Investors in all asset classes, whether focused on the stock market, investment property, or fixed income, value steady cash flows because they allow investors to perform more accurate retirement planning and manage income tax liabilities. Annuities fill this role in the investment community and have long been regarded as established vehicles that provide dependable cash flow to investors.
In this investor’s guide, we explore annuities as they apply to commercial real estate investing. We discuss various types of annuities and how investors should think about annuities in relation to commercial real estate investments.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers and take pride in providing our investors with a steady stream of income. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
The Basics of an Annuity
An annuity is a type of investment or financial product that produces regular cash flow over time. Often annuities are thought of as a form of guaranteed income or lifetime income by retirees, but in reality, they can take on many forms including insurance products, pension payments, and different kinds of income-producing investments.
An annuity contract establishes a payment structure both annuity providers and investors agree to upfront. Once the investor purchases the annuity, which is often a long term investment, the annuity provider is contractually responsible for making the agreed upon monthly payments on time and in full. Most commonly, annuities are associated with financial products offered by life insurance companies. However, annuitized payment structures are present in any installment-based financial transaction bound by an interest rate that takes place over a regular period of time.
Using this broad definition, the income from commercial real estate investing can be considered a type of annuity because commercial real estate investments produce regular cash flows for investors at set intervals.
Types of Annuities
To better understand how commercial real estate investments produce annuity-like returns, investors need to first understand the different types of annuities. Generally speaking, annuities are classified in two ways. We provide detailed information in the sections below.
Timing of payments
First investors must determine whether payments are made at the beginning of the payment period or at the end. Annuities are broken down into ordinary annuities and annuities due based on this determination. The difference between the two boils down to the timing of the payment.
Frequency of payments vs. interest compounding
Second, annuities can be classified as either simple or general. This difference between these two types has to do with the relationship of the payment frequency and the compounding frequency of the interest rate associated with the annuity.
Payment timing and compounding frequency are very important components when calculating the value of a cash flow stream. Investors must understand these differences when seeking to perform a valuation of the cash flows they are receiving.
Ordinary annuities are a series of regular payments received at the end of each period. The length of the period varies – monthly, quarterly, or annually. One example of this is dividends paid by real estate investment trusts. These are often paid to investors at the end of the quarter. Similarly, investor distributions made by private equity real estate firms like us are usually paid out at the end of the year unless the agreement with the investor specifies otherwise.
An annuity due is a series of regular payments where the payment is received at the beginning of each period. In real estate there are several prominent examples of annuities due. First, rent paid by tenants is often due to the landlord on the first of the month. The landlord can view this payment as a form of an annuity due, although as we will explain below, there are some potential differences due to the fact that rent has growth potential. The other common example in the world of real estate finance is related to loan payments. Real estate loan payments are typically paid to the lender on the first of the month. In this sense, the lender or note holder receives a form of an annuity from the monthly payment by the borrower.
A simple annuity is defined as a payment frequency that matches the compounding frequency. The payment frequency is simply how often the investor receives payments. The compounding frequency refers to how often interest accrues – monthly, semi-annually, annually, etc. For example, many types of debt – from car loans to student loans – require payments be made every month and also accrue interest on a monthly basis.
General annuities are a little more complex than ordinary annuities or annuities due. TheseGeneral annuities are defined by a scenario where an annuity’s payment frequency doesn’t match its compounding frequency. Mortgages are great examples of general annuities because the payments are due monthly, but interest typically accrues semi-annually.
Annuities in Commercial Real Estate
It is widely accepted among investors that annuity products fall into three categories – fixed annuities, variable annuities, and indexed annuities. Fixed and variable annuities are the most common types, while an indexed annuity is considered to be a hybrid product and is also known as an equity-indexed annuity or a fixed-index annuity depending on how it is structured.
Some investors think about commercial real estate investments as being similar to variable annuities because the cash flow streams can increase or decrease over time depending on the performance of the property. An investment strategy centered around commercial real estate features many of the same concepts present in annuity investing. Namely the real estate investor purchases a property or an interest in a property through a private equity sponsor like us, and in turn, receives regular periodic payments for the holding period of the property.
While annuity investing can be the right fit depending on the investor’s risk tolerance and investment objectives, there are several benefits associated with commercial real estate that are not present in annuity investing.
One of the most beneficial things about commercial real estate investing is the investor or the sponsor has the ability to build diversification into the investment portfolio. This means even if one property underperforms, there are others generating income for the investor. Annuities can be purchased from a variety of providers, but the products tend to be similar. Therefore, the value of annuity payments are usually subject to the same risks related to interest rate movements and increases in inflation. Higher interest rates reduce the value of the annuity payment stream, while inflation reduces the purchasing power of the cash flow received by annuity investors.
Unless held in a tax advantaged retirement account such as an IRA, annuity income is taxable. Commercial real estate, on the other hand, comes with several notable tax advantages. One of the primary tax advantages real estate investors have is the ability to take a deduction related to depreciation expense, which we will discuss below. Another important tax advantage is the ability to use tax-deferred strategies like 1031 exchanges upon the sale of a property.
Annuities typically pay the investor on a monthly basis, but the principal value of the annuity does not change over time. In fact, investors typically do not receive the upfront purchase cost of the annuity back at all. In commercial real estate investing, investors can benefit from property value appreciation over time. This means the investor earns income by way of monthly payments generated from tenants paying rent and also sees the market value of the property increase over time. The investor has the option to sell the property at the market value anytime and will receive a lump sum upon doing so. In effect, there are two ways to grow wealth in commercial real estate investing.
Commercial real estate allows investors to take an income tax deduction for depreciation expenses incurred during the year. This deduction is meant to account for the wear and tear the property experiences through the normal course of use by tenants. Claiming this deduction allows investors to reduce their taxable income. Annuities, like other financial assets such as mutual funds, do not have a depreciation feature.
Commercial real estate comes with one potential drawback not found in most annuity products. Namely, commercial real estate is subject to volatility in terms of the cash flows paid to investors and the market value of the rental property. Commercial real estate investors must be aware the cash flows they receive can vary over time depending on the performance of the property and the ability of the management team to retain tenants, raise rents, and manage expenses. Similarly, property values can increase and decrease depending on macroeconomic factors, interest rates, and local market conditions.
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First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.