The pros and cons of investing in commercial property: Is commercial real estate a money making investment?

Commercial property, also called commercial real estate, is any land used for business rather than living in. (Real estate for living is called residential). Commercial property can include everything from piers to farmland, but a typical investment is a city centre office building or a shop or shopping mall.

Unless you are already very wealthy (in which case you should already have some expert advice on hand) none of us are likely to buy a whole office block or mall. Most ordinary retail investors invest in property through funds (such as mutual funds, unit trusts or special Real Estate Investment Trusts). That is a good way of diversifying risk and make it much easier to buy and sell (it's easier to sell a mutual fund holding than a whole building).

Most property funds out there specialise in some sort of commercial property, although nowadays there are more opportunities for investing in residential property.

I'm not going to discuss residential property here, but it can be attractive to many investors because they at least feel like they understand it and how it makes money. In my opinion residential property is not generally a good investment for ordinary retail investors (despite the crazy success stories that do happen) because:

1. You probably already have plenty of exposure to residential property through your own home. Better to diversify your investments into other areas.
2. It's already popular as an investment idea, so chances are the price will be bid up by all those other investors.
3. Because "somewhere to live" is a basic human need, everyone has an interest in the residential property market. That means that politicians will always be tempted to interfere with the residential property market. Whether you think they should or not will depend on your political opinions but it does make it harder to predict what will happen to that market as you can't rely solely on the economic fundamentals.

As an investment commercial property is somewhere in between bonds and shares. Bonds have regular income but have limited capital gains potential (see here for more on the pros and cons of investing in bonds). Shares have great growth potential but the income is lower and return more variable (see this article for more on the pros and cons of investing in shares).

Commercial real estate has the regular income of bonds but potential for capital gains of shares. Does this mean it's better than both? Unfortunately you don't get anything for free in the world of investments and higher returns have to be paid for by taking more investment risk. Commercial property generally sits between bonds and shares in the risk/return spectrum (shares have higher risk and higher return, high grade bonds have lower risk and lower return).

Property investments also have higher running costs than shares or bonds. Don't forget the costs of refurbishment, wear and tear and insurance amongst other things will be netted off against the rent paid.

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1. Regular income

The rent paid by the companies who use the offices, shops or factories you have invested in is paid into the fund. It will either be paid out as income to the investors or reinvested - check on any individual funds policies before investing. Either way though, the investment should produce regular returns from those rents. Generally rents only increase not decrease. But beware of "voids" - if there is no tenant in a property no one is paying rent. Well managed funds will look to maximise rent while minimizing voids

2. More secure than equities

Shares can become worthless if the company issuing them folds. Land on the other hand, while it can fall in value (just ask anyone in Detroit) tends to have a minimum value. However be careful of funds which borrow to invest - they can become insolvent. Look at the proportion of the fund which is from borrowing rather than investors (this is called the gearing). Higher gearing means higher returns but also higher risks.

3. More capital gains potential than bonds

Remember that your investment returns can come two ways: income and capital gains. Bonds give good income, but the return on bonds has an effective ceiling, you can't do better than get your money back with interest. With commercial property the price of the assets can go up to any level giving you a capital gain. Of course they can also fall. Be aware that this cuts both ways.

4. Diversification

Commercial property investment returns will to some extent move in line with the wider economy as do shares. However they are not perfectly linked so you get the benefit of diversification (e.g. if shares are doing badly there is a chance commercial property will be doing well and vice versa).

Of course investing in commercial real estate is not all life on easy street. There are some downsides to commercial property investment.

1. Illiquidity

Commercial property, like all real estate is illiquid - that means it's hard to buy and sell quickly without selling it cheap. Even if you invest in a fund which allows you to buy and sell quickly there might be limits on how much you can buy or sell at a time.

Funds will generally hold some cash to pay out investors and they usually trade at a discount to their underlying asset value because of illiquidity

2. Income not as secure as high grade bonds.

Although property income is fairly secure for high qu ality real estate, there is always a risk that there will be voids, with no rental incomes coming in, or in tough times tenants might negotiate a rent reduction even if that isn't in their contract.

3. Isn't perfect diversification

Even though property offers diversification benefits together with investing in shares and bonds, real estate income still comes from companies renting shops and factories, so if the economy does badly and shares do badly, it will also affect commercial real estate.

Commercial property investments can be a really good way to diversify your portfolio (which should reduce your overall risk for the same return) and gives an investment which has some of the strengths and weaknesses of both bonds and shares. It is affected by wider economy, so it can be worth trying to think strategically about what to move in and out of your investment.