down payment. They can also be used as an income-producing approach to buying and financing strategic locations. For example, as communities grow and develop, demand for the site may increase for upgraded and, therefore, more valuable uses. Furthermore, they can usually be bought for less than replacement costs, and terms are often quite negotiable.

However, if a strip mall is poorly located or built without regard to market factors, tenants will be difficult to come by, and even harder to keep. Additionally, smaller, less-established tenants generally tend to have shorter life spans, and so may cause higher vacancy and turnover rates. Vacancies necessarily equate to lost rent, possible legal fees, retrofitting, and disruption to the center's traffic stream as the previous store's clientele suddenly begins to shop elsewhere. Just as with anchored shopping centers, it's important to evaluate the mix of tenant stores to ensure that they complement – instead of clash or compete with – one another.

Office buildings can be generally regarded as similar to apartment buildings for the purposes of investment, with the exception that office buildings are more service intensive. The owner not only pays for building electricity, but usually also supplies HVAC (heating, ventilation, and air conditioning) and cleaning services and makes internal repairs. New office leases typically stipulate that the landlord renovate the space involved to the tenant's specifications, the cost of which is usually added to the base rent and amortized over the life of the lease.

An office building's rental income fluctuates with general economic conditions. When the economy is enjoying growth and vitality, there's increased demand for office space, which results in low vacancy, higher rents, and greater net income. But during economic downtimes, there are more lease cancellations or non-renewals, which in turn leads to more vacancies, ultimately resulting in lower rents and therefore lower income. And because the value of commercial real estate is directly related to its income, prices of office buildings will also vary substantially in response to changing economic conditions.

Office buildings typically come with the advantage of "strategic location." As such, their replacement cost will continue to go up. A patient investor can buy an office building cheaply during a period of economic weakness and hold it until the subsequent economic recovery, virtually guaranteeing a substantial profit.

Conversely, office buildings usually have the disadvantage of requiring a substantial cash outlay. As such, they often represent too large an investment for the novice individual investor or even a novice investor group. Furthermore, they're management and labor intensive. Managing these properties typically involves dealing with demanding tenants who are paying for services as part of their rent. Inexperienced investor/owners just getting their feet wet in the inner workings of managing properties may find office buildings initially beyond their capabilities. Because of these factors they should generally be avoided by the new investor until more experience has been gained.

 

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