Commercial Real Estate Definition and Types

What Is Commercial Real Estate (CRE)?

Commercial real estate (CRE) is property used for business-related purposes or to provide workspace rather than living space. Most often, commercial real estate is leased by tenants to conduct income-generating activities. This broad category of real estate can include everything from a single storefront to a massive factory or a warehouse.

The business of commercial real estate involves the construction, marketing, management, and leasing of property for business use.

There are many categories of commercial real estate such as retail and office space, hotels and resorts, strip malls, restaurants, and healthcare facilities.

Understanding Commercial Real Estate (CRE)

Commercial real estate and residential real estate are the two primary categories of the real estate property business.

Residential properties are structures reserved for human habitation rather than commercial or industrial use. As its name implies, commercial real estate is used in commerce, and multiunit rental properties that serve as residences for tenants are classified as commercial activity for the landlord.

Commercial real estate is typically categorized into four classes, depending on function:

1. Office space
2. Industrial use
3. Multifamily rental
4. Retail

Individual categories may also be further classified. There are, for instance, different types of retail real estate:

• Hotels and resorts
• Strip malls
• Restaurants
• Healthcare facilities

Similarly, office space has several subtypes. Office structures are often characterized as class A, class B, or class C:

• Class A represents the best buildings in terms of aesthetics, age, quality of infrastructure, and location.
• Class B buildings are older and not as competitive—price-wise—as class A buildings. Investors often target these buildings for restoration.
• Class C buildings are the oldest, usually more than 20 years of age, and may be located in less attractive areas and in need of maintenance.

Some zoning and licensing authorities further break out industrial properties, which are sites used for the manufacture and production of goods, especially heavy goods. Most consider industrial properties to be a subset of commercial real estate.

Commercial Leases

Some businesses own the buildings that they occupy. More commonly, commercial property is leased. An investor or a group of investors owns the building and collects rent from each business that operates there.

Commercial lease rates—the price to occupy a space over a stated period—are customarily quoted in annual rental dollars per square foot. (Residential real estate rates are quoted as an annual sum or a monthly rent.)

Commercial leases typically run from one year to 10 years or more, with office and retail space typically averaging five- to 10-year leases. This, too, is different from residential real estate, where yearly or month-to-month leases are common.

There are four primary types of commercial property leases, each requiring different levels of responsibility from the landlord and the tenant.

• A single net lease makes the tenant responsible for paying property taxes.
• A double net (NN) lease makes the tenant responsible for paying property taxes and insurance.
• A triple net (NNN) lease makes the tenant responsible for paying property taxes, insurance, and maintenance.
• Under a gross lease, the tenant pays only rent, and the landlord pays for the building’s property taxes, insurance, and maintenance.

Managing Commercial Real Estate

Owning and maintaining leased commercial real estate requires ongoing management by the owner or a professional management company.

Property owners may wish to employ a commercial real estate management firm to help them find, manage, and retain tenants, oversee leases and financing options, and coordinate property upkeep. Local knowledge can be important as the rules and regulations governing commercial property vary by state, county, municipality, industry, and size.

The landlord must often strike a balance between maximizing rents and minimizing vacancies and tenant turnover. Turnover can be costly because space must be adapted to meet the specific needs of different tenants—for example, if a restaurant is moving into a property formerly occupied by a yoga studio.

How Investors Make Money in Commercial Real Estate

Investing in commercial real estate can be lucrative and can serve as a hedge against the volatility of the stock market. Investors can make money through property appreciation when they sell, but most returns come from tenant rents.

Direct Investment

Direct investment in commercial real estate entails becoming a landlord through ownership of the physical property.

People best suited for direct investment in commercial real estate are those who either have a considerable amount of knowledge about the industry or can employ firms that do. Commercial properties are a high-risk, high-reward real estate investment. Such an investor is likely to be a high-net-worth individual since the purchase of commercial real estate requires a considerable amount of capital.

The ideal property is in an area with a low supply and high demand, which will give favorable rental rates. The strength of the area’s local economy also affects the value of the purchase.

Indirect Investment

Investors can invest in the commercial real estate market indirectly through ownership of securities such as real estate investment trusts (REITs) or exchange-traded funds (ETFs) that invest in commercial property-related stocks.

Exposure to the sector also derives from investing in companies that cater to the commercial real estate market, such as banks and realtors.

Advantages of Commercial Real Estate

One of the biggest advantages of commercial real estate is its attractive leasing rates. In areas where new construction is limited by a lack of land or restrictive laws against development, commercial real estate can have impressive returns and considerable monthly cash flows.

Industrial buildings generally rent at a lower rate, though they also have lower overhead costs compared with an office tower.

Other Benefits

Commercial real estate benefits from comparably longer lease contracts with tenants than residential real estate. This gives the commercial real estate holder a considerable amount of cash flow stability.

In addition to offering a stable and rich source of income, commercial real estate offers the potential for capital appreciation as long as the property is well-maintained and kept up to date.

Like all forms of real estate, commercial space is a distinct asset class that can provide an effective diversification option to a balanced portfolio.

Disadvantages of Commercial Real Estate

Rules and regulations are the primary deterrents for most people wanting to invest in commercial real estate directly.

The taxes, mechanics of purchasing, and maintenance responsibilities for commercial properties are buried in layers of legalese. These requirements shift according to state, county, industry, size, zoning, and many other designations.

Most investors in commercial real estate either have specialized knowledge or employ people who have it.

Another hurdle is the risks associated with tenant turnover, especially during economic downturns when retail closures can leave properties vacant with little advance notice. 

The building owner often has to adapt the space to accommodate each tenant’s specialized trade. A commercial property with a low vacancy but high tenant turnover may still lose money due to the cost of renovations for incoming tenants.

For those looking to invest directly, buying a commercial property is a much more costly proposition than a residential property.

Moreover, while real estate in general is among the more illiquid of asset classes, transactions for commercial buildings tend to move especially slowly.

Commercial Real Estate and COVID-19

The global COVID-19 pandemic beginning in 2020 did not cause real estate values to drop substantially. Except for an initial decline at the beginning of the pandemic, property values have remained steady or even risen, much like the stock market, which recovered from its dramatic drop in the second quarter (Q2) of 2020 with an equally dramatic rally that ran through much of 2021.

This is a key difference between the economic fallout due to COVID-19 and what happened a decade earlier. It is still unknown whether the remote work trend that began during the pandemic will have a lasting impact on corporate office needs.

In any case, the commercial real estate industry has still yet to fully recover. Consider how American Tower Corporation (AMT), one of the largest United States REITS, was priced at roughly $250 per share in June 2022. Fast-forward one year, the REIT traded at roughly $187 per share in June 2023. At the end of June 2024, it was at about $194.

Commercial Real Estate Outlook and Forecasts

After major disruptions caused by the pandemic, commercial real estate is attempting to emerge from an unclear state.

In a mid-year update released in May 2024, JPMorgan Chase concluded that the multifamily, retail, and industrial sub-sectors of commercial real estate remain strong despite interest rate increases.

However, it noted that office vacancies were rising. Vacancies nationwide stood at a record-breaking 19.6% in the final quarter of 2023.

The Bottom Line

Commercial real estate has the potential to provide steady rental income as well as capital appreciation for investors.

Investing in commercial real estate usually requires larger amounts of capital than residential real estate, but it can offer high returns. Investing in publicly traded REITs is a reasonable way for individuals to indirectly invest in commercial real estate without the deep pockets and specialist knowledge needed by direct investors in the sector.