Introduction to Commercial Property Types
Unlike residential real estate which is really only classified in a couple categories, commercial real estate is much different.
There are numerous property types and each property type is divided into two main classifications, location and condition.
Condition classes are usually ranked with a letter grade we’re all familiar with A, B or C.
Location classes are commonly broken into Primary, Secondary and Tertiary.
These various property types are important to know because different lenders have very specific appetites for which type and class they wish to lend on.
Understanding what types of properties present various investment opportunities and who is most likely to lend on them can save you a lot of time while shopping for a commercial mortgage.
Understanding where the capital’s appetite is, should be your first area of concern.
Too often I have had rookie commercial clients come to me with a great deal on a property in a fantastic location. Once pressed on the type of property I found out that is was un-occupied warehouse space. Well, warehouse is a highly specialized investment class when it’s fully rented to an excellent tenant, forget empty. By highly specialized I mean nearly impossible to finance.
If you do not have experience investing in highly specialized areas stick with basic property types or find a highly qualified partner with vast resources, otherwise you’re going to have a very hard time capitalizing on what appears to be a great price.
Understanding what types of properties your lender is seeking to lend on at the moment will save you a ton of time and even potential embarrassment. To find out, simply ask the lender what they are looking for these days.
Basic Commercial Property Types
Any property that consists of 5 or more residential living units for rent, is considered a multi-family property. Multifamily is considered the most desirable investment class in the commercial space for a novice commercial real estate investor.
Typically a multifamily property in a good area with strong rents will be very desirable to investors and to banks and lenders you may do business with. It is common to pay a premium based on raw location as opposed to condition. Historical strong rents and decent sales of similar properties in the immediate area will outweigh the potential of possibly overpaying.
Multifamily should be your primary focus if you’re new in the area of commercial real estate investment. This asset class is considered very stable because the rental market is very transparent, it leaves little mystery to the lender.
Mixed use properties are pretty common in major and middle markets throughout the United States. A mixed use property will always have some element of residential living units mixed with either retail or office space, sometimes all three.
While the residential aspect of this property type is considered stable, the office or retail aspect does pose an added layer of risk to the lender and to the investor.
Office is a tricky rental market and will almost always suffer significantly in an economic downturn. Customarily office properties are rented based on square footage. For instance, a 1,000 sq ft office unit which is offered for $12.00 per sq ft would rent for $12,000 per year or $1,000 per month.
Office is risky because when economic conditions head south, landlords will lower rental prices in order to keep the space rented. Once this deterioration occurs in the market, rents can tend to spiral significantly.
It is also incredibly hard to know the financial condition of the tenant, a company that was in great financial condition a few years ago when they rented the space could suffer and default on rental payments quite quickly. This happens all the time and can come with little notice to the landlord.
A savvy office investor will have as great an understanding of general business and economic conditions as they will the real estate market. The overall business atmosphere is just as important as the real estate market to the office investor.
Very similar to office, retail tends to have violent swings in both rents and valuations in an economic downturn. Retail properties can be anything from storefront locations on the main street to strip malls on busy roads and single tenant (explained later).
Usually retail has one saving grace, long term leases. Leases in retail commonly run for 10 years and even up to 20 years. A good retail tenant in a good location can be an incredibly valuable asset.
Most small balance (under $3,000,000) retail properties do not have one tenant that drives a huge portion of the traffic to the property. They have a mix of “Mom and Pop” shops with an occasional “name you know” mixed in. These can be excellent investments if they are properly managed and on a main street with a high traffic count.
Prime retail will almost always be “anchored”, an anchor tenant is the one tenant that drives a huge portion of the daily traffic to the property and all the other tenants benefit from this traffic.
A classic anchor tenant is a full service grocery store, grocery stores drive traffic and every part of the population knows where it is and visits it often. This drives sales for the secondary tenants and it drives awareness of the existence for other tenants even if you don’t shop at these secondary stores often.
Other classic “anchor tenants” are bog box retailers and department stores.
