No matter the asset class, one of the bedrock principles of investing is that diversification is a key ingredient in the recipe for a well-balanced portfolio. Historically, conventional wisdom has suggested that a “basket” of stocks and bonds contains all the diversification necessary for a well-balanced portfolio. While this is true, there’s another asset class — private real estate — whose risk profile and return history suggest that it also deserves inclusion along with the traditional stock/bond portfolio.
In this article we will discuss what private real estate is, how it can benefit investors, and how to invest in it. By the end of the article, investors will have the information necessary to decide if private commercial real estate (CRE) is right for them, how to get started, and which strategies to focus on.
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What is Private Real Estate?
Private real estate refers to real estate assets that are not publicly traded on a stock exchange. These assets are typically owned by individual real estate investors or institutional investors and are not readily available for purchase by the general public.
Private real estate can include a wide range of assets, such as residential properties, office buildings, multifamily (e.g., apartment buildings), and land. This asset class is viewed as an alternative investment option to publicly traded real estate investment trusts (REITs) and can offer investors the opportunity to diversify their portfolio with assets that are not correlated with the stock market.
The word “private” suggests that real estate ownership was acquired through non-publicly traded means and there are two ways to do it, directly or indirectly.
Direct or Active Real Estate Investment
Direct, also known as active, real estate investment refers to a type of real estate investment where an investor purchases the subject property alone or with a small group, known as a partnership. In a direct investment, the investor is heavily involved in the daily management and operation of the property. This can include activities such as managing renovations or maintenance, leasing, and collecting rent.
Under this strategy, the investor benefits directly from the income and profits produced by the property. But, it also exposes them to portfolio concentration risk because individual investors and small groups may only have the resources to purchase one or a handful of properties.
Indirect or Passive Real Estate Investment
Passive real estate investment refers to an investment strategy where the investor is not actively involved in the management and operation of the property. This type of investment typically involves the investor providing capital to a professional management team, who uses it to purchase and manage properties on behalf of the investor. The investor earns a return on their investment through a share of the rental income or appreciation of the property’s value.
Passive investors may prefer to gain exposure to real estate by deploying their capital through a variety of investment vehicles, including an asset manager, syndicator, non-publicly traded REIT, or private equity firm.
The key thing is that outsourcing property identification, acquisition, and management to professionals provides an opportunity to acquire fractional ownership in institutional quality assets not normally available to individuals. In addition, an indirect purchase increases portfolio diversification because funds are pooled with other investors and spread across multiple properties. But, expertise comes at a price and indirect investment also comes with fees, which may affect return.
Benefits of Private Commercial Real Estate Investment
Whether purchased directly or indirectly, private commercial real estate ownership can yield important benefits to investors.
Many commercial real estate investors focus on buying rental property to lease it to tenants and generate rental income for themselves. Over time and with proper management, investors can create solid income streams to fund retirement, hobbies, other business ventures, or lifestyle expenditures. To many, establishing a reliable cash flow stream is the holy grail of real estate investing.
Property Value Appreciation
In addition to providing investors with cash flow, commercial real estate can appreciate in value over time. For this reason, many investors focus on building an investment portfolio of commercial property they can rely on to increase in value while they focus on building a career or starting a family. When the investor needs to liquidate the property to fund retirement or other living expenses, they can do so using one or more tax strategies, such as a “1031 Exchange”. This strategy allows an investor to sell a property without incurring capital gains as long as specific rules are followed.
Low Price Volatility
If the goal of an investment is the maximum possible return with the lowest possible price volatility, then private commercial real estate is an option worth exploring. Historically speaking, private commercial real estate prices tend to appreciate slowly over time, based on the cash flow of the underlying property, the improvements made to the property, and trends in the local real estate market. In contrast, prices for publicly traded real estate securities may trade on the fundamentals of the underlying property, but they’re also affected by things like market sentiment, news, or short-term earnings reports.
One of the things that makes private real estate ownership a good complement to the traditional publicly traded stock/bond portfolio is that, in addition to low price volatility, price movements also tend to have a low level of correlation to that of stocks and bonds. This means that prices for stocks/bonds and prices for private commercial real estate tend to move independently of each other. For example, if stock prices are falling, private real estate prices may be flat or rising. Portfolio diversification is important to the long-term health of an investor’s portfolio, and it helps them to weather bear markets in any given asset class.
Beneficial Tax Treatment
Private commercial real estate comes with a host of benefits related to favorable tax treatment.
First, depreciation allows a property’s owner to expense a portion of the asset’s value each year to account for its physical deterioration. The expense offsets income, which serves to lower the taxable income the investor shows on his or her tax return at the end of the year. This means the investor owes less in taxes than they would otherwise.
Second, upon the sale of the asset, the owner may use a strategy known as a “1031 Exchange” to defer taxes on a gain. Repeated use of a 1031 Exchange may allow an owner to defer taxes indefinitely, which serves to boost overall returns.
But, a private commercial real estate investment isn’t without risk. There are several to be aware of.
Private Commercial Real Estate Risks
Before jumping into private commercial real estate, investors need to be aware of the risks that come with this asset class.
- Illiquid: Private equity and direct purchases can be illiquid, especially in times of market distress. In many cases, a private real estate investment, especially those of the indirect variety, requires that an investor’s money be tied up for five or more years.
- Time Intensive: For direct purchases, the properties can be incredibly time consuming to manage.
- Tenant Risk: Tenants defaulting on their lease terms is an ever present risk that can reduce the amount of cash flow available to distribute.
- Fees: Property managers, asset managers, and brokerage staff usually charge management and acquisition fees that can cut into investors’ profits.
- Interest Rates: Finally, commercial properties are vulnerable to interest rate changes, which can reduce property values.
How to Invest in Private Commercial Real Estate
Investors who are interested in pursuing private commercial real estate investments have plenty of options to choose from.
Direct Purchase: Like we discussed earlier, an investor purchases an investment property directly by making a down payment, and borrowing the remainder of the purchase price from a lender.
Crowdfunding: Crowdfunding offers the opportunity for smaller, non-accredited investors to participate in commercial equity investments that they otherwise wouldn’t have access to. Perhaps the most commonly cited benefit of investing in crowdfunded commercial real estate projects is the low minimum investment requirements. For investors with lower annual incomes or those just getting started with commercial real estate investing, crowdfunding can be a big boost.
Private REITs: Privately traded REITs can only be purchased by “accredited investors,” who meet minimum income and net worth requirements. Investors like privately traded REITs for their specialization, expertise, and their ability to leverage relationships to find the best deals.
Private Equity: Private equity investments come in two structures: funds and deals. In a fund structure, investors contribute capital for the general purpose of real estate investment and the private equity firm decides how it will be deployed. In a deal structure, capital is raised to purchase a specific property.
Many investors choose to work with a private equity firm as a way to generate passive income. The private equity sponsor takes care of the hard work of sourcing deals, completing due diligence, and property management. Working with a professional management team that possesses the know-how to make successful investment decisions can be a source of comfort for investors. Additionally, investors who choose to invest with a private equity firm reap the same tax benefits that come with direct investing.
Finding the Right Investment Strategy
Every investor has a different risk tolerance, time horizon, liquidity needs, and individual preferences. For this reason, investors should take the time to think about what their objectives are and which investment options are the best way for them to build wealth. Before investing, it is important to speak with a financial professional and/or CPA to understand which option might be best.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.