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The Redbud, “Customer Discovery Article Series,” is a collection of sound bites from boots-on-the-ground industry experts and our industry commentary into a 3–5 minute intuitive read. Check out our second series on residential real estate here.
TLDR
In the United States, more than 2.4 million commercial real estate properties are in use. The market size for commercial real estate in 2023 is $1.2 trillion. Not only has the current economic climate caused supply-chain and development issues for developers, but within this vast market, investors, brokers, and business owners face daily adversity from issues with transactions, maintenance, and even escrow. In this article, we took a deep dive into the industry to understand these issues better. We interviewed two commercial real estate professionals with 40+ years of experience combined to gain insight from boots on the ground.
Commercial Real Estate Interviewees
We interviewed Landon Albertson, the founder of Alpha Real Estate, about his experience in the commercial real estate industry, the issues he’s taken notice of during his time as a broker, and the current economic climate. Landon started his career working with real estate giant Otto Maly. Alpha Real Estate, a commercial real estate brokerage located in Columbia, MO, Landon represents clients through commercial leasing, acquisition, and development.
Additionally, we interviewed Michael Link, Mizzou Alumni and Real Estate professional with over 20 years of experience in Commercial Real Estate, about issues he’s encountered during his time working in the industry and expectations in the current economic climate. Michael started his career working for Maly Real Estate while working on his MBA, where he helped retail giants like Lowe’s develop and open 30+ stores. He later moved over to work with The Kroenke Group, where he assisted owners in acquiring 70 retail centers. As a result, Michael has deep knowledge of the commercial real estate landscape, especially in the areas of Retail Acquisition, Transactions & Due Diligence, and Business Development.
What is Commercial Real Estate?
Commercial real estate refers to properties used for business purposes, such as offices, retail spaces, industrial warehouses, and multifamily apartment buildings. Investors or companies rather than individuals usually own these properties. Commercial real estate can be an attractive investment option because it has the potential to produce a steady stream of income. The property’s value can appreciate over time, and investors can strategically position the property and/or add to the property that increases foot traffic.
Commercial real estate investing is driven by capitalization rates — the expected rate of return on a commercial real estate investment (i.e., the property’s net operating income divided by current market value). Cap rates are indicators of risk and return for the property.
A riskier property (e.g., lumpy cash flows or deteriorating value) will have a higher cap rate, meaning the increased risk equals an increased required return. Cap rates are also affected by the macro environment with interest rates, supply, and demand. Where rates fall short, most buyers and sellers use few data points to assess a fair cap rate. This is especially true for middle markets with a lack of transparency with data from accessibility and tracking issues.
Financing for a commercial real estate property differs from getting a home mortgage. Commercial real estate, a more expensive and riskier asset class, tend to have higher interest rates, larger down payments, and shorter loan terms (higher loan payments). Additionally, qualifying for a commercial loan may be simpler than qualifying for a residential loan. The bank might require more personal information and a deep dive into personal finances for a residential loan. A commercial loan is based more on the property itself and how much cash flow it generates — more on how these loan types differ here.
The Commercial Real Estate Process
The process of buying, selling, and operating commercial property is complex and involves many steps. Sourcing for properties is usually the first step in investing in commercial real estate. Several factors should be considered when sourcing, including market research, occupancy rates, and local economics. Market research involves understanding the overall and local real estate market to identify properties that are or will be high in demand. Occupancy Rates are an important factor determining a property’s profitability, as a higher occupancy rate translates to higher revenue. Finally, local Economics includes factors such as the local job market, foot traffic, and local businesses’ health.
Many buyers, tenants, and brokers use Crexi to sort through potential investments or leases for commercial properties. Crexi also offers a data analytics service that allows investors to gain insight into the local market and development in the commercial real estate market. CoreLogic provides data analytics on a national scale on housing trends, liens, building, and replacement costs, criminal background records, and more. Advan Research uses geolocation technology to provide data on localities, including foot traffic, corporate activity, and customer behavior, to help the broker/buyer gain insight into the health of their local market.
