Whether planning for retirement or seeking to maximize returns, traditional financial advice tends to focus on a portfolio that consists of two types of assets, stocks and bonds. While this can certainly be a successful approach, we believe that there is a compelling argument to be made for the inclusion of commercial real estate assets in the traditional stock/bond portfolio.
In this article, we are going to define what commercial real estate is and identify nine reasons why investors should consider allocating capital to it in their portfolio. By the end, investors will have the information needed to determine if commercial real estate is a good fit for their own investment objectives.
At First National Realty Partners, we are a private equity firm who specializes in the purchase and management of grocery store anchored retail centers and, before committing to any transaction, we always use NPV to assess potential profitability. If you are an accredited investor, interested in partnering with a private equity firm to allocate capital to a commercial real estate investment, click here.
What Is Commercial Real Estate?
In order to understand why investing in commercial real estate is beneficial, it is first necessary to understand exactly what commercial real estate is.
Commercial real estate assets are those that are purchased with the intent to generate an investment return through income and/or capital gains. At a high level, there are four generally agreed upon commercial property types:
Multifamily: Commercial multifamily apartment buildings are those with more than four residential dwelling units within a single building or spread across multiple buildings.
Retail: Commercial retail properties are those that house a variety of tenants who operate direct to consumer retail businesses. For example, shopping malls, grocery-anchored retail centers, restaurants, or bank branches all fall into the category of retail.
Industrial: Commercial industrial properties are those that are utilized for logistics and/or manufacturing purposes. For example, a distribution warehouse is classified as an industrial property.
Office: Finally, commercial office properties are those that contain space used by businesses to conduct their operations. Office properties can be general in nature like those used by accounting or consulting firms. Or, they can be highly specialized like a dentist’s office.
Each of these property types have specific operational quirks and investment nuances. For this reason, real estate investors tend to specialize in just one or two of them. But, the common theme is these properties are leased to other businesses (with the exception of multifamily) and they generate income – two features that set commercial properties apart from residential.
Why Invest In Commercial Real Estate?
While there are many potential benefits from a commercial real estate investment, we want to highlight nine of them in this article.
First and foremost, commercial properties have the potential to produce regular income for their owners. The income is derived from the rents paid by tenants and it is first used to pay the property’s operating expenses like taxes, insurance, maintenance, depreciation, and debt service. If there is anything left over, it is distributed to investors in proportion to their share of ownership.
1. Cash Flow
For example, if a property produced $100,000 in income and had $80,000 in expenses, the remaining $20,000 would be distributed to investors as a dividend. If the property is managed by a third party, this can be passive income.
2. Portfolio Diversification
Historically, commercial real estate price movements tend to only be loosely correlated to price movements in other asset classes like stocks and bonds. As such, it provides an investment portfolio with additional diversification. So when stock market prices are down, real estate prices may be flat or even rise, which benefits portfolio performance as a whole.
Real estate is a “hard” asset, meaning that can be physically touched and seen by investors. For some this is a source of comfort relative to the pieces of paper that signify stock or bond ownership.
4. Tax Benefits
There are three major tax benefits to commercial real estate ownership.
First, commercial properties are typically owned in a Limited Liability Company (LLC), which is a single asset vehicle created just for the purpose of owning and operating the property. The LLC is a tax advantaged “pass through” structure that avoids the double taxation commonly seen in a corporation, meaning that profits are not taxed at the entity level. Instead, they “flow through” to investors where they are taxed at the individual level, according to the tax bracket of each individual.
Second, when a property is sold, profits are taxed differently than ordinary income. Each individual’s tax bracket is unique and the tax code is always changing, but the highest long term capital gains tax rate is in the neighborhood of 25% while the highest ordinary income tax rate is in the neighborhood of 37%. In short, capital gains have a lower tax rate than income, which is advantageous to commercial real estate investors.
Third, if an investor is fortunate enough to sell a property for a profit, they have an opportunity to defer capital gains taxes by reinvesting the sales proceeds into another, “like kind” property in a transaction known as a 1031 Exchange. There is no limit to the number of 1031 Exchanges an investor can complete, which means they could potentially grow their capital tax deferred over a long period of time.
While commercial properties produce income, they can also appreciate in value.
The key drive of property appreciation is known as “Net Operating Income” – NOI for short – which is calculated as a property’s rental income less operating expenses. The more NOI a property produces, the more valuable it is. With this concept in mind, there are basically two ways a commercial property can appreciate.
First, a property owner can “force” a property to appreciate by taking steps that impact the amount of NOI produced. For example, they could cut costs and/or increase rents over time and the difference will flow to NOI, making the property more valuable. At a 6% cap rate, every $1 added to NOI creates an additional $16 in value – a very powerful profit generator.
