It’s common knowledge that commercial real estate investments are best held for at least five years. In fact, according to experts, the average holding period for CRE properties is between 5 to 10 years.
And if you’re new to CRE investing, you might be wondering: Why does a commercial property asset need to be held that long?
We’ll answer this question in this blog.
Understanding holding periods in commercial real estate
The term ‘holding period’ refers to the length of time a commercial property investor plans to keep the asset in their portfolio. The start date is the day the property is bought, and the end date is the day the property is sold.
Even though holding periods are not set in stone, many experts recommend that CRE investments be held for at least five years. There are many reasons why this matters. Here are three of the most important:
Commercial real estate is mainly purchased to earn a return through rental income and price appreciation. Investors and lenders who put money in commercial properties expect to get their money back—with profit— in the future.
In typical commercial real estate investment scenarios, they will earn some of their funds via rental income. Still, they will receive the bulk of their profit only when the asset is either refinanced or sold.
Defining a holding period is essential before purchase. It can help manage investor expectations about the timing of the returns. After all, anyone who puts money in properties will naturally want to know how long it will take them to get their money back. Their capital is illiquid during this defined holding period, and they cannot access it in most cases.
For this reason alone, it’s crucial to specify a time limit on the commercial investment to give investors a general idea of how long it will take to get their funds back and realize their profits.
Holding periods are also significant for measuring the profits made on commercial property investment. Time is a critical variable in most return calculations. For example, the internal rate of return, capital gains, equity multiple, cash on cash return, and other metrics are all time-bound.
3. Business plans
It usually takes many years to implement a business plan in a commercial investment property loan. Particularly true for value-add strategies.
Commercial real estate is valued based on its net operating income (which refers to the gross income minus operating expenses). The main goal of a value-add investment strategy is to drive up the net operating income by decreasing costs, increasing rental income, or both.
One of the most common ways to implement a value-add strategy is to purchase a commercial property for a great price and invest capital in tenant upgrades and physical renovations. The plan is to finish renovations and upgrade the asset to attract better-quality tenants and command higher rents.
Can combine the increased income from this strategy with techniques to reduce expenses, resulting in a higher net operating income. And while it all sounds simple on paper, it takes a lot of time—anywhere from 5 to 10 years, on average.
Adding real value to a property cannot be done overnight. Even though property improvements and renovations usually only take 12 to 24 months, it takes much longer to increase lease rates and see the fruits of management efficiencies.
Can the holding period be shorter or longer than the 5-to-10-year average?
The short answer is yes. Many micro and macro-level factors may affect holding periods. Here are some of them:
- General real estate markets
- Rental growth rates
- Macroeconomic conditions
- Lease expiration of key tenants
- Debt maturities
- Cap rates
- Submarket absorption rates
- Debt market stability
- Planned capital expenditures
- Planned or contemplated new construction
- Investment goals (capital appreciation vs. cashflow)
- Risk tolerance
- Current and future perceived property condition
- Asset seasoning
- Changes to the business plan
- Portfolio objectives
On occasion, holding periods can be made shorter when market conditions allow investment objectives to be achieved faster than anticipated. It might make sense to sell a commercial property (if the price is right) way before the planned holding period ends.
But holding periods can also become longer when the end of the holding period is reached when there is a lot of market volatility in the property sector. Perhaps interest rates are much higher, or the stock market has crashed. Perhaps there is a recession, or as in the case today, a pandemic.
The pricing that could realistically be achieved when the property is sold might not allow investors to meet their target returns in such scenarios. It’s often more prudent to extend the holding period and sell the commercial property later when market conditions are more stable, and the asset can command a better price.
A holding period is no more than an estimate. It’s not set in stone. It’s essential to understand this if you’re interested in investing in commercial real estate. While targeted holding periods can provide guidance, they are no more than that—guidance. While many seasoned investors use holding periods as a metric for evaluating potential investments, they should use it cautiously because it is not the most reliable metric out there.
Holding periods in commercial real estate refer to the length of time for which investors plan to keep the asset in their possession. It starts on the date the property is bought and ends when the property is sold. The average commercial real estate holding period is 5 to 10 years.
Holding periods matter for three main reasons:
- They guide investor expectations.
- Help calculate potential returns.
- Guide the implementation of the business plan for the commercial property.
Holding periods can change depending on market conditions. It’s pretty standard for having periods to be extended if the market is not optimal for selling.
There you go. We hope we’ve helped you understand why commercial properties are usually held for at least five years and that you can apply this knowledge as you pursue CRE projects
If you’re interested to learn more about commercial real estate financing and commercial property investing in general, feel free to read our other blogs. And if you have questions about CRE investing that you want us to answer, go ahead and send us a message.