Conducting Diligence is the next important step in the investment process. It involves determining a commercial property’s value, evaluating its health, and checking for any safety issues to mitigate risk or eliminate potential lawsuits. To determine the value of a property, an investor can:
Obtain an appraisal from a professional appraiser
Conduct Sales Comparables to gain insight into what similar properties in the area are selling for or are valued at
After determining the property’s value, before listing or buying it, make sure to do a walkthrough as the agent or with an agent to check for any structural damage or environmental hazards. Then, as the seller, mitigate risk by ensuring the buyer is given all relevant information on the property during the Due Diligence process.
Altus Groups’ Argus Enterprise software helps users create commercial property valuations using the cash flow analysis model and stress test to help estimate value during uncertain times. Geophys’ Evra allows CRE professionals to assess data and gain insights on the attractiveness, health, and risk of a property, its tenants, and its surrounding area.
What most real estate data analytics platforms miss are deeper details for diligence. Cap rate data helps, but it’s a double-edged sword when there is still information asymmetry between large to mid and small real estate investors. For example, investors need insights on the property’s health, the weather, government tax incentives, diligence on potential tenants, etc.
Next is the transaction process includes negotiating the deal, signing relevant documents, and using an escrow service. The negotiation and contingencies of the transaction are generally the longest steps in closing a real estate transaction. Negotiations, amending legal documents, offline asynchronous redlining, etc., can hinder a deal from closing. After signing, an Escrow agent is needed to act as the intermediary for the upfront funds. They gather, hold, and distribute funds through local real estate law and ensure all documents are signed.
ProDeal is a cloud-based collaboration platform that allows brokers to secure and manage commercial real estate transactions. The platform tracks, analyzes, and stores deals and relevant documents for the transaction process. One issue with escrow, especially for middle-market buyers in a hot market, is having the liquidity for escrow before even winning a deal. Earnestly, an emerging fintech is pioneering a new model for escrow liquidity.
Operations is a crucial aspect of owning and managing commercial real estate. It involves the development of properties and ongoing maintenance, the sourcing, and closing of tenants, asset utilization, and more. In short, the process goes by selecting a building site, overseeing construction, selling or leasing the property, and maintaining the property. Generally, the management is outsourced, but some owners will have an in-house management team. Pains with using an outsourced team are i) less insight into operations, materials, and labor negotiation, and ii) unaligned incentives due to the pricing model historically being one-sided (e.g., Property managers spend more, they make more, and the owner loses more). Appreciate is building a software platform for owners to have insight into operations (e.g., expenses, material negotiating, etc.) and has structured a new business model that aligns incentives of owners and managers by taking a percentage of net operating income instead of revenue.
Maintaining a property is arguably just as important as developing one. Breezeway provides online property management for CRE; their platform provides real-time updates, scheduling, automated workflow, and task management for the entire maintenance team. GetDigsy is an on-demand brokerage services platform that helps clients find their commercial space or office within minutes. Brokers can use this platform to help identify properties for their clients on the fly. Keeping clients happy and keeping occupancy rates stable/increasing is another piece of the puzzle. Knock is an all-in-one multi-family property CRM and communications platform. They provide brokers the ability to coordinate communication and tours and track marketing and leasing effectiveness to help retain residents and boost NOI.
Last in the property-owning lifecycle is exiting the property, which, if you’re lucky, can take almost no effort but oftentimes is a long process of marketing and meeting with prospective buyers. In addition, it usually involves numerous middlemen, e.g., attorneys, real estate agents, etc. Buildout is an end-to-end solution for streamlining the property listing process for the CRE agent by providing simple marketing materials, live insights, and more. SharpLaunch is the CRE marketing platform that helps increase asset (property) visibility and streamline and track marketing efforts.
Commercial Real Estate in The Economy Today
The current economic climate has had a negative impact on the overall commercial real estate market. We see delays in the development of properties due to supply chain issues and construction costs. Brokers and investors in commercial real estate are moving into other investment tools, but Columbia, MO-based Alpha Real Estate is doing the opposite. They enter and stay on top of changing markets.
“If you’re not evolving, you’re dying,” said Landon.