In-line strip is commonly referred to as a “Strip Mall” and everybody knows what a strip mall is. A strip mall can run parallel or perpendicular to the major road it sits on. The key here is the major road the property is on. Visibility and accessibility are the main components of a successful in-line deal.
While parallel is the most desirable, perpendicular works as well depending on the population density in the area. Density = Traffic.
The tenants will usually be a mix of names you know and mom and pop shops such as hair stylists and boutique retailers. You could sort of call a high traffic convenience store or a bank a mini-anchor tenant in this situation.
Single tenant can be the most stable asset class when leased properly. A single tenant deal will yield a set rent with periodic rental escalations built into the lease. As it sounds, a single tenant building has only one tenant and the leases are typically 10, 15 and 20 years.
Even better, the leases are referred to as “Triple Net Leases”. A triple net lease relieves the landlord of any and all maintenance burden. No landscaping, snow removal, roof leaks, common area maintenance (CAM), property taxes or insurances (aside from casualty and condemnation insurance). The tenant essentially treats the property as if they own it during the term of the lease.
The owner of the property is only responsible for debt service in a triple net lease situation.
A great example of a “Single Tenant” would be CVS Pharmacy. CVS Pharmacy is one of America’s most significant single tenant lessees. When you see a CVS, 95% of the time it will be on its own piece of property with its own look and very distinctive feel.
The model is so successful that Walgreens imitated CVS and actually built a real estate scheme by putting a Walgreens on its own pad directly across the intersection from CVS on busy roads throughout the US. The intersection was key to this strategy as it increases automobile accessibility, it increases visibility and guarantees a maximum traffic count.
Credit or Non
This is more of a tenant class but it has a lot to do with property type as well. CVS is an example of a Credit Tenant. A credit tenant is a company who’s credit rating is monitored by the major credit rating agencies such as Standard and Poor’s or Moody’s. These companies have a very predictable future as they have a very well understood history that spans decades and several economic mood swings.
Whenever there is a solid history, which is well understood, a lender will typically make the best terms available to the potential investor.
Believe it or not, a rookie commercial real estate (C.R.E.) investor can get financing to buy a single credit tenant building. The reason for this is simple, the entire deal is evaluated on the strength of the tenant and not the sponsor (you’re the sponsor).
The key to this type of investing is to have patience and identify an established company with an established credit rating that is expanding in a particular market. An example of this that I was aware of and did quite well with as a commercial mortgage broker was “Jared’s Galleria of Jewelry”.
This company was pretty much unknown in New England but they had plans to expand here aggressively. I had sponsors, such as yourself, who were interested in single tenant as an asset class. I discovered that there was significant capital appetite for single tenant deals to tenants with established ratings.
While Jarod’s wasn’t a satisfactory credit tenant themselves, they were owned and operated at that time by Signet, PLC an established European jewelry manufacturer.
Signet had a great rating with Moody’s and S&P, this allowed for great financing terms to the investors. We assisted a group of investors in buying and pre-leasing properties to Jared’s Galleria of Jewelry from Maine to Massachusetts. The best part? The average down-payment for the sequence of deals was around 7% of the property acquisition costs.
These investors now have long term leases on good properties in fantastic areas, mostly around malls on major retail centers and they did it with nominal capital outlay. There is little doubt that Jared’s will renew their leases in the future as they come up for renewal.
Most of the major warehouse property around the country is owned by the tenant and the rest is owned by a limited group of very savvy and experienced warehouse investors. Warehouse valuations have dipped as much as 40% and even 50%+ in some markets over recent years. That said, there may be great opportunities right now, but probably not for you. I don’t believe I need to explain this property type, it’s self explanatory.
Flex is technically a sub-category of warehouse but it is slightly more desirable in this day in age. The “flex” part comes from a secondary use and level of appeal in the “front or entrance” portion of the building.
A flex warehouse building will have an office or showroom aspect in the front of the building where employees can work and managers can have their offices. A showroom and an office is even more desirable. There are many types of companies that can use this type of space, this is the only type of warehouse space I would ever consider if I were a new CRE investor.
