Investing in commercial real estate is a major industry in the US. In fact, It’s said to be the fifth biggest in the country. That makes it an important driver of the economy, generating many thousands of jobs and a healthy rate of return for investors. Over and above the rental income from commercial real estate is the appreciation of the assets. What is that, and what are the expectations for the years ahead?
Appreciation of a commercial property is an increase in value over time, the difference between the price paid and current market value. The extent and speed of this appreciation depends on factors specific to the asset, as well as external factors. Both impact appreciation and expectations.
If only our expectations of the appreciation in commercial real estate were guaranteed to be accurate, investment would be a simple, no-risk exercise. Unfortunately for investors, that’s not the case, and there is a wide range of opinions from property “experts” to confuse the issue. I will present various scenarios, examine the variables that can affect the market, and unravel the mysteries of appreciation.
Appreciation In Commercial Real Estate – What To Expect
There is no “one size fits all” when assessing the future of commercial real estate, as different areas in the country present varied pictures, and many factors can influence expected appreciation. Let’s first define commercial real estate before looking into its future.
What Is Commercial Real Estate?
In the simplest definition, commercial real estate is properties used specifically for business or the generation of income. The four main types are:
- Offices often classified as Class A, B, or C depending on age, condition, and position.
- Retail space, which includes hotels, shopping malls, restaurants, and healthcare facilities.
- Industrial space, including manufacturing and processing, storage, distribution, and flex units. (Some zoning authorities exclude industrial properties used for manufacturing and producing goods, but most consider them a subset of commercial real estate.)
- Multifamily properties which are rented on short-term leases.
Commercial real estate provides investors rental income and the potential for capital appreciation. There is no specific type of commercial real estate that is most profitable, but the top performers have several characteristics in common: a large number of tenants with long-term leases in place, excellent locations, and manageable debt levels.
What Is Appreciation in Commercial Real Estate?
As mentioned, the investor in commercial real estate has a steady return from rental income, but the actual wealth creator in this form of investment is the capital appreciation over time. Appreciation, the increase in value over time, is an even more significant part of commercial real estate than cash flow, and this growth in value is probably responsible for more millionaires in the country than any other activity.
Why Does Commercial Property Appreciate In Value?
Commercial real estate is one of the best hedges against inflation, with appreciation linked directly to it.
- Rental increases, which are driven by inflation, increase the return on a commercial property and, hence, its value,
- The replacement cost, also linked to inflation, increases the value as it rises.
Other factors that will result in commercial property appreciating in value are macro-economic, such as a healthy, fast-growing economy or low interest rates, which free more capital for investments that offer a higher rate of return.
On the microeconomic side, appreciation of commercial real estate will increase if the area goes through a growth phase, if the tenant mix provides a strong, reliable monthly income stream with long leases in place, or if the property is maintained in a better condition than competing properties in the area and has a reputation in the industry for being well-managed.
How Much Does Commercial Real Estate Appreciate Per Year?
Because commercial property exists in various forms, from manufacturing to hotels and auto-repair workshops, it’s impossible to calculate the rate it appreciates every year. Appreciation in one sector can be matched with a decline in another.
For example, the COVID-19 pandemic resulted in a massive increase in online shopping, increasing demand for warehousing, and an increase in its value. The pandemic, conversely, put many restaurants, shops, and gyms out of business, so properties relying on income from those businesses showed a depreciation (or negative appreciation) during the same period.
On average, though, a figure of between 4% and 6% is one that has been quoted.
What Affects The Appreciation That Can Be Expected Per Year?
Investors in commercial real estate look at maximizing the ROI or Return On Investment. That return comes from the net income, received monthly but calculated annually, and also from the capital appreciation. Low-risk investors place more importance on the guaranteed cash flow, while those prepared to invest in the long-term ROI with its risks are more interested in how much the property will appreciate.
The factors that influence capital appreciation across all the sectors of commercial real estate are:
The Economy And Interest Rates
The overall economy in the US is beginning to look more robust, with inflation slowly coming down, supply chain limitations on growth largely solved, and employment figures looking excellent. These factors all point to an increased appreciation in the value of commercial property in 2024 after some disappointing statistics in 2022 and early 2023, which show a decline in prices of around 15%.
Some industry experts, however, predict that with high interest rates persisting, some sectors of the commercial property sector may see a further decline in late 2023.
Growth Areas
The southwest, California, and Los Angeles, in particular, have shown the most growth in commercial real estate in the last year, with New York also featuring strongly. Again, investors with local knowledge will be able to identify pockets of growth In their own market and take advantage of the potential for future appreciation of commercial real estate.
Micro-Economic Factors
Investors looking long-term and concentrating on appreciation of the asset rather than the short-term cash flow to accumulate wealth need to look at the individual investment opportunities with regard to:
- The condition of the building, how well-maintained it is, when it was last upgraded, how attractive it is to tenants and customers, and how much potential there is to enhance its value.
- The location in terms of accessibility, prosperity of the local population, growth plans for the area, and competition from other commercial properties.
- The tenant mix and the quality of the leases they have entered into. The greater the number of long-term tenants, the lower the risk of defaults on rent payments and the more stable the cash flow.
Conclusion
The increase in value over time of commercial real estate is termed capital appreciation, but it is only realized when the property is sold. Many investors buy commercial property more for this appreciation than the monthly rental income, and it has made many of them millionaires. While expectations for the immediate future of commercial real estate are not all positive, in the long term, it is always an excellent investment.