Commercial Real Estate and the Economy

Definition, Impact, and Investing Through REITs

Architects examining commercial real estate.
••• Photo by Hello Lovely/Getty Images

Commercial real estate is any property owned to produce income. A 2019 study pegged the total value of all commercial real estate in the United States at between $14 and $17 trillion.

Here are the five largest categories of commercial real estate, how to invest in them, and how they impact the broader economy.

Types of Commercial Real Estate

Commercial real estate can broadly be defined as any property held for business purposes, but that doesn't give you much of a sense of the type of real estate being discussed. That's why it's common to break down commercial real estate into one of the following categories.

Retail

Retail includes indoor shopping malls, outdoor strip malls, and big-box retailers. It also includes grocery stores and restaurants. Its value is around $2.4 trillion, or 15% of the total value of commercial real estate. It consists of some 13.65 billion square feet of shopping center space.

Hospitality

Motels, luxury resorts, and business hotels are all examples of commercial real estate that fall into the hospitality category. This category does not include homes that rent out rooms through Airbnb. Hospitality real estate accounts for roughly 2.63 billion square feet. Its value is around $1.6 trillion.

Office Buildings

Office buildings include everything from Manhattan skyscrapers to your lawyer's office. There are roughly 11.27 billion square feet of office space. It's worth around $2.5 trillion or 15.63% of the total.

Apartments

Apartment buildings are commercial real estate. Companies own them only to turn a profit. That's why homes rented by their owners are residential, not commercial. However, some reports include apartment building data in statistics for residential real estate instead of commercial real estate. There are around 17.54 billion square feet of apartment rental space, and it's worth about $2.9 trillion combined.

Industrial Property

Industrial property is used to manufacture, distribute, or warehouse a product. It's not always considered commercial, especially in land use plans and in zoning. There are 20.75 billion square feet of industrial property worth around $1.5 trillion.

Other commercial real estate categories are much smaller. These include some non-profits, such as hospitals and schools. Vacant land is commercial real estate if it will be leased, not sold.

How Commercial Real Estate Affects the Economy

Real estate is a significant component of gross domestic product. In the first quarter of 2021, the seasonally adjusted, annualized gross output in the U.S. $39.45 trillion. Real estate, rentals, and lending made up $4.37 trillion of that.

One takeaway for some analysts after the housing bubble was that the commercial real estate market lags behind the residential real estate market. That's in part because commercial real estate construction simply takes longer than residential real estate construction.

Builders first need to make sure there are enough homes and shoppers to support new development. Then it takes time to raise money from investors. It takes several years to build shopping centers, offices, and schools. It takes even more time to lease out the new buildings. When the housing market crashed in 2006, commercial real estate projects were already underway.

You can usually predict what will happen in commercial real estate by following the ups and downs of the housing market. As a lagging indicator, commercial real estate statistics follow residential trends by a year or two. They won't show signs of a recession until a recession is already underway. They hit their low well after residential real estate.

How to Invest in Commercial Real Estate

A real estate investment trust (REIT) is a public company that develops and owns commercial real estate. Buying shares in a REIT is the easiest way for the individual investor to profit from commercial real estate.

You can buy and sell shares of REITs just like stocks, bonds, or any other type of security. They distribute taxable earnings to investors, similar to stock dividends. REITs limit your risk by allowing you to own property without taking out a mortgage. Since professionals manage the properties, you save both time and money when it comes to research and acquiring investment properties.

Unlike other public companies, REITs are legally required to distribute at least 90% of their taxable earnings to shareholders. This saves them the business tax cost, which is paid by the shareholder at the capital gains tax rate.

An alternative to REIT ownership is private equity ownership, but it is a lot more difficult for the average investor to join a private equity investment.

When to Buy and Sell REITs

When investing in REITs, be sure that you are aware of the business cycle and its impact on commercial real estate. During a boom, commercial real estate could experience an asset bubble after residential real estate decline. During a recession, commercial real estate hits its low after residential real estate.

REITs vs. Real Estate ETFs

It's easy to confuse REITs with real estate exchange-traded funds (ETFs) since real estate ETFs track the stock prices of REITs. Buying a REIT is investing in a single company (whether that company owns thousands of properties or just one), while buying a real estate ETF is investing in a bundle of different REITs.

Investors are attracted to these ETFs because they have low fees and provide diversification. However, they are one more step removed from the value of the underlying real estate. As a result, they may be more susceptible to stock market bull and bear markets.

Pros and Cons of REITs

Pros
  • Good for portfolio diversification

  • Generate income

  • Easy to trade

Cons
  • Market risks

  • Income isn't taxed favorably

Pros Explained

  • Good for portfolio diversification: Since commercial real estate values are a lagging indicator, REIT prices aren't as directly correlated with the overall stock market. That makes them a good addition to a diversified portfolio.
  • Generate income: REITs, like bonds and dividend-producing stocks, provide a steady stream of income.
  • Easy to trade: Like all securities, REITs are regulated by the SEC and easy to buy and sell through a brokerage.

Cons Explained

  • Market risks: Keep in mind that the value of your REIT reflects more than just the underlying real estate. It's also affected by the demand for REITs themselves as an investment. They compete with stocks and bonds for investors. So even if the value of the real estate owned by the REIT rises, the share price could fall in a stock market crash.
  • Income isn't taxed favorably: Dividends from many stocks and ETFs are taxed at a lower rate when you hold the security for a certain period of time. However, REIT distributions are always treated as ordinary income, and they'll always be taxed the same as any other source of income.