Rate Cuts Could See Commercial Real Estate Rebound. Take a Deeper Look At These Investments.

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Investors have their checkbooks ready, poised to go on a buying frenzy if interest rates continue to drop. Commercial real estate, in particular, has been decimated in recent years. 

The combination of discounted property with low rates is a tempting proposition for many investors. Despite this, knowing what to spend your money on and assessing risk is essential before calling your broker. Here are some commercial asset real estate classes worth considering.

Aging Office Buildings

The mere mention of buying office buildings amid all the bad press regarding vacant city centers and remote working may make you want to steer clear. However, if you’re well funded (tens of millions and up) and can afford to think long term, these are well worth looking into.

First, office buildings currently have the deepest discounts in commercial real estate. Second, the urban doom loop—as business districts have often been referred to—won’t last forever. In fact, office leasing is up in New York and San Francisco, some of the hardest-hit city centers. In May, Manhattan office leasing increased by 70%, making the 70% discounted deals savvy investors made during the height of the “doom loop” look prescient.

Repurposing apartments and data centers

The third thing worth considering is the use of these buildings in the future. Remote work may continue to affect the number of people commuting into the city. However, repurposing some office space could offer these buildings an alternate source of income and a new lease of life. 

The riskiest, most expensive adaptive use is converting them into apartment buildings. However, this strategy could be a winner, with the housing crisis looking like it will grip the U.S. for the long term. According to an analysis from RentCafe, there are currently a record 55,000 office-to-apartment conversions expected in major cities.

Another less expensive conversion is turning office buildings into data centers. There is an unyielding need for data storage due to the public’s use of the internet, mobile phones, and artificial intelligence (AI). Tech businesses such as Alphabet’s Google, Amazon, Meta Platforms, and Microsoft—known as hyperscalers—eat up data like whales swallow plankton. 

The global colocation data center market is projected to grow at a compound annual growth rate (CAGR) of 11.3% from 2021-2026, while the hyperscale market is expected to grow at approximately a 20% CAGR.

Demand is outpacing supply, and the need for easily accessible storage is paramount. Still, it’s not as if office owners can open a door to an empty floor and stack it with hard drives. Sophisticated HVAC and air filtration systems need to be installed, along with security and new layouts. 

The upside? Tenants always show up, and there is a high demand for space. The downside is that conversions are not cheap.

Rental Apartments Gone Bad

As interest rates drop, apartment complexes are finding themselves in trouble. According to the Wall Street Journal, more than $80.95 billion in apartment mortgages could soon be at risk, outstripping the $66.87 billion for distressed office loans, based on data from real estate analytics company MSCI.

The trouble is that the income generated by the buildings is barely enough to meet interest payments. Specifically, apartment flippers who took on short-term, higher-interest, floating-rate bridge loans have now adjusted at higher rates. Many of these properties were purchased in the Sunbelt before interest rates ramped up. As BiggerPockets has investigated, many investors have already lost a lot of money.

Fed Rate Cuts Won’t Be Enough

The Federal Reserve’s projected rate easing will not be enough for many of these buildings that banked on COVID-19-era interest rates as a financial model for profitability. As the WSJ article explains, in 2021, the secured overnight financing rate, which is typically used to price floating-rate loans, was around 0.05%, compared with 5.33% today.  

Without the money to pay for repairs, many tenants have bailed, and the apartment complexes are floating listlessly like a rudderless ship, waiting for a bailout. However, so far, many banks have been reluctant to foreclose, hoping for an increase in rents and a resurgent real estate market to breathe life into them. This could be wishful thinking, in which case, these could provide great discounted purchases for investors.  

Medical Office Buildings

Medical office buildings (MOBs) are traditionally robust performers due to ongoing demand for them, especially as baby boomers age. The U.S. pharmaceuticals market is projected to reach $24.18 billion in 2024 and $37.02 billion by 2029. In addition, profit pools for physician offices, healthcare services, and technology are expected to grow at a 7% CAGR from $583 billion in 2022 to $819 billion in 2027.

If you haven’t gone to a hospital for your healthcare, you’ve likely gone to an MOB, which serves as a hub for practitioners and hospital networks, offering a wide scope of patient needs. Though some medical centers choose to buy these buildings themselves, many also rent them. Demand for this real estate segment has been growing quickly since the pandemic, as many investors have sought to diversify their investments.

Long-term leases, economic resistance

Investing in MOBs requires considerable research to best judge demand, demographics, and transport hub access. One of the biggest advantages is long-term lease agreements with healthcare providers, allowing for predictable cash flow. Resistance to economic swings also makes these an asset class that can provide a truly passive income with low risk. Indeed, annual national healthcare spending is expected to reach nearly $6.8 trillion by 2030.

Five Commonly Overlooked Low-Barrier-to-Entry Commercial Real Estate Opportunities

A great advantage of commercial real estate is the ability to 1031 exchange one type of asset for another. With this in mind, the ability to generate cash flow from multiple real estate types is endless. If you’ve bought a commercial property and want something less labor-intensive or with a low barrier to entry, here are some types of investments you might not be aware of.

1. Flex warehouse

A flex warehouse is a single-story metal building with multiple tenants that can be as small as 1,500 to 2,000 square feet. There’s great demand for flex warehouses that offer a combination of storage and office space, allowing companies to access essential low-cost industrial space while growing and fine-tuning their supply chain operation.

2. Parking lots

Parking lots are low-maintenance investments that are in perennial demand due to the more than 282 million cars currently on the road. If you want a completely passive investment, you can lease the entire lot to a third-party operator. Dynamic pricing can help you adjust fees accordingly to maximize your ROI.

3. Self-storage

Competition for self-storage has increased in recent years. As housing affordability remains an issue, residents are increasingly looking to live in smaller homes and store essential items elsewhere. Expect this asset class to be in demand for years to come.

4. Senior living facilities

Senior living facilities are another asset class that you can choose to lease entirely to a third-party operator for a purely passive investment or partner with as a financial backer. As the population ages, the need for long-term living facilities will continue to increase. 

5. Cell phone towers

Cell phone towers are built on specific parcels of land designed to accommodate wireless tenants. The quest for optimum cell phone coverage is expanding to cheaper rural land, which communication companies would be only too pleased to lease from you for another easy, passive investment to consider.

Final Thoughts

Lower interest rates mean great buying opportunities in the commercial space. Seizing the right type of opportunity at a low price point could be a source of tremendous cash flow for years to come. Whether you buy the building and lease it to a business or become a partner/sole owner in the business yourself, the opportunities are endless. However, you must choose an asset class in high demand for your space to ensure ongoing income.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.