Market analysis

How Commercial Real Estate Stacks Up

These Investments Continue to Be a Stable Component of a Diversified Portfolio.

The recent tremors of an economic slowdown present new challenges to commercial real estate investors. Will property investments survive a soft landing, reflected by growing unemployment, weakening consumer spending, and the general economic malaise that seems to have gripped the nation?

Just a year ago, brokers faced a different scenario. In the face of huge returns from the stock market, buoyed by the technology bubble, commercial real estate returns of 8 percent to 12 percent paled in comparison.

“Things have changed dramatically,” says Richard A. Myers, president and co-founder of Coldwell Banker Commercial/the Mitchell Cos. in Southlake, Texas. “Investors were comparing our proposed returns on investment deals in our real estate projects with the 30 percent to 40 percent a year returns on a Fidelity mutual fund. The competition has gotten a lot easier as the stock market dropped.”

In the midst of heavy stock market fluctuation, investors recognize the stability of commercial real estate as an important consideration for a diverse portfolio.

“Real estate has a cycle of its own that has very low correlation with other assets, so it offers diversification of benefits,” says Youguo Liang, a managing director and head of investment research at Prudential Real Estate Investors in Parsippany, N.J. “It makes the whole portfolio more stable because its performance is not strongly related to or correlated with the performance of stocks and bonds. Real estate investments will most likely provide both stability and attractive returns in a potentially volatile investment environment,” Liang says.

“In most cities in the U.S., you now can buy real estate for less than its replacement cost,” says Terry Moore, CCIM, director of ACI Commercial in San Diego. “People have been paying more than replacement cost for stocks. They've been buying, not based on the cash flow that's happening today, but based on the profit they hope will be made one day. Real estate is more conservative. People generally buy real estate for income.”

One fundamental difference between income property and stock is “the stock market has jumped up and down,” Moore says, especially in the last year. “Real estate moves a lot more slowly than that. It's far less volatile.”

But today's economic picture offers new challenges. Since the bottom fell out of the commercial real estate market in the early 1990s, it has made a slow, steady recovery, helped, of course, by the longest economic expansion in American history. Many experts claim the market has changed: Fundamentals are stronger, lending practices are tighter, and the investment cycle for many property types has shortened. The resurgence of public equity markets — real estate investment trusts — also has opened up the market to closer scrutiny by investors. Yet the true test of any investment is how it performs in a down market. Can commercial real estate weather the choppy seas of the 21st-century economy?

Historical Perspective In the past, commercial real estate has been a stable investment option, providing competitive adjusted returns.

“Private real estate is less risky than stocks and bonds,” says Craig Evans, CCIM, senior director of Cushman Realty Corp. in New York. “The standard deviation of overall returns is much less than other asset classes. Variability is approximately 40 percent less than bonds, the next most stable asset. Therefore, on a risk-adjusted basis, the real estate returns are attractive.”

The overall real estate yield from 1987 to third-quarter 2000 ranged from a low of 11 percent to a high of 12.4 percent, according to investment surveys by the Chicago-based Real Estate Research Corp. This stability contrasts sharply with the yields on 10-year Treasuries, which ranged from a high of 9 percent in those early years to a low of 5.4 percent more recently.

In third-quarter 2000, when the overall yield was 11.6 percent, yield by property type ranged from 11.1 percent for apartments to 13.5 percent for hotels, according to RERC.

During that same quarter, RERC reports that on a scale of one to 10, one being poor and 10 being excellent, capital availability shrunk slightly to 6.6, while capital discipline tightened slightly to 7.1 from 6.7 the previous quarter. This is in sharp contrast to a decade ago.

During the late 1980s and into the early 1990s, money was freely available and pouring into the commercial real estate market. New construction was rampant, with little preleasing of space. This response to a healthy market was typical, says Liang, flooding the market with new supply just as the economy and demand collapsed. In turn, financing quickly dried up, as did the market for existing properties.

However, experts think the positive changes affecting the current market are permanent, making commercial real estate a less-risky investment today than it has been in the past.

“First, there's better and more information available,” Liang says. “Second, there's better and more discipline in the market, especially from the public side. REIT investors react to the marketplace much faster than private parties would have. And, there's slightly lower demand, which results in less construction. That all contributes to an environment that's safer for investors. No one should expect a recurrence of the double-digit vacancies that characterized the industry in the recession of a decade ago.”

