Direct investment in Commercial Real Estate (CRE), which includes apartment buildings, offices, hotels, retail and industrial buildings like factories and warehouses, as a concept is not new. More than $400 billion of CRE changes hands in the U.S. every year. It is a multi-trillion dollar industry and is the third largest asset class in the U.S. We can accurately say that it is a big business. Some of America’s richest individuals, like Donald Bren, StephenRoss, and Sam Zell just to name a few, have made the bulk of their fortunes from real estate.
Over the last several years, there has been an increased interest in real estate investments. In fact, more Americans believe real estate is a superior long-term investment to stock per a Gallup study. Below are seven reasons why more and more people are interested in investing in real estate and why you should not ignore it.
1) Capital Preservation & Stability
All investments have risk. However, they don’t all have the same risk. And when it comes to investing your money, I would think that your number one priority would be principal protection. Warren Buffett, one of the most successful investors in the world, believes that the number one rule of investing should be “Don’t lose money.” The second rule, “Don’t forget rule number one.”
The National Council of Real EstateInvestment Fiduciaries (NCREIF) has been measuring the performance of the U.S. commercial real estate market for more than four decades, the NCREIF Property Index (NPI). According to NCREIF, direct ownership of commercial real estate has the best Sharpe ratio over the last twenty years in comparison to other asset classes. The Sharpe ratio is an economic measure that looks at the risk adjusted return of an investment. The higher the Sharpe ratio the better the return is and the lower the risk.
Playing a part in the above results is the volatility that comes with the stock market; the higher the volatility, the riskier the investment tends to be. The NPI has only experienced three down years since it began tracking CRE returns in 1978; the worst year being 2009, when the index fell 16.9%. The S&P 500 has had far worse years, including a 38.5% loss in 2008. This year is a perfect example of the high volatility and associated risk with the stock market; it had a significant decline and yet somehow it has now rebounded and it is at an all-time high.
When commercial multifamily is examined by itself, the 20-year return is higher and the annualized risk is lower. That combination creates an even higher Sharpe ratio. Commercial multifamily real estate is an investment in the basic human need of shelter. We will always need a roof over our heads, just like food and water.
Investors often add investments such as bonds into their portfolio because they tend to be less correlated with stocks. When stocks go down, these investments tend to go in the other direction. For many investors, especially those who are risk averse or approaching retirement, these investments can help smooth out returns and preserve capital. But bond yields have been on a decline over time, so investors are instead turning to alternative investments. Commercial real estate makes sense as a diversification tool for their portfolio given its low correlation with the stock market.
Correlation coefficients measure the degree to which two variables are associated and move in relation to one another. When two securities are perfectly correlated — meaning they move exactly in tandem with each other — they will have a correlation coefficient of 1. Conversely, when two assets move in exact opposite directions, they will have a coefficient of -1. Two securities with no association to one another will have a coefficient of 0.
As you can see in the chart below, the correlation coefficient between NPI (labeled Private Real Estate) and S&P 500 (labeledPublic Equity) is just 0.19, suggesting a positive but very weak relationship between the two asset classes. This means that movements in the stock market have almost no bearing on the returns of commercial real estate, making it an excellent asset to diversify one’s portfolio. REITs (labeled Public RealEstate) on the other hand have a higher coefficient, 0.56, with the stock market since they are constructed and traded like general equities.
Keep in mind that the NPI tracks not only multifamily but also industrial, retail, office, and hotel. Between 1983 and 2012, the correlation coefficient for multifamily alone is even less at 0.13, making commercial multifamily even more uncorrelated to the stock market and ideal for diversification.
3) Reliable Income
Income investing is a strategy of purchasing assets that produce recurring income. The more recurring passive income you can achieve to offset or even cover your expenses completely, the less dependent you are on earned income. You can even achieve financial freedom and stop working for a paycheck if you choose to.
Unfortunately, good yield has been hard to find. Savings accounts, money market funds, CD’s and government bonds have provided little to no returns. Some investors have chosen to pursue higher risk investments like high yield corporate bonds. Others have found direct ownership of commercial real estate, especially multifamily, to provide higher yields without the added risk.
From 1977-2007, 80% of total U.S. real estate returns were derived from cash flow, not appreciation. This shows the reliability of income return from real estate investing.
4) Equity Growth
Equity growth in multifamily real estate happens in two ways. The first is in the form of loan principal pay down. As tenants pay down the mortgage, the investor’s equity grows. The second is appreciation of the asset. With this type of asset, we have the ability to force appreciation and accelerate that equity growth. The value of the asset is determined by the Net Operating Income (NOI) and market Cap rate. In a stable Cap rate market, you can increase the value of the property by increasing your NOI. This can be achieved through efficiency of operation such as decreasing expenses, increasing renter retention, and timely rent raises. The equity growth is harvested at the time of sale or through refinancing the property.
5) Hedge Against Inflation
With trillions of new dollars being pumped into the economy by the Federal Reserve, many expect inflation to hit hard once the economic recovery takes off. Granted, that may not happen for a while but sooner or later, it probably will. And real estate makes the perfect hedge against inflation.
Inflation is defined as a rise in the general level of prices of goods and services in an economy over a period of time. When prices rise, each unit of currency buys fewer goods and services, eroding real consumer purchasing power. The inflation-hedging benefit comes from the ability to adjust rents over time, which in turn increases your revenue stream while your biggest expense, assuming you have a fixed rate debt on it, is held in check.
6) Ability to Leverage
When purchasing property, investors have more leverage over their money, enabling them to buy a more valuable investment vehicle. Putting $50,000 into securities buys $50,000 in value. Conversely, the same investment in real estate could buy $250,000 or so in property with a mortgage and tax-deductible interest. To continue with this simplified example, let’s assume the value of this asset increased by 2%. You would have a return of $5,000 but that is really a 10% return on your initial $50,000 investment. The effect of this leverage is that it can dramatically amplify your returns.
Even when using margin loans to invest in the stock market, most brokerages won’t lend an investor more than two times the value of their account. And on the margin loans brokers do make, the rates they charge tend to be extremely high and variable. That makes it too costly for investors to take excess risks on stocks.
In real estate, banks and mortgage lenders usually lend at four or five times the investor’s equity or down payment. In addition, these loans tend to come with fixed interest rates that are low or, in times like this, incredibly low.
7) Tax Advantages
Real estate is a highly tax advantaged asset class. With multiple benefits and strategies like depreciation, bonus depreciation, cost segregation, lower taxes with capital gains tax vs income tax, and 1031 exchange, investors will have largely tax-free use of recurring income until the time of sale. For details on tax benefits, check out one of our blog posts here.
In conclusion, the advantages of investing in real estate are very compelling. With the current recession, low yield economic environment, high market volatility, and high likelihood of inflation, direct ownership of real estate, whether aspart of your personal active real estate portfolio or through passive investing into commercial real estate, should be a strong consideration.