What Is Commercial Real Estate?

How Important Is Commercial Real Estate to the Economy

The Plaza hotel is commercial real estate.
The Plaza hotel in New York City is commercial real estate. Photo by George DeSota/Getty Images

Definition: Commercial real estate is any property owned to produce income. There is about $6 trillion worth of commercial real estate in the United States. Here are the five largest categories of commercial real estate.

Retail includes indoor shopping malls, outdoor strip malls, and big box retailers. It also includes grocery stores and restaurants. Its value is around $2.1 trillion, or 36 percent of the total value, and consists of at least 9.5 billion square feet of shopping center space.

For more, see What Is Retailing?

Hotels include motels, luxury resorts, and business hotels. It does not include homes that rent out rooms through AirBnB. There are roughly 4.4 million hotel rooms worth $1.92 trillion.

Office buildings include everything from Manhattan skyscrapers to your lawyer's office. There are roughly 4 billion square feet of office space, worth around $1.7 trillion, or 29 percent of the total.

Apartment buildings are commercial real estate. That's because 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 residential real estate statistics. There are around 33 million square feet of apartment rental space, worth about $1.44 trillion.

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 13 billion square feet of industrial property worth around $240 billion.

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. (Source: "Signs of Recovery,"  The Wall Street Journal, October 5, 2010.

"Statistics About the Real Estate Industry," The Real Estate Roundtable. "Commercial Real Estate Indices," Standard & Poor's.)

How Important Is Commercial Real Estate to the Economy?

Commercial real estate construction contributes 3 percent of the U.S. economic output. That's because it's a component of GDP. In 2016, that was $501 billion, down from $507 billion in 2015. The record high was $586.3 billion in 2008. The low was $376.3 billion set in 2010. That represented a decline from 4.1 percent to 2.6 percent of GDP. 

Why did commercial real estate construction peak in 2008, two years later than housing? Builders first needed to see there were enough homes and shoppers to support new development. It then took several years to build shopping centers, offices, and schools. Commercial builders had to purchase larger lots of land than homebuilders. That forces them to raise more money from investors. Finally, construction of a large office building or shopping mall takes longer than building a house. It also takes longer to lease them out.

You can usually predict what will happen in commercial real estate by following the ups and downs of the housing market.  Commercial real estate statistics follow residential trends by a year or two.

They won't warn of a recession. They typically hit their low well after residential real estate. Commercial real estate statistics are a lagging indicator

The Best Way to Invest

Real Estate Investment Trusts own 34 percent of the equity in the commercial real estate market. That's the second largest source of ownership. The largest is private equity, which owns 43.7 percent. (Source: "Scaling New Heights," National Association of Realtors, 2015.)

REITs are the safest way for the individual investor to invest in commercial real estate. That's because they are bought and sold on the stock market. 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. Finally, professionals manage the properties, saving you both time and money.

 

Commercial Real Estate During the Financial Crisis

Commercial real estate lending has solidly recovered from the 2008 financial crisis. As of June 30, 2014, the nation’s 6,680 FDIC-insured banks held $1.63 trillion in commercial loans. That's 2 percent higher than the peak of $1.6 trillion in March 2007.

The first signs of decline in commercial real estate occurred three years after residential real estate prices started falling in 2006. By December 2008, commercial developers faced between $160 - $400 billion in loan defaults if they weren't able to find banks to refinance them. Most of these loans had only 20-30 percent equity. Banks now require 40-50 percent equity.

Unlike home mortgages, loans for shopping centers and office buildings have big payments at the end of the term. Instead of paying off the loan, developers typically refinance. If funding isn't available, the banks must foreclose. 

Loan losses were expected to reach $30 billion, pummeling smaller, community banks. They weren't as hard hit by the subprime mortgage mess as much as big banks, but had invested more in local shopping centers, apartment complexes and hotels. Many feared the meltdown in small banks could have been as bad as the Savings and Loan Crisis 20 years ago.

A Washington trade association for developers, the Real Estate Roundtable, estimated that nearly $300 billion a year in short-term commercial real estate loans would mature. A lot of those loans could have gone bad if they are unable to be refinanced. 

By October 2009, the Federal Reserve reported that banks had only set aside $.38 for every dollar of losses, which could reach 45 percent of the $3.4 trillion outstanding debt. Shopping centers, office buildings and hotels were going bankrupt due to high vacancies. Even President Obama was informed of the potential crisis by his economic team.

The value of commercial real estate fell 40-50 percent between 2008-2009. Owners scrambled to find cash to make the payments, since many tenants have either gone out of business or renegotiated lower payments. Commercial property owners tried trying to raise cash by selling shares of new stocks. Normally, they would use extra cash to buy more properties, thus increasing shareholder wealth. Instead, they used the funds to support payments on existing properties, and so couldn't increase value to the shareholders at all. They are diluting the value to both existing and new  shareholders. The new stockholders could be just "throwing good money after bad." (Source: Interview with John Cona of TARP Capital)

By June 2010, the mortgage delinquency rate for commercial real estate worsened. According to Real Capital Analytics,  4.17 percent of loans defaulted in the first quarter of 2010. This is $45.5 billion in bank-held loans. It is higher than both the 3.83 percent rate in the fourth quarter of 2009 and the 2.25 percent rate a year ago. That's much worse than the 0.58 percent default rate in the first half of 2006, but not as bad as the 4.55 percent rate in 1992. By October 2010, it looked like rents for commercial real estate began stabilizing. For three months, rents for 4 billion square feet of office space fell by only a penny. The national office vacancy rate seemed to stabilize at 17.5 percent, lower than the 1992 record of 18.7 percent, according to real estate research firm REIS Inc.

REIT values were depressed for years.Why? Owners of commercial real estate were upside-down in their mortgages. Their commercial property values had dropped 40-50 percent since 2008. They scrambled to find cash to make the payments. Many tenants had either gone out of business or renegotiated lower payments. But, unlike banks, they didn't have the FDIC to stand behind them. So, many of them went bankrupt and defaulted on their loans whether they wanted to or not.  (Source: Mark Heschmeyer, "CRE Lending by Banks Suprasses Pre-Recession Levels," CoStar News, September 3, 2014.)

Commercial real estate loans could have caused a second recession. In 2013, banks held $991.2 billion in commercial loans, a 3.3 percent increase over 2012.  Most of this was for apartment buildings. About a third of this came due between 2015-2017. Most of these loans were written in 2005-2007 when property values were high. These loans could have defaulted if apartment building prices drop. Instead, people who had lost their homes became renters.