One of the things that is common when discussing investing is the fact that diversification is important. To most people that means having a diversified portfolio of stocks, bonds and other securities in addition to 401(K)/retirement investments. Fewer individuals invest in alternative vehicles such as businesses and real estate.
There has always been a stigma with real estate investing and the fact one will have to deal with ‘tenants, toilets and termites’, which often makes it unappealing. Moreover, people tend to think flipping/renting single family homes are the only ways to invest in real estate, especially with the amount of HGTV shows out there these days.
Commercial Real Estate (CRE) has historically been a vehicle for institutional investors and Ultra High Net Worth (HNW) individuals as the barrier to entry was very high. However, with the creation of the JOBS Act in 2012 and general increase in awareness, the ability to invest in CRE (directly or indirectly) has improved for most investors.
CRE includes various asset types such as office, retail, self-storage, hospitality, warehouse, apartments, etc. There are pros and cons of each asset type, which we will discuss in another article.
It should be noted that investing in CRE is not for everyone and there are some drawbacks. The main ones being that the investment is illiquid due to it’s long-term nature (+/- 5 years), it requires significant upfront investment ($50K+ typically) and it requires specialized knowledge to properly assess opportunities.
However, if you have a long-term investment mindset and can overcome some of the challenges to invest in CRE, then there are several reasons why investing in CRE can be a beneficial addition to your investment portfolio.
Top Reasons to Invest in CRE:
The following are some of the top reasons we believe illustrate the power of CRE investing:
Consistent Income Stream: Most CRE investments drive cash flow through regular rental income that is predictable and have generally long leases. Examples of this include 5 year leases by office tenants, 12 month leases by apartment residents, etc. This regular cash flow helps reduce the volatility of the investment especially as compared to stocks. The chart below shows the S&P over the last 80 years and it’s clearly volatile.
However, it’s nearly impossible to adequately compare returns in private CRE investments to the stock market as there are so many factors to consider and the market efficiencies vary widely. But research has shown that stocks have provided a 10% annualized return (7% after applying inflation). Whereas, based on my experience passively and actively, the average annualized returns in private CRE investments are easily 16-20%+ and are generally consistent if you invest in stabilized deals with sponsors that have a proven track record.
Leverage: The ability to get great financing (70-80% LTV) at low rates helps improve the returns on your equity, which is also amplified by paying down the loan principal. Further, most investors can leverage other people and invest passively and not have to deal with the headaches of management by investing with companies that have the experience in finding, managing and operating such properties. Investing via a syndication is a common form of passive investing. A syndication is the pooling of capital from multiple investors to invest in an opportunity that makes an otherwise cost-prohibitive investment, such as CRE, accessible to an individual investor.
Forced Appreciation: As I mentioned in a previous article regarding cap rates, CRE is valued based on it’s net operating income, which is a lot more controllable than single family real estate, which is valued based on comparable sales (i.e. market sentiment). There are strategies that can be employed, commonly called “value-add”, that experienced operators use to raise income or reduce expenses, that enable forced value appreciation. This appreciation is in addition to any market appreciation that can be had by investing in the right location, asset class, etc.
Tax Benefits: Everyone’s tax situation is unique so the tax benefits will vary by individual and it’s important to seek CPA advice before investing. However, it’s no secret that real estate provides significant tax planning opportunities. Usually, paper losses via depreciation (which now can be accelerated under the new rules around cost segregation), result in investors having write-offs that offset the cash distributions received in the year. Essentially, investors are earning cash flow yet incurring no tax liability! Of course, when the property is sold (usually +/- 5 years later), there will be recapture of those taxes, but there are ways such as refinancing and 1031 exchanges that savvy investors can utilize to continue deferring the taxes!
Control: Investors have very little control on their investments after buying stocks or bonds, let alone any access to the key decision makers of large companies. However, with private CRE investments, investors have a lot more control over the sponsors they invest in, the asset type they invest in, the location they invest in, etc. Furthermore, investors would have built a relationship with the sponsors, which enables them to communicate with directly if there are any questions, concerns or feedback on the investment’s performance.
Inflation Hedge: As a hard asset in limited supply there is true intrinsic value in real estate that provides a great hedge against inflation. Generally speaking, organic growth in rental income follows CPI providing the mechanism to offset inflation. Furthermore, most CRE is purchased with leverage (i.e. debt) that can be procured at very low current interest rates. This enables investors to pay off the debt in the future with dollars that have less purchasing power, thereby hedging inflation risk.
These are only some of the high-level benefits of investing in commercial real estate. CRE investing has had a long history of being an attractive investment, especially for institutions and ultra HNW individuals, and now is more accessible to mainstream investors as well. Investing in CRE should be viewed as a possible way to augment, not replace, an investment portfolio that provides diversification via hard tangible assets.