The real estate market can seem like an attractive investment opportunity for those looking to grow a small business. However, commercial real estate also comes with significant risks and drawbacks that small business owners must consider. This article explores the key advantages and disadvantages of real estate for small businesses, whether private or public real estate is better, how real estate funds work, and ultimately why commercial property is often not the wisest choice for small companies.

Why Real Estate Is No Friend To Small Business?

Advantages and Disadvantages of Real Estate for Small Businesses

Some potential advantages of real estate for small businesses include:

• Real estate can appreciate in value over time, allowing business owners to grow their assets and net worth.
• Owning the property rented for your business space gives more control and stability versus leasing.
• Real estate could produce rental income if extra space is leased out.
• The property serves as collateral for securing small business loans.

However, there are also considerable disadvantages of real estate ownership, including:

• Real estate requires large upfront capital investments beyond what many small businesses can access.
• Costs like property taxes, insurance, maintenance, and repairs eat into profits.
• Income can be inconsistent when spaces sit vacant between tenants.
• Attempting to manage an investment property diverts focus from core small business operations.
• The relative illiquidity of commercial real estate poses challenges if the owner needs to access cash quickly.

Overall, while real estate investment offers some advantages, most small business owners are better served by focusing capital and attention on growing their core business in the early years. Real estate diversification can come later once operations are stable and excess capital has accumulated.

Private vs. Public Real Estate for Small Businesses

Private real estate essentially refers to direct ownership of property assets, either by individuals or via pooled private capital vehicles like real estate private equity funds. In contrast, public real estate involves owning shares in publicly traded real estate investment trusts (REITs) or real estate operating companies (REOCs).

Private real estate offers some advantages but also has significant drawbacks for small business owners, including:

• Requires large upfront outlays of capital to purchase assets, which most early small businesses lack.
• Assets are illiquid, tying up the owner’s capital for years. Selling can be challenging.
• Can divert focus and resources away from developing the core small business.
• Produces inconsistent and unpredictable returns.
• Involves hands-on management of property assets, or paying a third-party manager.

Public real estate accessed via REITs and REOCs provides a more feasible and passive way for small business owners to gain some real estate exposure while avoiding major capital outlays. However, returns tend to be lower over the long run compared to directly owning property.

Ultimately, given capital constraints and the need to focus on business operations, small business owners tend to be best served avoiding direct private real estate ownership in the early years. Modest investment into public real estate vehicles like REITs and REOCs can provide some diversification without major headaches or capital risk.

Why Private Equity Real Estate Funds Are Not Ideal for Small Businesses?

Private equity real estate funds pool capital from institutional investors and accredited individuals to purchase real estate assets. While this expands access to acquire properties, private equity real estate has some significant disadvantages for small business owners, including:

Disadvantages of private equity real estate funds:

• Requires high net worth to qualify as an accredited investor.
• Often have high minimum investments of hundreds of thousands or millions.
• Management fees can eat into returns significantly over time.
• Assets still remain illiquid for long periods, tying up capital.
• Returns tend to be unreliable and unpredictable year-over-year.
• Small investors have little control or input on deals.

Considering the hands-off nature of small investors and high capital requirements, real estate private equity does not align well with the needs of most small business owners. Tying up precious capital for 5-10 years can severely limit the ability to redeploy funds into growth opportunities for the core small business.

While real estate private equity promises the lure of outsized returns, the risks and illiquidity make it poorly matched for the needs and constraints of small business balance sheets in the early years.

Why Private Equity Instead of Public Investing for Small Businesses?

Beyond direct private real estate deals, small business owners may also consider private equity funds focused on other industries. However, here too they face many disadvantages versus public market investing.

Disadvantages of private equity funds for small businesses include:

• High minimum investments beyond what small businesses can commit.
• Assets remain illiquid for as long as 10-12 years.
• Little control for small limited partners over deal terms or exits.
• Returns tend to be uneven year-to-year.
• High fees are charged by fund managers.

For these reasons, despite the lure of potential outsized returns compared to public markets, private equity remains poorly suited for small business owners in the early stages. Tying up precious capital for over a decade can severely restrain operational flexibility.

