When someone wants to start investing in real estate, the first question they normally ask is “what type of real estate should I purchase?” Before that question can be addressed, any would-be investor needs to answer this: What’s your tolerance for risk?
Every type of investment carries some risk. Whether you invest in stocks, bonds, mortgages, or a CD (Certificate of Deposit) from your local bank, there is some risk involved – from losing all of your money to the loss of some higher returning investment compared with a safer investment choice. With each investment option, there are benefits and drawbacks.
Commercial investment properties can be looked at in several different ways to determine the level of risk involved. I like using a property’s cap rate as a measuring stick. Generally speaking, the lower the cap rate, the lower the risk. The higher the cap rate, the higher the risk and the reward.
A cap rate represents the annual return on your investment and is expressed as the relationship between the net income and the purchase price. Mathematically speaking, a cap rate is your net income (your investment’s total annual income minus all of the investment’s expenses – not including any mortgage payments) divided by the purchase price of the property.
Different types of real estate (retail, office, warehouse, multi-family, etc.) have different cap rates and different amounts of risk. These variations in cap rates reflect the supply and demand of that type of real estate in a particular market. For example, if there is very little available retail space in your market and there are many retailers looking to lease space there, the cap rate will be lower – as will the risk.
In my market, residential real estate (apartments) have the lowest cap rate followed by warehouse, retail and office. However, even within each general type of real estate there are sub-categories that will affect your level of risk:
- Residential can be a single house, a duplex or a triplex, or even a large apartment. You could also start with raw land where you build apartments or a different type of real estate (like a warehouse) that you convert into apartments or condos.
- Warehouse can be anything from a small garage, flex building, up to a million square foot distribution center.
- Retail covers single-tenant triple net buildings, strip centers, grocery-anchored centers and malls.
- Office can be a small house converted to offices an office condominium, all the way up to an office complex of several million square feet.
The risk/cap rate of these investments are all affected by the property’s location, term and type of current lease, tenant’s credit, age and condition of the property and the supply and demand of similar properties.
If worrying about your investment keeps you up at night, you might want to focus on a safer investment and a lower cap rate. A safe investment has a financially strong tenant with a long-term lease and is located at the “corner of Main and Main” – meaning it’s a great location. That way, should the tenant ever decide to leave, another retailer will want to lease that building again.
If you maintain a higher tolerance for risk to achieve higher returns, then you might want to purchase a property that needs work. You might also have a property re-zoned, re-tenanted, change the type of real estate altogether through construction or buy land and build a new investment property.
As you might expect, investments with a higher level of risk can require more of your time as well as money. But nobody will watch your investments like you will. Understanding your tolerance for risk will help to guide you to the appropriate type of real estate investment.
So, the question remains: What’s your tolerance for risk?
The information contained herein has been obtained from sources deemed reliable. While every reasonable effort has been made to ensure its accuracy, we cannot guarantee it. No responsibility is assumed for any inaccuracies. Readers are encouraged to consult their professional advisors prior to acting on any of the material contained in this report.
As Senior Managing Director of Colliers International in Princeton, Tim has focused on helping his clients achieve their space and investment goals in the Greater Princeton market for the last 30 years. As a Certified Commercial Investment Member (CCIM), Tim has the background and experience to provide effective and creative solutions for his clients.