Many major colleges and universities have their own dormitory space and they coordinate with private owners of student housing properties to provide room and board for students.
Major market student housing properties can be excellent investments when they do coordinate with the school. They look and feel very similar to multi-family properties however, the inner layouts are very different.
Student housing units are typically laid out as “pods” with one common kitchen and bath area that 4, 6 or even 8 bedrooms stem from. This is great for college living but the layout has virtually no appeal to a residential rental tenant in the event the landlord loses his deal with the college (which happens all the time).
Colleges will depend on a landlord for decades and then decide they will allocate some endowment money to building a new 600 unit dormitory. A 600 unit dormitory can house 1,800 to 3,000 students and this will take a major bite out of your rental income.
These properties are also only rented for 9 months of the year, the maintenance in the offseason is extensive and liability is enormous.
Again, this is a very specialized property type and one that should probably be left to the big boys.
Self Storage Facility
Middle market self storage is simple, low maintenance, consistent and the tenants are items and not people. The buildings themselves are usually steal or cinder block, professional management is not necessary and if a payment doesn’t come in, you auction the unit contents off to the highest bidder. (State laws apply)
Self storage works well in a down economy, sometimes even better than in a great economy. People lose their homes or change living situations often in a down economy and this creates revenues for the self storage operator.
Self storage became slightly over cooked during the mid 2000’s as capital flowed toward this asset class. However, there are legacy owners in this business who will sell in the coming years and the income/expense numbers are very easy to understand.
If your lender has an appetite for this type of property, then start looking for a deal. It won’t be easy to find but, patience will prevail.
Hotel / Motel
Hotel properties are highly specialized. The hotel industry has suffered significantly since 2007, with many large scale and high profile properties in default either covenant, technical or monetarily. We won't discuss those three types of default right now but, let's just agree that hotel is a tough business right now.
Hotel financing is all about location and booking system. Hotels are broken into two groups, flagged and non-flagged. Flagged is a property which is part of a booking system such as Best Western. The property is independently owned but is allowed to "hang the flag" of Best Western through a franchise agreement. It also has access to the Best Western booking system. In other words a a potential stay can be booked through the vast resources of the Best Western online and over the phone booking system.
Non-flagged is much different, it is independently owned and it does not hang the flag of a major booking system. It has to rely on it's own efforts to market the property and generate stays.
Hotel is a building with multiple floors and access to the rooms will be through an elevator bank or stairwells inside the building. It is rare that an individual room will have its own secondary egress to the outside.
Motel is a building with only 1 or 2 levels and access is through individual doors on the main level and what amounts to a deck on the second level. Each unit has a private entrance, open to the outside, from a courtyard or parking area. A motel may or may not have an elevator.
Hotel and motel is as much an entertainment and service business as it is a classic real estate play. It requires highly specialized management and valuations swing violently with the economic landscape.
Yes, this is an asset class. Many people believe that parking garages are owned by the mall or the office building or attraction it sits near. Usually this is not the case. Parking garages can be absolute gold mines but identifying one for sale that is performing well can be incredibly difficult.
I met and did some business with a gentleman in Deerfield Beach, FL who owned a garage near the beach, directly across the street. Yet it sat empty for months at a time during the summer months, and it was barely used during the winter.
He came to us looking to refinance the property in 2003 and we found a very creative investor willing to give this guy financing, mainly on the strength of his personal balance sheet.
Yet, there were condo and mixed use projects going up like crazy in the area. By 2005 this savvy and very patient owner had deals with two major condo complexes and the city of Deerfield Beach which amounted to a license to print money. As stores and attractions built up in and around the area, this parking garage became a central hub and this patient genius can’t even count the money he’s making.
Like any other asset class, parking is a specialized business and these operators have significant systems in place to handle security and collection of parking fees.
We’ve discussed many types of properties in the previous part of the article. While the property type is important, the location and condition of the property is equally important.