This also means that markets are less cyclical, without booms followed by busts because overbuilding is less likely, he adds. And, with vacancy rates for nearly all property types near historic lows and less new construction in the pipeline, markets are well positioned to withstand some deterioration on the demand side.

Myers also points to the importance of extensive, current market data now available. “The sophistication of market data is just light years ahead of what it was just 10 years ago,” he says. “So it's much easier for bankers and investors and developers to really understand what's going on with the market almost on a daily or weekly basis vs. being six months behind.”

Indeed, technology has played a huge role in revolutionizing how real estate is bought and sold. Property information, once the sole province of brokers, now is available online to investors, property owners, tenants, and brokers alike.

“All the information an individual investor needs can now be obtained with a business search engine such as Northern Light and the Web sites for Dow Jones and such investment houses as Bear Stearns and Moody's,” says Bill Miller, vice president of Appraisal Research Counselors in Chicago.

“There's more market-type data and information at your fingertips,” agrees Keith P. Grothaus, CCIM, SIOR, vice president of Caldwell Watson Real Estate Group in Houston. For instance, information is available from local government, business, university, and newspaper Web sites about local economies, neighborhoods, demographics, traffic counts, employment patterns, and business expansions and contractions, he says.

Besides technology, other changes have affected today's market. Money is not freely available for just about any deal. “The capital markets tend to react much quicker now,” says S. Thomas Mitchell, co-founder of Coldwell Banker Commercial/the Mitchell Cos. in Southlake. “There's better information systems and better checks and balances. We've seen capital markets respond to overbuilding in a matter of months or even weeks.”

Holding periods have shortened, meaning that sales have increased. “The recent average holding period is approximately eight years,” Liang says. “In the early '90s, the holding period was more like 11 or 12 years. Even if you wanted to sell, you couldn't sell at a price you wanted because there was no market. The transaction market is stronger today. Some investors hold a property as short as a few months.”

Growth also has occurred in public markets such as REITs and commercial mortgage-backed securities, he notes. “REITs are a significant market today,” he says, noting that the total equity capitalization of the REIT market now is more than $160 billion. “REIT investors demand information and REITs are subject to all kinds of disclosure requirements that private investors are not,” Liang says.

CMBS investors also demand more information, he adds, noting that CMBS issuance reached about $61 billion last year, down from about $78 billion and $67 billion in 1998 and 1999 but still higher than their previous high of $44 billion in 1997.

“So the development of the public markets, whether REITs or CMBS, makes the market ... more disciplined,” Liang says. “They react faster and more dramatically than the private sector, and if they see something going wrong they can cut off the capital flow instantaneously.”

Lenders also are more disciplined today in their underwriting of the loans and the amount of equity they demand of borrowers, he says. “Because of all that, overbuilding is less likely. The market will continue to go through cycles, but the cycles will be much smaller and shallower with more frequent corrections.”

Investor Variety The booming market of the past few years has broadened the appeal of commercial real estate to a wide variety of investors.

“The only investment sector that was running weak last year was the REIT sector,” Liang says. “Last year, their performance was good but before that, they had two bad performance years and REITs didn't have much money to invest. But everybody else was very active in the market.”

That includes pension funds, corporations and real estate partnerships. Pension funds, like REITs, he says, invest in just about all property types, including office, retail, multifamily, industrial, hotels, seniors housing, and even self-storage facilities.

“But pension funds may hold slightly better properties than REITs hold. They specialize in the upper segment of the market, institutional quality properties that they hold for a very long time,” Liang says. “Last year, the East and West Coasts were very strong — like Boston, New York, Washington, D.C., San Francisco, and Los Angeles. Markets in the Midwest and South were relatively weak.”

But in many small to medium-sized markets, which may be considered too small by major investors, individual investors are big players.

And of late, business is brisk. Existing investors are expanding their holdings as many new investors enter the commercial real estate market. With its revival, old investors also are re-entering the market, according to brokers. “One thing that has changed in the past 12 months [is that] investors previously were also involved in the stock market,” Myers says. “Now, real estate is seen as more attractive and more stable. Some are selling their stocks and looking at other alternatives. Real estate is on that list.”

Some are entering the market for other reasons.

Tom Kaufman, commercial broker with Re/Max Commercial Services in Denver, says that with the rise in real estate values and the accompanying rise in rents, many businesses are interested in purchasing properties rather than continuing to lease space. And they often purchase buildings with more space than they need.

