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Why You Should Add Commercial Real Estate to Your Investment Portfolio

Why You Should Add Commercial Real Estate to Your Investment Portfolio

Investing in commercial real estate is an increasingly popular way for individuals to diversify their retirement portfolios away from traditional holdings like stocks and bonds. Depending on the investment vehicle used, people will find that they can reap the benefits of owning commercial real estate without having to be hands-on. In other words, investing in commercial real estate can provide truly passive income.

Although technically considered an “alternative” asset class, real estate is becoming more mainstream. Changes to federal regulations in 2012 have since made it easier than ever for individuals to own fractional shares of the real estate alongside similarly passive investors. The ability to co-invest has lowered the historically high barrier to entry for those looking to own commercial real estate for the first time.

In this article, we explore some of the primary reasons why individuals may want to consider adding commercial real estate to their portfolios in the months and years to come.

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Portfolio Diversity is Highly Attractive

Institutional investors – such as pension funds, endowments, and insurance companies – have invested in commercial real estate for decades. Their ability to bring tens of millions of dollars to single transactions has given them an upper hand in purchasing some of the most desirable real estates, regardless of product type or geography. On average, institutional investors have about 10 percent of their equity investments in commercial real estate assets, a number that continues to climb.

One of the reasons institutional investors are drawn to commercial real estate is that it allows them to diversify their portfolios. The stock market, for example, can experience dramatic ebbs and flows.

Real estate, on the other hand, has very little correlation with the stock market. One way for investors to hedge against broader economic volatility is by investing in real estate since its value tends to be more stable. Diversification, through real estate or otherwise, helps investors to mitigate risk.

Conversely, the average investor’s portfolio only has 3 percent of funds allocated to real estate. Practically speaking, this means that most individuals own zero real estates whereas a select group of high net worth (HNW) individuals have significant real estate holdings.

For example, the average accredited investor has 12 percent of their portfolio dedicated to real estate. Someone looking to have a truly balanced portfolio might look to increase the real estate allocation even more.

The 20% Rule was made famous by Yale’s Investment Office, which has one of the highest performing endowments of all time. Its investment strategy includes a portfolio balanced as follows:

  • 30% domestic stocks
  • 30% bonds and securities
  • 20% real estate
  • 15% foreign developed markets
  • 5% of emerging markets

Just as Yale dramatically reduced the endowment’s reliance on stocks and bonds 30 years ago, we expect individuals to similarly begin following suit – especially now that the options for co-investing in real estate have expanded.

Adding multifamily, senior housing, or other forms of commercial real estate to one’s portfolio is now a proven way to diversify one’s portfolio with great success.

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The Diversity of Investment Opportunities

One reason people are drawn to commercial real estate is that the asset class itself is quite diverse. Properties can range in size, scale, and price – from less than $500,000 to properties worth $500 million or more. There are many product types to choose from, including multifamily apartment buildings, offices, retail properties, hotels, industrial buildings, self-storage facilities, data centers, and more.

Depending on someone’s personal interests or investment objectives, investments may include a range of commercial properties, and often, in different geographies.

For example, with an estimated 10,000 “baby boomers” (those born between 1946 and 1964) turning 65 each day, savvy investors might look to add senior housing to their investment portfolios.

Moreover, an investor might assume that these baby boomers would prefer to retire in warm weather climates, thus choose to invest in multiple projects located throughout the Sun Belt or Southeast. Even millennials are influencing the growing demand for suburban Multifamily housing.

In other words, commercial real estate is a way not only to diversify someone’s broader investment portfolio but even within those real estate investments, there are abundant ways to diversify one’s real estate-specific holdings.

Investment Strategies for Every Risk Level

Just as there are many property types to consider across various geographies, there are also different investment strategies for investors to consider depending on their risk tolerance.

Someone who is more risk-averse might be drawn to Class A investments where the properties are either newly built or recently renovated, stabilized, and already cash flowing. These projects tend to generate lower returns but carry substantially less risk than other investment strategies.

An alternative would be to consider investing in a value-add real estate deal. Value-add real estate strategies usually involve a sponsor purchasing an underperforming property, making the necessary improvements to raise rents and lease the property, and then stabilize prior to refinancing or selling the property for a profit.

Executing a value-add investment strategy can take time and may involve complexity, which is why these projects are considered to carry more risk. In turn, though, investors can expect to earn higher returns than if they were investing in an already-stabilized, cash-flowing deal.

At the far end of the spectrum are development and/or speculative deals. These projects may require a demo of an existing building and clearing the site for entirely new construction. Ground-up construction usually requires obtaining new zoning and permits at the local level, which, depending on the nature of the project could take months or even years to secure.

Another type of speculative development would be the conversion of a property – such as transforming an underperforming hotel into a multifamily apartment building or senior living facility. Again, these projects are major undertakings that require a highly qualified sponsor. However, those who are able to execute will find themselves well compensated (i.e., higher returns) in exchange for taking on the risk associated with these deals.

With over 40 years of experience, Lloyd Jones sits well positioned to help you find the right investment approach for you and maximize your portfolio performance.