The overall construction cost has increased due to materials like Iron and Steel increasing in cost. Landon mentioned that he’s noticed developers switching materials mid-build and reverting to using wood over steel due to the price increase. Input costs for nonresidential construction rose 42.5% from March 2020 to March 2022 and are forecasted to continue growing through Q1 but slowly dissipate in 2023. According to CBRE, the US has softened its tariffs on EU steel to help relieve current demand and decrease input costs.
Search for properties with a grocery store in the area (this is a sign of excellent foot traffic)
Look for properties in markets such as those in college towns
Find properties in major growing metropolitan areas such as Dallas, Los Angeles, Denver, etc.
Value and being more precise in the investment process is very important in an economic downturn; even a more sophisticated property-sourcing process can go a long way.
We are still seeing supply chain bottlenecks due to the Russia-Ukraine conflict and recent surges of Covid-19 in China. Both of these issues result in persistent commodity shortages.
Construction costs are the sum of material costs, labor costs, and margins. Due to inflation, a tight labor market, and contractors trying to recoup margins lost in 2022 from high material costs, it’s expected we will see a rise in labor costs and, therefore, a rise in overall construction costs. Although with supply-chain issues easing, a slow balancing effect might occur. CBRE expects construction costs to grow by 5.4% in 2023.
Supply Chain issues are affecting the development process of commercial real estate significantly. Not only did the cost for singular components needed for development increase, but delays are occurring with certain materials or components in a CRE project. According to Landon, a broker may have an entire development project done but cannot get a single component in. Therefore, the investors are left holding on to debt, so much as they are losing money the longer the property stays in development. Companies like Flexe help solve this issue by providing warehousing spaces on-demand via an online marketplace, allowing businesses to stay ahead of supply chain issues and store necessary items for development ahead of time at convenient locations.
Not only is the current economic climate affecting the development of projects, but inflation and a weakening labor market can increase the probability of vacancies as people lose their jobs and can no longer afford leases. In December 2022, the total number of shifts worked by people in the US declined by 2.9%, and retail in the public sector decreased by 4.1%, indicating a weak labor market at the start of 2023. Additionally, Americans losing their jobs and affording less may lead to late rent payments, increasing vacancies, and pushing property managers towards more sophisticated background checks. Darwin is a property management platform providing necessities from repairs to resident screening, rent collection, and more. This company is trying to solve the renting experience for the tenant and property manager today.
Other Solutions
Commercial real estate investing is a complex landscape to navigate. Subsequently, commercial property comparison enables investors to thoroughly evaluate prospective properties before spending time and money on investigating in person. Companies like 42floors allow users to conduct specific searches for commercial properties they’re interested in and increase their exposure by providing listings from all US markets. LoopNet is another excellent example of this solution.
Getting funding for CRE investing can be an intricate process as well; some may come into trouble when attempting to get a commercial loan due to the process. RealtyMogul aims to solve this by providing a crowdfunding platform for commercial real estate, allowing individuals and institutional investors to make simple and accredited investments in properties. Another company that aims to bridge the gap between investors and commercial real estate is CrowdStreet; they provide an online marketplace for accredited investors to evaluate and invest in potential properties.
According to Michael, capital planning is a pain that shows up frequently when developing and maintaining a property. However, spending estimates only go so far; if there were a better way to help evaluate the short-term and long-term needs of a building or development project, capital planning would be much more efficient. Consequently, brokers could predict cash flows and returns better, making for a more profitable investment.
Closing Remarks
The commercial real estate process is complicated; many factors must align (e.g., the economy), and many intricate operations must come together to maximize profitability. Investors should be aware of all operations and current events to shift their business strategy to navigate the CRE landscape properly. Although many innovations have been launched to solve the industry’s pains, we still need help with painstaking processes like underwriting, escrow, and property maintenance. With the current economic downturn, it could be a prime opportunity for new proptech businesses to thrive as real estate operators shift a focus from expansion to maintenance. This will launch us into a year of growth and more truly-valuable proptech startups in 2023.
Redbud VC is an early-stage venture capital fund and studio investing monetary and social capital in early-stage tech founders.
Reach out to Brett Calhoun, Managing Director & GP at Redbud VC, at brett@redbud.vc to learn about Redbud, and subscribe to our newsletter here.
Co-authored by Brett Calhoun and Yahav Sal
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