In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi continue the REconomy “Summer School” series, discussing what makes real estate “commercial” with Senior Economist Xander Snyder.
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“Owners of both commercial and residential real estate hope to benefit from price appreciation, but with commercial real estate, owners are also seeking to generate some sort of income from their commercial property in addition to that price appreciation. Income is generated by charging rents to businesses or individuals to use some of the space in that building. And that rental income is then offset by various expenses that commercial property owners incur while operating that building.” – Xander Snyder, senior commercial real estate economist at First American
Odeta Kushi - Hello and welcome to episode 94 of The REconomy Podcast and our third session of the Summer School series, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist and Xander Snyder, senior commercial real estate economist. Welcome one. Welcome all to our third Summer School session.
Mark Fleming - Hi Odeta. Yes, welcome all and for those tuning in just now in mid-summer, in the first two episodes of The REconomy Summer School, we covered an overview of the closing process for purchasing a home and the drivers and benefits of homeownership. So today, with Xander joining us, we're going to turn from residential to commercial real estate. While most people are familiar with residential real estate, even if they don't own a home themselves, it's less common to be familiar with the ins and outs of commercial real estate, if you don't work directly in the industry. Today, we're going to wax philosophical a bit on the nature of commercial real estate. So why don't we just start there? What makes commercial real estate, commercial, in the first place, Xander?
Xander Snyder - Hey, Odeta. Hey, Mark. Well, the key to waxing philosophical about commercial real estate is to first wax on and then to wax off. Hmm.
Mark Fleming - There we have the '80s reference, a little Karate Kid. And for our listeners, I do believe that continues the unbroken streak of '80s references in The REconomy.
Xander Snyder - Yes, indeed, you see, Soccrates would be proud. Now, the main difference between individual homeownership and commercial real estate is that commercial real estate is acquired exclusively as an investment of some sort. Now, while the house you live in also serves as a type of investment, in that it can go up in value over time when you live in it. Commercial real estate doesn't usually provide that shelter aspect to the individual or the company that owns it. There are some exceptions, where perhaps an individual might own a small apartment building and live in one of the units and rent the rest out. But, typically, commercial real estate is conceptually better understood as a financial asset.
Odeta Kushi - So since commercial real estate is a financial asset, it's primarily purchased and owned to provide a return to investors rather than to shelter an individual or family. One consequence of this is that the dollar amounts involved in purchasing and managing commercial properties are usually significantly larger than for single-family homes. As a result, you often find large institutional owners prefer purchasing commercial properties rather than individuals.
Xander Snyder - Right. And here, institutional just means a professional money manager or property manager. But even when you don't have a large institutional investor purchasing a commercial property, you often find syndicates or groups of individual investors that each own a portion of a building and leave the daily management of the building up to a general partner or operating partner.
Mark Fleming - Okay, so here's a question Xander. You mentioned that the primary purpose of owning commercial real estate is to generate a return for investors, but single-family homes, which individuals buy and live in, also appreciate and value. So what's so different about commercial property if both residential and commercial owners to some degree benefit from prices going up over time?
Xander Snyder - Well, it's true that owners of both commercial and residential real estate hope to benefit from price appreciation. But with commercial real estate owners are also seeking to generate some sort of income from their commercial property in addition to that price appreciation. Income is generated by charging rents to businesses or individuals to use some of the space in that building. And that rental income is then offset by various expenses that commercial property owners incur while operating that building.
Odeta Kushi - Income and expenses. This is starting to sound like a business.
Xander Snyder - That's right. In fact, a helpful way to think about commercial real estate conceptually is as the business of space. Just as with other types of businesses, owners and operators of commercial real estate hope to have some profit leftover after those expenses.
Mark Fleming - So in our space business, let's drill a bit more into the income component, what is the tenant getting in exchange for paying rent to the property owner of a commercial building?
Xander Snyder - Well, a tenant purchases with the rent that they pay the right to use space in the owner's commercial building. Commercial tenants can be all different sorts of businesses that need space for a variety of different reasons. As an example, a retail store needs space to sell its goods or services. Now, most businesses only need that space to facilitate their primary operations, which is usually something other than owning and profiting from real estate. It's usually, therefore, more convenient for businesses to lease space, rather than own the space that they operate from outright.
Odeta Kushi - So, retail, as you just mentioned, is one type of commercial space. But, of course, there are all sorts of different space uses for commercial properties beyond selling retail goods and services. And this is where commercial real estate really becomes interesting because there's a greater variety of types of space in commercial real estate than in residential real estate, each with its own set of unique demand drivers.
Mark Fleming - Yes, after all, just think about how many different types of businesses there are out there, and how they might use space differently depending on what they sell. In the commercial real estate world, buildings are categorized into what's called asset classes, which just means that the space has a designated use case. Xander, beyond retail, what are some of the other major asset classes?
Xander Snyder - Well, when many people think of commercial real estate, they might first think of office space, as a lot of people have spent some time in an office before. So office is another major asset class. There are also apartment buildings which, though they are residential in that people live there, they're typically owned by people or entities looking to generate income from residents' rents. Apartment buildings, oftentimes referred to as multifamily properties, are therefore another type of asset class. One that listeners might be a little less familiar with is industrial since unless you've worked in a warehouse or manufacturing facility, you've not interacted with this type of space before. Hotels are yet another type of asset class. And hotels vary from the other asset classes that I just mentioned because hotels usually have short or very short-term leases, where as with most commercial leases, especially non-residential leases, they're longer term. Hotels are also somewhat different from other asset classes since hotel owners often either run the business of the hotel as well, or at least have some sort of relationship with the operating entity of the hotel.