Leverage Extends One’s Investment Reach

Most commercial real estate is financed using “leverage,” a fancy term that simply means financing of some sort. Typically, the total equity in a deal only accounts for 25 to 30 percent of total costs. The balance is financed using a bank loan or other type of mortgage.

This allows investors to purchase real estate at a fraction of its actual cost – something that cannot easily be done when purchasing the equivalent value of stocks, bonds, or other traditional equities.

For example, let’s say you have $500,000 to invest. You could spend $500,000 to acquire $500,000 worth of stocks – or you could use that $500,000 to invest in a $2 million piece of commercial property. The remaining $1.5 million would be financed with a bank loan.

The rents collected from that property will go toward paying down that loan and eventually, then you will own $2 million worth of real estate have only put in 25 percent of the funds needed to acquire the site.

Alternatively, you could take that $500,000 and invest it across four separate commercial properties, each worth $500,000 a piece ($2 million worth of real estate in total). This approach allows you to spread your risk across various opportunities instead of putting all of your equity into a single deal.

In any event, you can see that leverage is a powerful concept in commercial real estate. The ability to pair equity with debt allows investors to stretch their dollars and extend their investment reach.

Good Cash Flow is Always a Reliable Investment

Another reason to invest in commercial real estate is that as properties are stabilized, they tend to generate consistent, reliable cash flow that is then distributed to and amongst passive investors. This is particularly true amongst housing investments, where both rental prices and occupancy rates in most markets hover at or near record highs.

Senior housing, specifically, benefits from stable occupancy rates as aging individuals typically prefer to age in place. This means that investors can feel confident that if and when units turn over, they will be released quickly and for a premium—and by extension, that their passive income will continue to roll in on a monthly basis.

The Potential for Appreciation is Real

Many people invest in real estate for the consistent cash flow it generates. Others, though, will find that a property’s appreciation potential can be equally as rewarding. While appreciation is never guaranteed, real estate has historically appreciated in value for those who hold for long periods of time.

Often, properties continue to appreciate despite other market volatility.

For example, between March 2020 and March 2021, a period that covers the COVID-19 pandemic, real estate prices increased a staggering 13.3 percent.

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How Does Commercial Real Estate Valuation Work: There are many factors that influence a property’s ability to appreciate, including current interest rates, rates of new construction, and geography.

For example, properties in fast-growing markets like Austin, Texas, and Phoenix, Arizona have experienced double-digit appreciation for the last several years.

Meanwhile, year-over-year growth in Cleveland, Ohio is just below 5 percent. That said, even in the slowest-growing markets, properties have historically appreciated faster than the rate of inflation which makes them an appealing investment alternative.

Owning Property Without Active Management

A common criticism of investing in real estate is that it can be management intensive. Tenants call at all hours of the night. You need to respond to leaks, frozen pipes, clogged toilets, and more. Leasing units can be a challenge and will often require showings during night and weekend hours when owners would rather be spending time with their friends and family.

While these criticisms are valid, they only hold true if taking an active role in the investing process. It is possible to invest in a real estate fund or syndication in which a highly qualified sponsor and its team take the lead on all day-to-day management activities. This frees the investors’ time and allows them to sit back and collect truly passive income.

Tax Benefits to Investing in Commercial Properties

The Internal Revenue Code provides several tax-saving benefits for those who invest in commercial property.

These tax saving benefits include several kinds of “depreciation”. The first is straight-line depreciation, which allows investors to offset the gains produced by investing in real estate through an annual tax deduction for reasonable wear and tear as well as functional obsolescence over time.

Depreciation is typically calculated over 27.5 years, which the IRS considers the “useful life” of a residential building. With straight-line depreciation, the owner takes an equal fraction of that depreciation each year.

Alternatively, an investor might choose to pursue “accelerated” depreciation using what’s known as a cost segregation study. A cost segregation study will separate personal property from land and building improvements, and then assign a useful “life” to each asset segregated.

This allows investors to front-load depreciation in the early years of ownership which in turn, can result in tens of thousands (or more) worth of tax benefits for investors. Investors may also be eligible for “bonus” depreciation on newly constructed properties through at least December 2022, which would bolster these tax savings even more.

Real estate investors also benefit from tax-saving tools like the 1031 exchange. Upon selling a property, an investor can roll the proceeds from that sale into the purchase of a “like-kind” asset (e.g., another higher valued real estate asset) and in doing so, can defer paying capital gains tax in the interim.

Conclusion

As you can see, there are many reasons why institutional and HNW individuals have long invested in commercial real estate. Today, everyday investors are following suit and with record speed. The asset class’s returns speak for themselves.

For example, according to the National Council of Real Estate Investment (NCREIF), the ROI for senior housing investments has consistently been around 13 percent – well above the returns one might expect to earn by investing in the S&P 500.

In fact, data indicate that the average 20-year returns in commercial real estate, regardless of product type, outperform those of the S&P 500. With these returns come greater portfolio stability.

In short, those who are looking to generate truly passive income and create multi-generational wealth will find few options better than commercial real estate.

Ready to get started? Contact us today to learn more about our investment philosophy and more specifically, why we remain bullish on the multifamily and seniors housing sectors.