Pros and Cons of the 5 Main Types of Real Estate Investment Properties
There are five main types of real estate investment properties according to the National Council of Real Estate Investment Fiduciaries: multifamily, industrial, office, retail, and hotel (and sub-types in each group). Each type of property has its own unique characteristics, from different demand drivers to the underlying cash flow cycles. Moreover, all are deeply affected by market conditions; as economic headwinds shift, so do the ups and downs of each. For example, office properties may be a standout investment opportunity one year and then can face headwinds the next year, or vice versa.
Investors can own real estate properties as direct investments or through private equity real estate funds or REITs. But prior to making a real estate investment, it’s important to assess the potential for risk and reward with each type of property and use this knowledge to create a diversified portfolio. That’s why it pays to understand the pros and cons of each type of real estate investment property type, and their outlook for the next few years.
Multifamily Outlook: Secure Income, But Disruption Ahead
Though multifamily generally implies an apartment building, a wide range of residential subtypes—from townhouses and developments of single-family rental homes to student housing and senior living developments are incorporated in this category. Economic drivers that impact multifamily include demographic trends (age, income, and preferences of each generation forming households) to employment growth and home ownership.
Millennials and baby boomers are showing a preference for apartments, just as tax reform gives these generations fewer incentives to buy homes. Generation Z, the cohort born between 1998 and 2012 and set to comprise almost one-third of the U.S. population this year, is entering the rental market now as well. These demographic trends have boosted multifamily demand, but private equity investors also find multifamily real estate a lower-risk proposition. Multiple units generate a diversified and steady passive income stream. Annual lease periods allow landlords to adjust rents for inflation and to replace tenants or renovate apartments with little downtime between leases. Turnover is at its lowest point this century in the most recent National Apartment Association (NAA) annual survey.
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From an investment perspective, attractive financing is readily available. Fannie Mae, Freddie Mac and the Federal Housing Administration all supplement multifamily lending from banks and life insurance companies, creating significant competition among the various lending sources. This competition, along with falling Treasury yields, has allowed developers and investors to borrow at historically low-interest rates. These low rates, when combined with stable underlying cash flows, create attractive annual cash flows.
Affordability is a concern for landlords as well as tenants. New construction costs are rising steadily, which has limited development to projects that can achieve top-of-the-market rents. In some submarkets, there is a concern of overbuilding relative to the number of residents with high enough incomes to support the new supply. Also, there are other barriers to activity: Labor costs are holding down new permits, the NAA says, along with regulation, approval snags, and community opposition.
As costs continue to increase, urban supply pipelines already are shrinking. To get creative, builders are exploring prefabricated, panelized and modular systems to deliver on budget. Further disruption is ahead as a 3D printed house, built at this year’s South by Southwest conference as a third-world housing solution, may be the future of urban multifamily development. Meanwhile, the driverless car may turn the parking garage from an amenity to a white elephant.
Office Outlook: Don’t Underestimate the Complexities
It’s easy to underestimate the complexity of office properties. While they range from small, single-tenant buildings or several such structures grouped into office parks to huge multitenant skyscrapers, office real estate has exacting sub-categories because some of the tenants have special needs, such as medical offices that have highly technical requirements. Demand for office space is highly correlated with regional economic activity and job growth.
Low unemployment signals continue strong demand for office space, particularly in fast-growing cities where jobs in technology, financial services, and healthcare concentrate. Demand is strongest with amenities nearby, which has given urban centers an edge. But as millennials put down roots, suburbs with quality schools and parks stand to benefit in the next three to five years as millennials will want to work close to home.
In markets where character is a differentiator, neglected spaces have become an opportunity. Downtown high-rises are being remodeled as mixed-use magnets, with ground-level food halls and boutique penthouse hotels. Google’s Chicago region headquarters retains its character as a former cold storage warehouse. Water mains, rail lines, and other manufacturing artifacts lend character to the American Tobacco Campus in Durham, North Carolina. Tenants will pay a premium for a cool environment that helps recruit and retain talent.
Office leases are usually long-term (five, seven or 10 years) and have built-in annual rent increases, which are a great hedge on inflation. A long-term lease to a tenant with strong credit is advantageous for many reasons, not the least is that it can help owners weather economic downturns.
The office market stands to get more competitive as job growth cools, increasing the need to fund expensive renovations and the costs to complete this work is increasing rapidly. Co-working spaces such as WeWork, Spaces and Industrious will compete with traditional landlords for smaller tenants because their business models offer economies that traditional office landlords can’t contest economically.
The new creative offices will be more compact: Space planning aims to improve efficiency by putting more employees in the same footprint. Businesses used to allow 400 square feet of space per employee, but now can get away with 150 to 250 square feet. Job growth has accelerated the drive to densify, says real estate advisor Cushman & Wakefield. The average floor plan now has 194 square feet per employee.
Compared with multifamily, vacancy risk and the costs to re-tenant increases with fewer office leaseholders in a building, and credit risk rises as landlords lease to startups. An early lifecycle company can burn through private equity or venture capital funding and go bankrupt in the middle of a lease term. Lost tenants reduce revenue and the cost to re-tenant can add significant capital expenditures.
