Commercial real estate is among those asset classes that have the potential to offer stability of investment and competitive returns over the long term. While the general rule of thumb for any prudent investor is to stay invested for a longer duration, especially in commercial real estate, sometimes your goals might require you to invest in assets for shorter periods — a year or lesser.
Short-term investing, while not advised, can be done intelligently, while diversifying your portfolio as well. No matter what term or tenure you wish to choose to stay invested for, diversification is as important in commercial real estate as in any other kind of investment.
Here are the options available to an investor to diversify their commercial real estate investment portfolio.
Short-Term Vs Long-Term Investment in Commercial Real Estate
Before tackling the matter of diversification, it is important to understand what is called short term and long term with respect to commercial real estate.
Short-term investments in most asset classes are under a year, but for commercial real estate a short-term investment would mean a duration of two to three years, while a long-term investment typically means durations of five years and above.
Commercial real estate as an asset class is illiquid in nature and offers quantifiable returns only when long term investments are considered. That is the primary reason why it is advised to get into commercial real estate investments only if you are looking at longer tenures. Longer tenures help add on to the investment through capital appreciation by increasing the value of the asset over time. This translates to better returns for the investor over the investment period.
Capital appreciation is the difference between the purchase price and the selling price of an investment. Since real estate is immovable and properties generally tend to be long term in nature, time plays a crucial role in increasing the value of the asset. That is why the very method of investing in real estate becomes for a longer tenure than other contemporary asset classes.
For any commercial property, the investment period for two to three years can offer a return of 3% to 4%, while gross yields across investment periods of five years or more can be from 6% to 10%, as per the 2021 statistics shared by Knight Frank India.
Commercial real estate is a rather resilient asset class that stays insulated from sudden market changes, but at the same time is also quite responsive to positive trends in the market. The same can be observed by the quick comeback of the investment class even when the pandemic situation caused a lot of doubt and uncertainty in the market. Now that the differentiation between long- and short-term investments in commercial real estate is sorted out, let us look at how diversification can be achieved in commercial real estate .
Diversification in commercial real estate can be done in a similar manner for long-term as well as short-term goals. Let us outline the methods available for diversification –
- Multiple transaction sponsors/investment firms
- Multiple types of real estate
- Multiple property classes
- Multiple locations
Multiple Transaction Sponsors/Investment Firms To Diversify Your Investment
For investors who are looking to earn passive income, it is quite logical to approach different firms for investment. That will involve looking into the performance history of the firm and how well it has been delivering on the estimate of yields.
- Be careful of “promised” yields, since that is not a way a proper investment firm should advertise their capability.
- Look for the IRR mentioned on each asset listed by them and be clear about what the parameters are for arriving at the figure. Different firms will have different investment strategies and methods via which they seek out promising assets and how they assess the market.
- Make sure you do a thorough research on every firm before going ahead with anyone. For example, if you want to invest INR 75 lakhs, you might choose to split that investment amount with 3-4 different firms/transaction sponsors based on how their investment strategies are.
Multiple Types To Diversify Your Investment
In India, there are majorly four types of commercial real estate that are recognized. They include commercial office spaces, industrial floors, warehousing, and mixed use. With every kind of real estate comes its own return rate, popularity, and susceptibility to the demand in the market.
Office spaces
These are the most known and easily understandable forms of commercial real estate. They are created to cater to the unique needs of running a business. It can be general purpose wherein it can cater to marketing, finance-related businesses. It can also be specifically created to fit the requirements of a laboratory, a doctor’s clinic, or the like. Investors in office spaces generally benefit from long term leases because it is rather costly to move a business once it has been established in an area.
The downside to such long leases is that rental increases might suffer a hit if the market is on a favourable trend. Secondly, based on the location of the asset, the office space might have to be outfitted with expensive add ons to entice newer and better-paying tenants.