Second, market conditions can cause cap rates to decline, which is a good thing for real estate investors. For example, suppose a property produces $100,000 in NOI. At a 6% Cap Rate, the property has an estimated value of $1.6MM ($100,000/6%). If that same property produces $100,000 in NOI and the market drives the cap rate to 5%, the value increases to $2MM ($100,000/5%), a $400,000 difference.
The optimal condition is that a property owner is able to increase NOI and real estate market conditions drive cap rates lower. When this happens, the appreciation can be significant.
6. Hedge Against Inflation
Traditionally, real estate performs well in an inflationary environment because property owners can raise rents in conjunction. Doing so causes NOI to rise, which drives the property value higher, which can offset the purchasing power lost through inflation.
But, it should be noted that real estate as a hedge against inflation can be a double edged sword. A highly inflationary environment will typically cause central banks to increase interest rates in an effort to cool the economy. Doing so can both increase the cost of capital for investors and slow down markets. So, this is a risk that investors should be aware of.
Commercial properties are rarely purchased with cash. Instead, they are typically purchased with a mix of cash and debt or “leverage”, which is beneficial for two reasons.
First, debt is widely available from real estate lenders at generally favorable terms. Depending on the property type and condition, lenders can range from banks, government agencies (e.g. FNMA), insurance companies, or private lenders who specialize in real estate debt.
Second, the addition of debt to a transaction can boost returns for investors. For example, say a property has a purchase price of $1,000,000 and produces $50,000 per year for investors. If this property is purchased with cash, the cash flow generates an annual return of 5% for investors ($50,000/$1,000,000).
Now suppose this property was purchased with $750,000 in debt and $250,000 in equity. The addition of loan payments reduces the cash available for distribution to $20,000 each year, but investors only put in $250,000 in cash. So, their annual return increases to 8%.
However, investors should carefully study the dynamics of adding debt to a deal. There is a situation that occurs, when interest rates are higher than cap rates, that the resulting “negative leverage” can actually drive returns lower.
8. Yield Potential
Again, the point of commercial real estate space is that it is leased to business tenants, which produces cash that can be distributed to investors.
These cash distributions generate a “yield” on the original investment, which both allows investors to earn a return and allows them to recover a portion of their upfront commitment with each payment. Because rental rates tend to increase over time, it can also result in an increasing yield, especially when market conditions are strong.
9. Capital Preservation
Commercial real estate investment opportunities exist on a spectrum of risk. At the high end, land, restaurants, ground up development, or hotels are examples of higher risk investment properties and their returns can be both high and have a high degree of volatility. These options tend to be a good fit for investors with a high risk tolerance, a long time horizon, and significant amounts of investable capital.
At the lower end of the CRE risk spectrum are properties like grocery-anchored retail, single tenant triple-net leased assets, certain real estate investment trusts, class A office buildings, or multifamily. While these assets may provide an overall lower return, they also tend to be far more stable, akin to a corporate bond. These lower risk-type investments tend to be a good fit for investors who prioritize preservation of capital over earning the highest possible returns.
The point is, there are certainly commercial real estate investment options that provide both the benefits of ownership and the ability to preserve capital in a safer, income producing investment.
Summary of Why Investors Should Consider Commercial Real Estate
Commercial real estate is a class of real estate assets that are purchased and operated with the intent to earn a profit through regular income and/or price appreciation.
At a high level, there are four types of commercial properties, industrial, retail space, office space, and multifamily. Each has their own operational quirks, which is why investors tend to specialize in just one or two of these categories.
There are a number of reasons why investors should consider investing in commercial real estate including income, price appreciation, tax benefits, capital preservation, and protection against inflation.
Investors should always perform their own due diligence on potential real estate investments and choose those that are a good fit for their own risk tolerance, time horizon, and return objectives.
FNRP’s Investment Thesis
The First National Realty Partners (FNRP) team has developed a carefully considered investment strategy, designed to adapt to evolving market conditions and identify risk-adjusted opportunities in neighborhoods all across the United States.
Currently, FNRP’s primary focus is grocery-anchored shopping centers. Two other types of opportunities FNRP looks for, supported by many of the same economic trends discussed in Lee’s article, include premium multi-family housing and strategically-located industrial properties.
Andrew DeNardo, President and Head of Investor Relations at FNRP, says, “Retail was once thought of in 2017-2018 as a suffering asset class with the emergence of ecommerce and Amazon. FNRP saw this as an opportunity in CRE then. Now in light of the current macro-economics, we see that investor sentiment is changing and our belief in our thesis is as strong as ever.”
The 2,500+ Partners who invest alongside FNRP in its properties say they do so because they value the firm’s deep expertise, large geographic footprint spanning 23 states, and attractive risk-adjusted returns. They also appreciate the smooth, fully passive investment process with white-glove support along the way from a team of seasoned CRE experts.
How To Get Involved
If you would like to explore investing in the retail strip center play, we’d welcome the chance to get to know you. Please get in touch with our Investor Relations team by emailing email@example.com, calling 855-622-3677, or simply click on the button below to schedule a consultation.