Retail Outlook: High Highs and Low Lows
The retail sector includes everything from small neighborhood shopping centers to large super-malls that draw shoppers from miles around, but in every subgroup, it’s in the throes of cataclysmic disruption thanks to e-commerce. But it’s not dead yet. People still need to grocery shop, try on clothes and still enjoy the communal experience provided by experiential retail. The successful pockets in the retail market are influenced by regional economic indicators such as employment growth and consumer confidence levels and locally by a property’s location, surrounding demographics, household incomes, buying patterns and tenancy.
When office tenants mention amenities, they talk about the places nearby where they eat, drink, work out and head for entertainment. This “experiential” retail is alive and well, both infilling well-positioned properties, where higher quality tenants—often with creative concepts—are replacing failed businesses and backfilling empty big boxes and malls. Experiential retail has healthy tenant demand and aggressive capitalization rates.
Lifestyle malls are drawing attention as value-add investments: Luxury retail has performed well in the recent past, although it’s starting to face headwinds thanks to the Asian and European economic slowdown. Discounters like Ollie’s and warehouses like Costco continue to expand, and Amazon’s Whole Foods takeover is just one example of e-commerce adding brick-and-mortar stores to its foundation.
There’s experiential retail (which can include grocery-anchored centers), the super-regional mall in primary markets, and then there’s everything else. For many transactions, especially those in over-retailed and tertiary markets, demand is weak on both the buyer’s and the seller’s side, which can create significant downward pressure on valuations. As national retail chains continue to shutter locations, quantifying the future risk in certain assets in retail real estate can be quite difficult.
Industrial Outlook: Online Retail Demands the Total Package
Industrial properties include everything from warehouses and distribution centers to manufacturing facilities and research & development spaces. However, some of these properties are leased to a single tenant and then built to the tenant’s specifications due to the complex machinery and technology they house, which can increase risk. Partially offsetting this risk, single-tenant leases are usually long-term and provide a bond-like cash flow stream so long as the tenant remains in occupancy. Yet due to the customization, they may require, these properties can be difficult to lease without significant modifications when a tenant leaves, increasing risk still further.
E-commerce and its near-instantaneous delivery have changed the look of the warehouse. Amazon is reportedly leasing multistory distribution centers in metro suburbs, as well as Amazon Hub city storefronts to get even closer to customers. Warehouses are in high demand across all segments, especially in nautical port locations as mega-ships traveling through the Panama Canal change import distribution practices. Even older warehouses are drawing higher rents for cannabis cultivation. Industrial has become the most desirable property category among institutional and private investors alike due to the favorable supply and demand fundamentals that exist today, which are expected to remain in balance long into the future.
Warehouses often require all-cash funding to acquire because low capitalization rates don’t justify the borrowing costs. Data centers require access to fiber optic networks and cheap power, as well as redundant generating and cooling systems. The more specialized an industrial property, the harder it becomes to convert for another tenant.
Hotel Outlook: Lower End is Slow; Higher End is High
Hotels are defined by the amenities and services they offer, from budget no-frill motels with only the basics to limited service facilities that may lack room service or an on-site restaurant to full-service hotels with a 24-hour concierge and spa amenities. And within these levels, there are many variations on the lodging theme—also at every price point. Property types range from independent boutique hotels to establishments under the aegis of a major chain to extended stay lodging and resorts, all with amenities tailored to fit a very specific demographic. For instance, hotels attached to a celebrated lifestyle mall, a major medical center, a popular casino or even an acclaimed restaurant serve as the primary demand drivers for the targeted guest.
Unlike landlords with long-term leases, hotels and short-term rentals are more flexible and can survive economic change by adapting quickly to occupancy rates, guest demands and amenity trends. They can adjust pricing, renovate, run promotions, change their offerings and more. These tactics can stave off vacancies in the event the competition is not keeping pace. And because hotel guests must pay upfront, delinquencies (and evictions) aren’t an issue.
Luxury and high-end hotels are in strong demand because guests are embracing experiences, according to JLL’s Hotel Investment Outlook 2019. In 2018, luxury hotel transactions in the United States increased by 76 percent, and brands are not only responding to this growth by acquiring one-of-a-kind luxury properties, but they are also adding luxury elements to already existing concepts, the report notes.
It’s obvious that if a hotel is not in an area that visitors find desirable, lacks the right kind of amenities relative to its competitors, is not well-run, or doesn’t react to market trends in real time, it won’t prosper. Be it no-frills or luxury, every part of a hotel, from its rooms to amenities, needs daily cleaning and restocking and constant updating. This requires a healthy operating budget; keeping guests happy and their needs fulfilled is essential since reviews on websites like Trip Advisor or Yelp have a big impact on a hotel’s reputation and occupancy rate (or lack thereof). This requires a knowledgeable, talented and extremely proactive management team, and requires investors to do deep due diligence before investing in any type of hotel. Additionally, in most hotel chains, a property improvement plan (PIP) is required to be completed periodically by the owner to bring a hotel in compliance with brand standards. Required upgrades could include new furniture, fixtures, carpeting, and lighting and can be quite expensive to implement, substantially reducing net cash flows.
The Bottom Line on the Types of Real Estate Investment Properties
Investors can manage the risk of any single type of property with a diversified portfolio of private equity real estate, public REITs and direct acquisitions. But with such varied risk profiles, real estate investors should take care to assess the potential for setbacks in holding each type of real estate, as well as the opportunities for higher returns.