Others are finding new reasons to become investors. For instance, Kaufman helped convince an environmental clean-up company that had been remediating properties for others to start buying the properties itself. The company now buys distressed properties at a discount, cleans them up, and sells them for a profit.

Helping Clients Invest A changing economic picture means reconsidering clients' portfolios in light of new information. While investments tend to be influenced more strongly by local economic conditions, the national economy does have a greater effect on local properties today than it did in past markets.

For example, less-experienced, risk-averse investors who want to avoid management concerns may want to start with a single-tenant, triple-net leased building with a creditworthy national or regional drugstore tenant. Such a property also is good for retired investors, since little or no involvement is required. Returns can range from 8 percent for the least risky investment to 12 percent, says Keith Sturm, CCIM, a principal at Upland Real Estate Group in Minneapolis.

However, the highly competitive nature of national drugstore chains and the recent build-up of these properties in some markets send a warning signal. “People are building and selling so many triple-net leased properties in so many locations that eventually some are going to have to go under,” warns Ernest L. Brown IV, CCIM, vice president of the investment services group at Grubb & Ellis in San Antonio. Thus, what used to be a safe investment for risk-averse clients now carries an element of danger.

Other problems may crop up disguised as good news. For example, urban areas regentrify much faster than they used to, which should be a cause for celebration. But investors locked into long-term triple-net leases can't capitalize on the increasing market rents.

Of course, it helps to recognize basic investor types in clients, says Michael Randall, CCIM, senior vice president in the investment services group at Grubb & Ellis in Newport Beach, Calif. These include the aforementioned passive investors who buy already-leased properties, value-creation investors who buy problem properties at discounted prices and revive them through rehabilitation or tenant replacement, and speculative developer investors who build properties and take all the entitlement and construction risk.

Passive investors usually purchase fully leased properties for security and increases in rents. “They're not looking for the deals that have development risks or the risk of a big tenant vacating the property,” Randall says. “And they're not trying to fix a problem. They're not real estate experts. They're interested in the income stream, the ongoing cash flow, and long-term growth.”

Choices can be found in a few property types, depending on local market conditions. “If you have a well-located grocery- or drug-anchored neighborhood shopping center with strong sales and no risk of competition coming in, it will just click along without any problems,” Randall says. “If multifamily residential demand is strong, you will have very little risk of vacancies. That in and of itself is the definition of passive investment. You don't have to do anything to it.

“Office buildings are a little less of a passive investment because they are more management and capital intensive,” he continues. “But for an investor who has the capital and management expertise, an office building can be considered a passive investment.”

Value creators buy properties at discounted prices that are not initially good investments, but these investors, using their expertise, are able to increase a building's cash flow by rehabbing it, finding new tenants, or converting its use.

“This type of buyer is the opportunistic investor who has the skills to complete the task,” Randall says. A lot of the value-added investors are developers or ex-developers who have the expertise but just don't want to go through the time and the risk of ground-up, spec development.

“They typically hold property three to five years, maybe even shorter depending on their tolerance for risk, how long it takes to increase the value, and how patient their financial partner or capital source is.”

Value creators are specialists; few are generalists who will buy anything, Randall explains.

Spec development is the highest risk investment, Randall says. These investors build properties from the ground up, without any preleasing or any tenants in hand, taking all the permit, entitlement, construction, and timing risk, yet theoretically gaining the highest return.

“This is the most hands-on investment; the highest expertise is required,” he explains. “Once the property is completed and leased, some refinance it, often taking out their development partner, and keep it long term. Others, depending on their desire or willingness to hold the real estate, may sell it right away. There is no one answer.”

But commercial real estate investors shouldn't necessarily stop at one property, Liang says.

“Ideally, an investor shouldn't own a single building, like you shouldn't own only one stock or one bond,” he says. “Owning one building that represents 30 percent of your portfolio is not a prudent way to invest. The market is huge and you should diversify somewhat, diversify by property types and economic, rather than geographic, locations or regions. But that depends on the amount of money an investor has.”

A good mix for those new to commercial real estate investing, Liang suggests, would include some multifamily and warehouse for downside protection, then some retail, especially well-located, grocery-anchored community centers, and, finally, some office.

Partnership Possibilities Some clients look to expand their portfolios by taking on partners, which can present opportunities for commercial real estate professionals. Partnering with clients on deals can be financially and emotionally beneficial; however it also may have risky consequences.

“If you think so highly of real estate to sell it to investors, then there's no reason you shouldn't put back your commission in the deal and even add a little bit to become an equity partner. That shows you're interested,” says Kenneth D. Rosen, CCIM, president and owner of Kendar Realty in Coral Gables, Fla.