Mark Fleming - So the incredible variety of different types of commercial space makes commercial real estate a heterogeneous good, as we say, which if you listen to our REconomy Summer School Episode 1 is a term you're already familiar with. But, for those who haven't, or as a refresher, a heterogeneous good is one that varies substantially across different examples of it. Even two similarly constructed buildings are different if they are located in different locations. Compare this to a homogeneous good like a wrench or a hammer, where each unit is largely indistinguishable from one another and can be used interchangeably. Arguably, CRE is even more of a heterogeneous good than single-family homes, since the commercial real estate permitted uses of space can vary in addition to the location.
Odeta Kushi - Even within specific asset classes, there's quite a bit of heterogeneity. And now that you're familiar with that word, you can use it to bore your friends at cocktail parties. Also, we have lots more where that came from. So please let us know if you want boring words for a cocktail party, so you've got plenty. Variations within an asset class are called sub-asset classes. Here, if you have it handy, it'll be worth referring to our handout for this episode that has the five major asset classes that we just discussed: office, retail, industrial, multifamily, and hotel, as well as several varieties of sub-asset classes for each.
Xander Snyder - Yes, sub-asset classes can be distinguished a couple of different ways. For example, by different use cases for space, as well as the structure type or location, such as proximity to dense areas, of the particular building. So consider retail space, again, which has sub-asset class distinctions based on very specific space use designation. So shopping malls, for example, are a distinct sub-asset class from strip centers. And since people go to each of these for different reasons, the drivers of demand for space in each of these types of buildings is also different. That might make the mall more or less valuable on a per square-foot basis than the strip center, depending on where either is located.
Mark Fleming - Right. So think about the need for space from a business perspective. If you run a business that requires a lot of foot traffic, then retail space in a strip center on the side of a highway won't suit you as well as a corner spot in a popular, well-located mall. Other retail businesses might need to ensure that customers have ease of access to its facilities. Think fast food drive throughs or banks or gas stations. These businesses might therefore look for space in what's called a single-tenant building. Yet another retail sub-class where the tenant does not share of a building's interior space with other tenants.
Odeta Kushi - Sub-asset classes for industrial properties also distinguish between more specific space use cases. For example, if you're an eCommerce retailer that needs to store a lot of products, you probably need a warehouse or some sort of logistics facility. If your business involves building something, you probably need a manufacturing facility that has sufficient electrical service to power your heavy equipment. And, if you're running a data center, yet another sub-asset class within industrial, you might need even greater electrical service to cool the space and you might also have strict physical security requirements if private or confidential information is stored there.
Xander Snyder - Yes, but unlike retail and industrial sub-asset classes, office sub-asset classes distinguish between the location of the office buildings, so large high rises and urban cores, where at least historically, people tended to commute and congregate during the work week, are often referred to as central business district or CBD offices. Suburban offices, the other main type of office sub-asset class, are exactly what they sound like, office properties located further from urban cores in more suburban locations.
Mark Fleming - If the listeners are getting the general gist here of the heterogeneity of commercial real estate, there's one more. One more. Similar to office sub-asset classes, multifamily sub-asset classes sort of distinguish between that proximity to the urban core, but a little less directly. The main sub-asset classes within multifamily our high-rise and garden properties, which refers to the density allowed by the layout of the property rather than the geographic location. Mid- and high-rise apartment buildings are typically found in urban cores, but not always. And garden-style properties, the other major multifamily sub-asset class, have fewer floors, usually have more space than mid- or high-rises, and sometimes even have gardens in them, hence the name, typically found in the suburbs. They can also be sometimes found in urban locations. I'm channeling Melrose Place right now, if you got the reference.
Xander Snyder - Yeah, there's a lot of different ways to split or slice sub-asset classes. And, just to make it even a little bit more heterogeneous, hotel sub-asset classes typically refer to the length of the lease and the amenities provided by the hotel. So yet another axis on which a distinction can be made for sub-asset classes. So, for example, a major tourist destination on the Las Vegas Strip probably doesn't have a lot of long-term tenants, but it will have all the food that you can imagine right there on site. By contrast, extended-stay hotels might not have room service, but they likely have kitchens in each unit, since business travelers could be staying there for several months at a time.
Odeta Kushi - Right, let me summarize all of this information. So, in short, there are lots of different types of commercial space, each with its own unique demand drivers. And, as we'll discuss in greater detail on the next episode of The REconomy Summer School series, the demand to lease space influences the demand to own space. This influence points to a central relationship in commercial real estate between the income generated by a property's rent, less expenses, and its value. But more on that in the next episode. In the meantime, don't forget to check out the handout for today's episode, which includes detail on all the different types of asset classes and sub-asset classes we talked about today. And there were many. Thank you all for joining us on this episode of The REconomy Podcast. If you have an economics-related question you'd like us to feature, you can email us at economics@firstam.com. And, as always, if you can't wait for the next summer school episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark and @XanderSnyderX for Xander. Until next time.
Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.
This transcript has been edited for clarity.