An investment in commercial real estate, as with any investment, is a bet on future events and circumstances. Since the value of the acquired property can change if its location’s demographics and economy shift over time. That’s why it is critical to determine at the start of your search how much and where to invest in order to hedge your real estate bet. There are certain basic factors that real estate investors generally consider when assessing the viability of an investment in a specific property or region. A proper assessment of these factors will result in a determination of where to invest and what type of property to invest in.
One of the factors to consider is the investment time horizon or holding period. Over time, as we’ll discuss later, markets change and, therefore, so will investment returns. The investment strategy will dictate the holding period and will lead investors to specific markets. For example, an investor may be willing to accept higher risk and may be looking to capitalize on a hot and growing market over a shorter holding period. Conversely, a more risk averse investor may be looking for steady cash flow from a more established market over a long-term holding period.
The holding period assessment naturally leads to a number of other factors to consider, such as continuing urbanization around the world. Urbanization, the population shift from rural to urban areas, has a significant impact on the prospects for commercial real estate.
Urbanization doesn’t affect all urban areas equally and some urban areas grow faster, and sometimes significantly faster, than others. (In fact some urban areas shrink over time, but we’ll save that for another article.) In addition to growth rates, the physical growth of urban areas (i.e., horizontal or vertical growth) differs depending on a number of factors, but most importantly available land. Urbanization factors will dictate the types of properties that will perform better in a given market at and over a given time period. For example, high-rise office and multi-family buildings combined with street-level retail will generally out-perform in quickly growing vertical cities whereas office parks and destination malls and power centers would perform better in cities with moderate horizontal growth.
The sibling, maybe more of a cousin, of urbanization is demographics (defined as the quantifiable statistics of a given population at a point in time). Similar to the manner in which urbanization has an effect on market and property type, demographics and projected demographic shifts also play a role. Factors such as education levels, income levels, age and family composition, have a specific impact on the types of properties that will perform in a given market. Markets with younger populations with growing families (think multiple kids) would warrant different retail and healthcare properties than those with older populations. Similarly, markets with higher education or skill rates would warrant different commercial properties than those with lower or more unskilled labor populations.
Another key factor to consider is how saturated a given market is currently, or is projected to become. Put another way: how quickly vacancy in a given property type will be absorbed by a given market. Market saturation is of particular importance to real estate developers or those looking to redevelop or re-purpose an existing property. Overall, commercial real estate investors (and developers) generally seek properties in markets that will be able to better absorb the available space or that will benefit over time from the factors discussed above. Of course there are always exceptions to the consensus, especially when looking at trophy properties and “international” or “gateway” cities.
MAKING THE INVESTMENT DECISION
As one seeks to make an investment in commercial real estate and searches for the perfect property and market, the key is developing a reasonable prediction of future events and circumstances. In his recent article in the National Real Estate Investor, Looking Backward, Looking Forward, The Evolution of Commercial Real Estate, David J. Lynn provides some insight into the history of commercial real estate investing and, more importantly for our purposes here, certain future global trends relating to urbanization and demographics. These trends are clearly important to commercial real estate investing; specifically to identifying the appropriate market and property type to achieve the investment objectives within the investor’s specific time horizon.
By: Anthony La Malfa This article originally appeared in BDO USA, LLP’s “Real Estate Monitor” newsletter (Winter 2015). Copyright © 2015 BDO USA, LLP. All rights reserved.
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