In contrast, public market investments in index funds, blue chip stocks, and bonds offer the following advantages:

• Far lower minimum investments.
• Assets remain liquid.
• Low management fees.
• Smoother returns year-to-year.

While public market returns may not reach the same stratospheric heights, stability, liquidity, and flexibility provide a better mix for small business balance sheets. Private equity is better left to later-stage small businesses with established operational cash flows and excess capital.

How Real Estate Funds Are Structured and Valued?

Real estate funds come in a variety of structures, but most take the form of either private equity closed-end funds, or public REITs.

Private equity real estate funds work as follows:

• Fund manager raises capital commitments from accredited investors and institutions.
• The typical fund lifespan is 10 years.
• Investor capital is used to purchase real estate assets like apartment buildings, offices, retail centers, or hotels.
• A typical fund may own 10-20 underlying property assets.
• The fund charges annual management fees (1-2% of assets) and a 20% cut of final profits.
• Investors commit capital upfront but money is called over time as deals are made.
• Investors receive periodic distributions as property incomes are generated, with the bulk of capital returned at the end when assets are sold.

Given the long-term nature and lack of regular valuations, private real estate funds returns are very uneven from year to year. Overall performance is judged based on the total multiple of capital returned to investors at the end of the typical 10-year lifespan. Top-quartile managers aim for 2-3x invested capital over the life of a fund.

Public REITs have a more transparent structure and valuation:

• REITs are corporations owning portfolios of real estate assets that are publicly traded on exchanges.
• Requirements around distributions of taxable income shape their dividend-focused nature.
• Valuations on underlying property assets drive overall share pricing.
• Investors can buy/sell shares daily, providing greater liquidity than private funds.

While differences exist across the structures, core drivers of long-term returns for both public and private real estate vehicles include rental income growth, property appreciation, and leveraged debt use.

How Real Estate Funds Make Money for Investors?

As highlighted above, real estate funds generate returns for investors in a few key ways:

Rental Income

Most real estate funds focus on assets that produce consistent rental cash flows from tenants, like apartments, offices and shopping centers. Rental rates and occupancy levels drive overall returns.

Property Appreciation

Historically, values of commercial real estate have grown faster than inflation over time. Selling assets at appreciation toward the end of the holding period contributes to overall investor returns.

Leverage

The use of debt financing magnifies equity returns. Typical commercial assets finance 50-65% of costs via long-term mortgages. As properties appreciate, leverage boosts equity multiples.

Expense Controls

By managing operating costs and limiting budget overruns, funds preserve more income for investors.

The interplay of these core drivers allows top-performing real estate fund managers to achieve annualized returns historically in the 10-15% range for investors, despite ups and downs.

However, it’s important to reiterate that the long-term illiquid nature of these vehicles makes them poorly matched for small businesses needing consistent short-term returns and operational flexibility.

Real Estate Funds Carry Higher Risks for Small Businesses?

While real estate funds promise the potential for strong returns over decade-long horizons, they also carry risks, such as:

Illiquidity

Not being able to access invested capital for as long as 10-12 years can constrain flexibility for small businesses should promising growth opportunities arise.

Inconsistent Returns

Unlike public stocks and bonds, real estate funds see significant variability in returns from year to year based on property operational factors and markets.

Loss of Capital

Estimates indicate that 20-25% of private real estate funds lose investor money after fees are factored in.

Lengthy Holding Periods

The typical 10-year locked-up horizon requires strong long-term confidence in asset class performance through market cycles.

Weighing these meaningful risks against the pressing short-term capital needs most small businesses face, real estate funds appear poorly matched despite promises of strong long-term returns.

In summary, while commercial real estate investing offers certain advantages, significant risks, and disadvantages exist for small business owners that make it an unsuitable option in most cases. Difficulties accessing sufficient capital for private real estate deals, the risk of taking focus away from core operations, unpredictable returns, and pressures from ongoing ownership responsibilities all represent major barriers.

Small business owners tend to be best served by focusing energy and capital on building their core business in the early years, rather than attempting to balance commercial property ownership. Modest allocations to public real estate via REITs and REOCs offer a more hands-off way to gain some exposure. But in general, small businesses and commercial real estate make uneasy bedfellows at best.