Industrial floors
They can sometimes include warehouses – especially if you have encountered terminology from the US. In India, warehousing is generally treated differently from industrial spaces. Industrial spaces are mostly specifically built for the businesses frequenting the market in the area. Manufacturing units can be housed in such spaces, and they generally are in industrial hubs as well, with connectivity that allows for heavy transport commutation.
As an investment option, industrial spaces are closely linked to the business that require them. Unlike offices, a business will only increase its involvement in industrial floors if it is serious about expansion. Generally, the lease tenure is similar to that of warehouses, from mid to long term.
Warehousing
These picked up pace especially after the pandemic, with a rise of ecommerce. These are wide open spaces that are used to store goods, for manufacturing and industrial sectors, or as a waypoint in the supply and logistics chain of any business.
Of late, in commercial real estate, warehousing has been a much safer bet, even if the comparative rate of return is lesser than that of office spaces and industrial floors. Some warehouses can even be made special purpose and they can have a longer lease term – from 5 years, up to 10 years. While such spaces offer stable returns, rental increase can be stunted.
Mixed use spaces
These mean what they spell. They can be a combination of retail, warehouse, industrial purposes, while also allowing for dining, lodging, parking, and the like. Larger malls and shopping complexes can fall into this category.
The yield of such spaces is an aggregate of the businesses that occupy the space. In such cases, sub-leases can also be involved wherein the investment firm deals with different owners that sublet the space to different businesses.
The lease agreements of such spaces are multifold and rather complex. Based on the location and population density of the area, such spaces can have a great return on investment.
A mix of warehousing, industrial and office space assets is advisable for any portfolio, but you should also watch out for where the market is headed. That will help you allocate more funds to a particular asset type or pull back from another type.
Multiple Property Classes To Diversify Your Investment
If you have encountered advertisements for investing in commercial or residential properties, you might have come across terms like Grade/Class A, B, C, and D. Mostly, the C and D classes are not featured as prominently. It is important to understand what these grades are and how they affect your investment.
Grade A
These properties are mostly new, less than five years old and are built matching or exceeding the accepted norms or standards. They are located smack in the middle of business districts or industrial areas and have top notch connectivity to other commercial hubs in the region. They are the least risky and generally offer the most stable returns.
Grade B
These buildings are well-maintained, refurbished and might need some light renovations. They can be anywhere from seven years to 15 years old and are in or around the periphery of high commercial activity. The rents are comparatively lower than Grade A buildings but can offer higher return on investment as they are much more accessible to tenants.
The risk involved is higher than that with Grade A assets.
Grade C
These buildings are generally located away from business hubs and do not feature great connectivity. They could be up to 25 years old and will require moderate upkeep, maintenance, or repairs. Risk is higher, but it is also the class of buildings that might be vacant the least.
Special attention should be paid to the lease terms and the conditions for the increase in the rent upon renewal. While these buildings can offer high returns based on income and growth, the returns can also be variable from year to year.
Class D
These assets are something that most investors stay away from. Based on the boom/bust scenario of the market, these assets can either result in amazing returns or total loss on investment. They can require major overhauling to bring them back to market standards.
As an investor, a mix of Grade A and B assets can be good for an average portfolio, while only seasoned investors can venture into Grade C assets for growth opportunities.
Multiple Locations To Diversify Your Investment
The commercial real estate market is insulated from the stock or bond market but is dependent on the demand in the general real estate market and the associated businesses that require commercial properties. Thus, location matters a lot.
Stable office markets can be chosen from metros like Bengaluru, Mumbai, Pune, Delhi while growth opportunities can be picked from nearby suburbs where the working population is growing in numbers. Another way to stabilise a portfolio is to look at long term warehousing and industrial spaces where your investment can provide a steady inflow of passive income.
Bottom Line
Diversification is important in any kind of investment and the same holds true for commercial real estate as well. A planned diversified portfolio can boost returns and reduce whatever little risk is present in commercial real estate investments.
At the same time, you should also bear in mind that riskier opportunities can come with the hope of higher returns, but as an investor, you need to be clear about your goals and the time for which you can stay invested in an asset.