Different lenders classify properties differently. Here is a basic overview of condition classifications.
Class A Condition
Class A CRE is a trophy property in excellent condition, usually less than 10 years old. It has virtually no deferred maintenance issues and it has significant appeal to major potential tenants.
The grounds are well maintained and the property just looks like it will attract top notch tenants. A Class A Office property will have amenities like gyms, cafes and visually appealing common areas.
The property will almost always have multiple elevator banks and convenient delivery areas with loading docks.
The property is usually considered almost impervious to destruction from natural disaster. It can sustain flooding, hurricane winds and earth quakes with relative ease.
It has more than enough parking on the grounds or nearby via contracts with parking garage operators.
Class B Condition
Class B CRE may only be so due to its age, a Class A 3 years ago may just be class B due to an increase in age. Usually a Class B will have slightly less appeal and will show minor signs of age and some deferred maintenance.
This class can still command great rents if it sits in a good area and is well maintained by the owner and the manager.
Class C Condition
Class C can not be dressed up with simple improvements. It is aged and it shows. Typically systems are somewhat dated and the overall construction quality is slightly lower due to zoning and engineering guidelines when the property was built.
This class will not command premium rents regardless of the strength of the surrounding market.
While Class C will typically be overlooked by large CRE Operators, this class may just be your perfect target if you’re reading this article.
Location, Location, Location
This is common sense in all levels of CRE investment.
Visibility and accessibility is the key to retail, office, mixed use, single tenant, inline strip and self storage. A great retail property on a back road is hardly a great retail property.
Traffic count is key and if the traffic can easily access the property you have a great location, it’s like built-in advertising for the property and the tenants.
Multifamily is more of a population density and industry density concern. If there are people and jobs for those people in the area, a multifamily property can do well on a back road.
These location classifications are usually broken into three main categories.
A primary market has all the components the major landlord and tenants are seeking. The population density is high, usually supported by a major city and the suburb communities of that city. Traffic counts are high and a major lighted intersection funnels traffic into the property location.
A primary location is a thriving area with jobs and a strong economic driver like major employers and large industry concentrations.
More of a true outer suburb of a major city or an outlying area of a mid-sized city. A secondary market will have moderate to high traffic counts with slightly weaker income demographics than a primary market. Or, it will have strong income demographics with a lower population density.
There are many common factors that can make an otherwise tough market pretty lucrative in a secondary area. The presence of a mid-sized hospital for instance can make a small concentrated area a stronger market within a Secondary market. Hospitals are common, the jobs in hospitals are lucrative and many hospital employees walk to work.
A tertiary market pretty much covers everywhere else. The area is considered to be somewhat rural and there are no nearby major traffic hubs or population centers.
By rural, I mean rural in the eyes of a major lender. There are many small local banks that are more than happy to lend in their home town, they live there and they work there, they understand it.
Major lenders typically won’t touch a tertiary market regardless of how strong the property or the sponsorship is. There’s just no appetite.
What does this mean for you?
I hope you’ve learned a little bit about property types, condition classes and general markets.
If you’re a new Commercial Real Estate Investor or an Up and Coming Commercial Mortgage Broker, it is important to learn what the capital is up to.
What are the bankers looking for?
What property types is there a current appetite for?
Learning where the appetite is and then identifying the properties that fit the appetite is a far more efficient way of doing business. Don’t go looking for a deal and then try to find a home for it. This rarely works. Work smart and not so hard.
A conversation with your banker about a deal will always start with two questions:
What type of collateral is it?
Where is it located?
These two concerns are far more important to the banker than your credit history and your balance sheet, it’s not like getting a home loan.
If you get by those two questions, the next will be:
What is your experience with this type of property?
This question is an easy one to answer. Why is that? Experience can be bought.
Next week we’ll go over due diligence and how to evaluate a property both short and long term. How much money will I need to get started? When will I see a financial gain? What is upside? How do I achieve upside?
Where do I go for different types of financing?