Three Headed Monster: What is the Commercial Real Estate Market?
The built environment is all around us. When we wake up in our apartment in the morning, hit the gym, and grab coffee at Starbucks on the way to work we are beneficiaries of individual entrepreneurs and self interested organizations with expertise who risked capital and resources to construct the buildings around us that we, as a society, have come to rely on.
Specifically, someone obtained title to real property and, collectively with a marketplace of professionals with a variety of roles and specializations at their disposal, constructed a building which, because of market research, the owner infers will provide the real estate structure for a local business operation producing some good or service that the local market demands.
When we stay in a hotel for a wedding, buy goods and products produced at manufacturing facilities, get pizza from our favorite restaurant, or eat too much pizza and have to go to the doctor for heartburn, we are de-facto consumers of the products the commercial real estate market has to offer.
All of these daily occurrences which sustain the daily lives of everyday Americans in this country are largely provided by private real property owners with different operational strategies. Importantly, these daily consumption activities that the built environment supports provide the basis—from a flow of funds perspective—of the commercial real estate buildings as income producing assets.
Each one of the above situations involves some type of commercial real estate asset class. When you rent an apartment, that is multi-family asset. When you buy a stroller that was produced at a manufacturing facility, the facility is considered an industrial asset class. When you stay at a hotel it is a hospitality asset and when you order pizza or coffee it is from a retail asset. You go to work in an office asset and when you get a check-up from a doctor, the doctor is operating a healthcare asset. These are just a few.
The Commercial Real Estate market is more than just a market for income producing assets. It is actually three (3) markets: (i) the asset market, (ii) the space market, (iii) the capital market.
Before elaborating further on income producing real property as an asset, it is important to touch on the ownership structure issue mentioned above. Generally, there are two types of property owners: landlords and owner operators. This article is not concerned with owner operators. Landlords provide the service to society of procuring property and providing that “space” to businesses in the space market looking for real estate to operate their core business and generate revenue.
A common legal structure to execute this function would be a lease agreement. In a lease agreement the landlord gives the tenant the present possessory right of exclusion, use, enjoyment, and sometimes other benefits in exchange for rent payments. The tenant uses that space in some type of productive capacity. In the case of multi-family, the apartment is likely near a job or school, or some opportunity. While most other commercial properties are secured by commercial leases with business organizations and operators that will use the space to produce some good or service. This market where landlord provide space to business operators who do not have the capital or expertise to structure their real estate strategy, or feel that company resources are better devoted to core operations rather than property management, is called the space market.
The space is secured by lease contracts, and lease contracts make the real property valuable as an income producing asset. The asset market is where income producing properties trade.
The third component of the commercial real estate market has to do with the dual nature of real estate transactions. Due to desire to diversify capital into projects with different risk profiles or other valid investment reasons, or due to insufficient equity to make a cash purchase, purchasers in the asset market for commercial real estate income producing assets often must seek leverage to bridge the gap between their upfront equity and the total project cost. Therefore, closing for the purchase of a commercial real estate asset often involves a simultaneous execution of a security agreement granting the purchaser’s creditor a number of rights in the event of default of said security agreement; among other things, the lender’s right pull the loan back and foreclose on the property.
This third market, the capital market, is comprised of a financial ecosystem of many different players with different capital solutions. Different equity sources and different lenders of debt. In short, in the debt capital markets the owners of real property shop the opportunity to invest in notes secured by the real property. Similarly, in the equity capital markets real property owners or potential owners team up to put up the necessary liquidity to secure debt and acquisition of real property.
The three headed monster that is the commercial real estate market is complex. However, the wonderful symphony of each actor—with their different and important roles in producing the built environment—is responsible for facilitating many of the material comforts we take for granted at a historically affordable prices.