For individual investors, there are many ways to build wealth over the long term. For example, some investors like the growth potential of the stock market. Others like the relative safety of the bond market or the comfort of hard assets like gold or silver. There is no right or wrong way to build wealth, but one of the most consistent ways is through commercial real estate investment.
In this article, we are going to describe how commercial real estate investing can build wealth. In doing so, we will highlight the benefits of investing in commercial real estate, how to invest in it, and what qualifications investors need to have. By the end, readers will have the information necessary to determine if a commercial real estate investment is a good fit for their own return objectives and/or risk tolerance.
At First National Realty Partners, we believe that commercial real estate (CRE) assets are an integral part of a broadly diversified portfolio of risk assets. If you are an accredited investor and would like to learn more about our current investment opportunities, click here.
How Investing in Commercial Real Estate Builds Your Wealth
According to the National Council of Real Estate Fiduciaries (NCREIF), the average annual return for commercial real estate assets has been 10.3% annually over the last 25 years. For context, the S&P 500 (equity index) returned an average of 9.6% annually over the same time period.
This level of performance means that investors who chose to stick around for the long term have been rewarded handsomely for their patience. In other words, they have been able to build a significant amount of wealth. $10,000 invested in commercial real estate assets 25 years ago would be worth $115,000 today. If that same $10,000 was invested in the S&P 500, the ending balance would be $98,915.
The key point here is that investing in commercial real estate assets is a time tested way to build wealth. But, before an investor can start building wealth, they must define what their goals are.
Defining Wealth Goals
The first step towards building wealth through commercial real estate investment is to define exactly what the goal is. For some investors, this could be a certain dollar amount – like $1,000,000. For others, it could be a certain amount of passive income – say $10,000 per month. Or, some investors just desire to achieve financial freedom so they can spend their time working on things that are important to them.
The goal is likely to be slightly different for each individual investor, but the important point is that they figure out what it is first, and then start working towards it. If the commercial real estate asset class is chosen as part of the wealth building process, there are several benefits to investing in it.
Benefits of Investing in Real Estate
There are a number of benefits to investing in commercial real estate as a way of building wealth. We want to highlight three of the biggest in this post.
Cash Flow
Regardless of the commercial property type, the wealth building process is the same. The space is leased to tenants and the resulting rental income is used to pay for the property’s operating expenses. Anything left over is distributed to real estate investors. These distributions produce consistent cash flow, which can be further reinvested into other assets.
Tax Benefits
There are two major tax benefits to investing in commercial real estate.
First, operating expenses are tax deductible. One line item in particular, depreciation, allows property owners to expense a portion of the property’s value each year to account for its physical deterioration. This is a non-cash expense so it does not reduce the cash available for distribution, but it does reduce the property’s tax liability.
The second major tax benefit of commercial real estate is the way that capital gains are treated. If a property is sold for more than its cost basis, the difference between the sales price and the cost basis is classified as a “gain” for tax purposes. Gains are taxable and investors may choose to pay them. Or, they could choose to defer them under a program known as a “1031 Exchange.” In this program, investors may defer their capital gains tax liability as long as their sales proceeds are reinvested into another property of “like kind.”
Financial Security
Over a long period of time, the positive returns earned on a commercial real estate investment can be a major factor in the creation of financial security for the individuals who hold it.
It should be noted that one of the bedrock principles of investment risk management is diversification. For this reason, it is likely not a good idea for most individual investors to allocate capital only to commercial real estate assets. Again, the best practice for commercial real estate is to hold them as part of a broadly diversified portfolio of risk assets (stocks, bonds, commodities, etc). The exact percentage to hold is dependent upon each investor’s own risk tolerance and return objectives.
Qualifying To Invest In Commercial Real Estate
There are two types of commercial real estate investors, accredited and non-accredited.
Accredited investors are those who meet certain income and/or net worth criteria as defined by the Securities and Exchange Commission (SEC). For those that meet this criteria, they are eligible to invest in almost any opportunity, including the privately issued securities like those offered by our firm.
For those that don’t meet accreditation criteria, they can invest in publicly traded securities, but not those offered in private markets. While this may sound limiting, there are many potentially profitable real estate investments that can be found.
Ways to Invest in Commercial Real Estate
In the commercial real estate industry, the investment options available are guided by an investor’s accreditation status.
