Understanding the basic economic forces of supply and demand will help the novice commercial real estate investor build a real estate portfolio that provides a consistently high rate of return. Looking at each side separately helps define a strategy for buying investment property and maximizing investment returns.
The Demand Side of Real Estate
This can be a very simple and effective way to purchase commercial real estate. The basic premise is the theory that crowds make better decisions than any individual can and invest where others are already investing. This is certainly an accurate reflection of the real estate investment acumen of the beginner. Seasoned professionals have a greater understanding of what drives market values, so following their lead makes sense.
The internet provides plenty of opportunities to find where professionals are investing. “Hot” real estate markets in 2017 are identified by several real estate investment firms for free. Some of these are obvious, such as San Francisco, but others may still be in the beginning stages of their growth.
The shortcoming of this approach is the possibility that the fundamental value proposition of a “hot” market has already been taken. Early buyers in an area realize their value, at least in part, by selling their appreciated assets to later buyers. While this cycle can be repeated if new investors continue to enter the market, it can’t go on forever. The risk is that the crowd will have moved on before a buyer realizes they have left.
It is possible to reduce this risk by diversifying into two or three “hot” markets, but this solution raises another problem. Building a commercial real estate portfolio by buying individual properties is an expensive approach even when each property is leveraged. A diversified approach might be out of reach for the average investor. Crowd funded real estate and REITs might be a suitable alternative to direct ownership for new investors with smaller amounts of capital to commit.
The Supply Side of Real Estate
If it is difficult to judge where the market is going. Creating value in commercial real estate can be as simple as finding and polishing a diamond in the rough. Basic improvements are sometimes the key to seeing a property realize its true market value.
Cell phone towers are a classic example of this approach. A commercial building in a suitable location can improve cash flow by leasing the roof to a wireless carrier. Of course, most prime locations already have towers in place, but other ways of improving cash flow still exist in the market. The key is identifying them.
One of the challenges of this approach is the need to act quickly when a good opportunity arises. New York real estate, for example, requires swift implementation of buying decisions or the opportunity can be lost to another buyer. The speed of this decision making can make the novice real estate investor uncomfortable. In addition, a seller may not be willing to wait even a reasonable amount of time for a buyer to arrange financing or other details of a large purchase if they are pricing the property for a quick sale.
This is another example of why many real estate investors forego purchasing individual properties. Professional investors have the acumen and resources to quickly commit to and close on properties with unique value realization opportunities. Novice investors can access their expertise through an eREIT or similar investment structure.
Understanding supply and demand is fundamental to building a commercial real estate portfolio. Investors willing to spend the time to learn either side of the equation can see the rewards of a strong rate of return on their asset allocation.