This shows that you have confidence in the property you are convincing your client to purchase, he continues.

“I've had buyers ask me, ‘Would you put your money in this deal?' ” Mitchell says. “That's an opening for brokers to validate their conviction in that market and in that deal. They can take part of the fee that they're earning and invest it in that deal to show they have confidence in the deal.”

However, partnering with some clients can take brokers away from their primary business.

“There are some ancillary benefits from making more personal and business connections from it,” Myers says. “But a lot of brokers get distracted. There are a lot of details with managing and developing property. Brokers can end up spending a lot of time on things they aren't very good at when they should spend their time doing what they're good at.”

Partnering with a client also can have a negative effect on a broker's relationship with other clients.

“You might not be able to bring all your clients in and some might have hurt feelings or start to wonder whether you have a conflict of interest,” Myers says. “And when brokers go into buying properties on their own, sometimes their clients will start to look at them as if they were competition,” wondering if the brokers are only trying to sell the properties they don't want.

“There's a fine line between investing in commercial real estate and dealing with your clients,” Mitchell adds.

Investment Benefits Despite economic changes, commercial real estate still retains many unique benefits compared to other investments.

“Real estate offers tax advantages and leverage advantages that are not easy to obtain with routine stock and bond investments,” Moore says. “The [Internal Revenue Service] allows you to write down the value of improvements over 271/2 years for apartments and 39 years for other commercial properties.”

An investor also can take depreciation of a property as a tax-deductible expense to shelter other income, he adds.

Further, Moore continues, investors can leverage their investment by making a low down payment and borrowing against the property when its value increases to make additional real estate purchases.

“Nowhere else can one borrow upward of 80 percent of the value of an asset to benefit from an increase in 100 percent of the asset,” Randall says. “If a property increases in value by 10 percent, the investor actually receives a 50 percent increase in that 20 percent down payment.”

Also, by using a tax-deferred exchange, investors can invest the full proceeds from the sale of one or more buildings that have appreciated in value into the purchase of one or more other buildings without paying capital gains taxes, Sturm says.

However, tax benefits should not be the only reason for investing in commercial real estate. Investors also can take emotional satisfaction in pointing to the commercial property that they own. “Real estate allows you to see, touch, and feel your investment,” Randall says.

“With real estate, you own something tangible,” Brown agrees. “You can go out and knock on the walls. That makes people feel comfortable. There's not the fear of losing everything.

“Another reason people feel comfortable with real estate investments is you can take an active role,” Brown continues. “You have more control of your destiny than you do with a stock or a bond or a mutual fund.”

Core Real Estate Investments Perform Well

During the past three years, “core” real estate investments have significantly outperformed all major asset classes on a risk-adjusted basis, according to a recent Lend Lease Real Estate Investments report.

Two basic characteristics define a core style of investing, the report states: income from core holdings is stable, predictable, and constitutes a significant proportion of total return, generally 70 percent to 80 percent over the holding period; and core investments are readily marketable, enabling an efficient exit and minimizing liquidity risk.

The complete report is available at

Property type


Not core


  • $350 psf super-regional malls
  • Two-anchor regional malls


  • Neighborhood centers with large, dominant supermarkets
  • Outlet malls



  • Unanchored strip centers


  • Class A buildings with 200,000 sf in top 10 CBDs
  • Class B/C buildings


  • Class A buildings with 100,000 sf in major suburban centers
  • Old buildings


  • Class A/B locations
  • Single-tenant assets


  • Multitenancy, strong credit
  • Commodity product


  • Staggered rollovers
  • Secondary/tertiary cities/locations



  • Under-parked buildings


  • 24-36-foot clear-height warehouses
  • Manufacturing facilities


  • Modern industrial parks
  • Flex space


  • Multitenant, large R&D
  • Mega-warehouses


  • 14 top distribution markets
  • Secondary/tertiary markets


  • Large A/B complexes
  • Small, urban projects


  • Vibrant higher-income neighborhoods
  • Lower-income or ultra-luxury complexes


  • Effective age of 10 years or less
  • Tertiary markets


  • Extensive, contemporary amenities
  • Declining neighborhoods

Source: Today's Core Values, Lend Lease Real Estate Investments

Jerry DeMuth

Jerry DeMuth is a free-lance writer based in Chicago. He has written for CIRE about land sales and commercial real estate financing.


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