Non-Accredited Investors
A Direct Purchase
The first – and perhaps most obvious – option is for a non-accredited investor to purchase commercial real estate property directly, either on their own or with a group of partners.
The benefit of this approach is that investors have control over the property identification, financing, and management processes. The downside is that management can be time consuming, purchases can be capital intensive, and diversification options are limited with all funds invested in one or two properties.
Real Estate Investment Trust (REIT)
A real estate investment trust is a specialized type of investment company that owns, operates, and/or finances commercial real estate rental properties. Often, they specialize in certain property types like multifamily apartment buildings, office buildings, industrial and logistics facilities, self-storage, or retail centers.
The benefit of this approach is that REITs have a low minimum investment, are publicly traded/liquid, and are highly diversified since they own many properties. The downside of this real estate investment strategy is that REIT fees can be high and returns can be highly impacted by public market sentiments, regardless of the performance of the underlying properties.
Real Estate Investment Groups (REIGs)
Real Estate Investment Groups are similar to REITs in the sense that they pool investor money and use it to purchase commercial properties. But, there are a few key structural differences in that REIGs are not publicly traded and there is no limit to the number of investors or distributions.
REIG is that investors can earn a strong annual rate of return, can construct a diversified real estate portfolio, and can benefit from passive income streams. On the downside, REIGs are not subject to anywhere near the same level of regulatory scrutiny as publicly traded REITs. For this reason, it can be difficult to independently verify key information during the due diligence process.
Accredited Investors
From a regulatory standpoint, accredited investors are eligible for all of the above real estate investment products plus those offered in private markets.
Private Equity Commercial Real Estate Firms
Private equity firms invest in the privately held equity of other companies, including those that own real estate.
For accredited investors, the benefit of private equity partnerships is that they get access to institutional quality deals that they could not afford on their own. In addition, they are able to leverage the private equity firm’s experience and expertise to ensure that the deal is underwritten conservatively and that the needed property management activities are covered.
The downside of working with a private equity firm is that these real estate deals can require lengthy holding periods during which time the investment is illiquid. In addition, they are only available to accredited investors which makes them somewhat less accessible.
Crowdfunding
Crowdfunding is a method of raising investment capital from a “crowd” of investors, each of whom contribute a small percentage of the total needed. In some ways, this is similar to what a private equity firm does, but the key difference is who is acting as the General Partner. In some cases, it could be a private equity firm. In others it could be a real estate developer, an individual deal syndicator, or real estate investment firm.
The benefit of a crowdfunded approach is that individual investors get fractional ownership of an institutional quality asset. The downside is that they can be illiquid and close attention must be paid to the deal sponsor to ensure they have the required resources and expertise to manage the deal.
Choosing the Right Investment Method
There is no right or wrong way to build wealth by investing in commercial real estate. But, the right investment strategy varies by individual and usually depends on four factors:
- Accreditation Status: The world of options is much broader for accredited investors than it is for non-accredited folks. So this is a primary consideration.
- Time Horizon: Investors who have a long term time horizon may be a good fit for a private equity or crowdfunded investment. Investors who need more liquidity are likely a better fit for a publicly traded REIT investment.
- Risk Tolerance: Certain commercial real estate property types have more risk than others. For example, multifamily properties tend to be at the low risk end of the spectrum whereas properties like restaurants or hotels tend to be at the higher end of the risk spectrum.
- Desired Return: Risk and return are correlated. For individuals who are chasing higher returns, they will need to take more risk. Individuals who are OK with a lower return can afford to take less risk.
As a general rule, investors with a lower risk tolerance who want liquidity are likely going to be a better fit for publicly traded REITs. Investors who have a longer term time horizon and can afford to take more risk may be a better fit for a private equity or crowdfunded investment.
Summary & Conclusion
There are a number of ways to build wealth through investment. For example, some investors like stocks. Others like bonds, commodities, or collectibles. But, one of the most time tested methods of building wealth is through commercial real estate investment.
There are a number of benefits to owning commercial real estate investment property, including: tax treatment, recurring cash flow, and financial security.
For investors who like this asset class, there are a number of options for investment including: REITs, private equity, and purchasing a property directly. Options may be somewhat limited depending on an investor’s accreditation status.
When choosing a commercial real estate investment method, investors must consider their time horizon, risk tolerance, return objectives, and accreditation status. The right strategy is the one that is the best fit for these unique preferences.
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 info@fnrpusa.com for more information.
