While every commercial property transaction is undoubtedly different, the general cast of characters (the role players) involved is often the same.
Below, we discuss the four groups—the “who,” “why,” “what,” and “how”—that typically influence a transaction in the commercial real estate industry.
What influences a commercial property transaction?
While none of these should be surprising to those familiar with the complexities of commercial property transactions, it serves as an introduction for those new or less familiar with the process.
In its simplest form, a transaction takes place where supply and demand meet. The road to transaction completion, however, can be much more complicated given the numerous variables involved.
While the stars don’t necessarily have to align perfectly for a transaction to take place, there are many inputs that need to be in order to close a deal.
Transaction details that can affect the outcome of a transaction include, but are not limited to:
- Participants (The “who”)
- Motivations (The “why”)
- Property characteristics (The “what”)
- Experience (The “how”)
Participants (The “Who”)
There will always need to be at least one buyer and seller for a transaction to take place; but not all buyers and sellers are the same.
While there are many ways to differentiate between buyers and sellers, we will cover four ways that are commonly used to differentiate between market participants.
1. Individual or Institution
While much of commercial property ultimately is held in some form of corporate structure (e.g., often in a shell limited liability corporation, or “LLC,” for liability purposes), the ultimate owner, or beneficial owner, of the property is often either an individual or an institution.
An institution is a formal organization operating together to benefit from the transaction, while an individual is often a single person.
While an individual might use a corporate structure, what separates the “individual” from being an “institution” is the fact that the individual retains the power and sole-decision making power.
Because of its inherent traits, individuals tend to be smaller in size, more nimble, but with taste preferences that vary more widely, and much less process oriented.
On the other hand, institutions tend to be more complex, larger in size, less agile (generally), but more clearly defined preferences and more process oriented.
2. Type of Business
Another way to differentiate between buyers and sellers is giving consideration to the company’s primary lines of business.
While this is less applicable to individuals, it is frequently used with institutions, because there are a handful of institutional archetypes that are most active in commercial property.
Understanding the characteristics of the archetype can help to better understand the motives and intentions of the participants within the transaction.
Those archetypes include:
- Owner-Occupiers: As their name implies, this archetype is both the owner and the user of the property. Unlike single-family homes around the US, where the vast majority is occupied by the owners, approximately 75% of all US commercial property is occupied by tenants other than the owners.
Based on Freddie Mac and Reonomy data, the graphics below show the breakdown of U.S. real estate properties (in millions).
Graph #1 shows the proportion of property that is Owner-Occupied vs. Non-Owner Tenant occupied:
Graph #2 shows the composition of commercial property by property type:
- Investors: Similar to the owner-occupiers, this group is an owner, but generally not a user or consumer of the space. A seemingly broad category of market participants, investors can be categorized by their intent to make a profit on the purchase and sale of commercial properties. While other market participants might also benefit from an profit at sale, the investors are differentiated from these other market participants because this is their primary business – they will often raise external funds or capital in order to invest. There is further differentiation among investors by their investment strategies and tactics. Because investors are looking for direct exposure to commercial property, if they are involved in a transaction, they are often the buyer or seller. Institutional investors include REITs, mutual funds, real estate private equity (RE PE), endowments, pensions, etc.
- Lenders: Lenders, another large and diverse group of institutional stakeholder, can range from smaller debt funds, to specialized REITs, to community banks, universal banks, and life insurers. While these different institution types might not have a great deal in common when looking across their business models, they do share a similar role in regards to the commercial property market – by providing debt capital to borrowers. Lenders are often operating at a level above the property, [see side bar], at the loan / mortgage level, so while they do have some influence in the transaction, their impact is indirect.
- Brokers: Brokers can be viewed as connectors; they connect buyers to sellers. Before they find buyers and sellers willing to transact, it is the brokers that are answering the questions from interested parties and conducting much of the due diligence for clients who are searching for properties. Brokers are often acting as agents in transactions, paid commissions on the deal. Brokers are frequently involved in the transactions – on both sides, representing buyer and seller.
- Other Participants: Other parties often involved in transactions include Legal Counsel, Appraisers, Consultants (engineering consultants, environmental consultants), Property Managers, and other Service Providers (accountants, insurers, financial advisers, etc.). While each of these participants are important and contribute in a specialized way, they generally are helping to facilitate the transaction but are not the driving force behind the transaction.
Motivations (The “Why”)
Motivations play a major role in transaction outcomes, but are difficult to measure.
The reason for the difficulty in measuring motivations of buyers and sellers is that motivations are present but not always stated.
Motivations are driven (at least in part) by the perceived incentives to complete the transaction.
Famed investor Charlie Munger said, “Show me the incentives, I’ll show you the outcome,” noting the power that incentives have on investor behavior and influence on ultimately the end result.
Motivations for a transaction may be to alleviate a bad situation or improve upon a good situation.
Motivations can be need-based (e.g., a young growing company needs more office space to fit its growing workforce) or aspirational (e.g., an investor is expecting the local economy to expand and price of commercial properties to appreciate, so wants to purchase an investment property to realize a positive investment return).
One of the “six D’s” might be motivation enough for a property transaction: Death, Disease, Divorce, Dissolution (LLC or partnership), Debt (maturity or refinance), Default, Downsizing (labor force or space).
Property Characteristics (The “What”)
The third group of transaction inputs covers a broad range of details, too many to cover in a single short definition; this catch-all category includes features of the commercial properties that might be considered by an owner, tenant, lender, or potential buyer.
This includes everything from year built and construction type, to number of parking spaces and proximity to local employment centers.
While we won’t spend too much time discussing it, this is incredibly important in the transaction process.
Two of the key property characteristics that we call attention to should not come as a surprise: property type and location.
1. Property Type
Whether it has to do with zoning (a potential legal issue) or practicality, the property type matters. If somebody is looking to sell an office building, but the only buyers on the market are looking for retail space, there will be no transaction.
The old aphorism, “Location. Location. Location.” still contains a great deal of wisdom. Given that commercial property is usually immovable land and permanent physical structures – this maxim is super important.
Location of the commercial property can impact the current use and value derived from the property, but also can have a major impact on the the potential value or expected future value which can influence the overall return profile of an investment.
Experience (The “How”)
The last of the four major groups of transaction inputs that we highlight is a bit vague in name, but can have a major impact on the outcome of the transaction.
The commercial property market has been around for centuries, but for much of its history, commercial property was not viewed as an investment—so the market did not develop the same way or at the same speed as the other financial asset markets.
Matter of fact, it has only been widely considered an “investment asset class” for decades.
Despite the rapid growth and advancement it has experienced over the most recent decades, the commercial property market still has features of a relationship-centric market.
Knowing other industry participants and being known is generally a strength.
Relationships are still very important when it comes to finding deals (sourcing), making deals (negotiating), and closing deals (financing).
This has to do with how the potential transaction opportunity was identified (e.g., who discovered it and how?).
The power to negotiate well during the transaction can be the most important skill for either of the parties involved.
The outcome of the transaction is frequently determined by the negotiation, so the ability to do it better than one’s counterparty can be a significant advantage.
The vast majority of commercial property is purchased with external financing (i.e., bank mortgage, CMBS loan, SBA loan).
This is essential to the deal closing on time or not at all. Having good relationships with sources of financing (lenders, investors, etc.) is essential.