In a typical composition of an investment portfolio, investors have some amount of stocks which are held for their growth potential and other income producing investments like bonds or annuities.
In this article, we are going to describe commercial real estate annuities. We will describe what they are, how they work, the pros and cons of investing in one, and how to find them. By the end, investors will have the information necessary to determine if this type of investment is a suitable fit for their unique financial circumstances.
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What is an Annuity?
For the purposes of this article, there are two potential ways to define what an annuity is.
First, an annuity is an investment product – usually offered by life insurance companies – that allows an individual to invest a lump sum of money up front in return for a guaranteed income stream down the road. For example, an individual could invest $100,000 into an annuity contract and it may guarantee them $5,000 in income annually for the rest of their life. Depending on the financial product offered, there could be a fixed annuity, indexed annuity, deferred annuity, or immediate annuity.
As it relates to real estate, the annuity investment product is often conflated with the term “annuity” which is often used simply to refer to an ordinary income stream received over a certain period of time. In this context, there are a number of investment products that could produce a stream of income that is similar to an annuity. They include bonds, dividend paying stocks, and commercial real estate.
Ways To Invest In Commercial Real Estate Annuities
So, when an annuity is thought about as a recurring stream of income, it is easy to see how a commercial real estate asset can produce it. Commercial space is leased to tenants, who pay rent for the privilege of occupying the space. That rent is used to pay operating expenses and debt service on a loan and anything left over is distributed to investors – producing a regular stream of recurring income. As a stream of income, it can be a great way to add diversification to an investor’s portfolio. For those seeking it, there are three ways to get it.
Method #1: Buy a Property Independently
The first, and most obvious, way to purchase a commercial real estate backed annuity stream is to buy a property directly. Perhaps an individual investor could buy a small retail center, office building, or small multifamily apartment building and operate it themselves. There are pros and cons to this approach.
The major benefit of the independent route is control. Investors have complete control over which property they purchase and all of the operational decisions that go into managing it. As such, it also means that the individual gets 100% of the income produced by the property.
Many annuity investors are looking for the income, but not the work. So, the major downside to the independent route is that the individual also has to do all of the work to operate the property. This requires a high degree of operational expertise and a lot of experience in this field. If an investor does not have this, the independent approach may not be the best fit for their needs.
Method #2: Invest in a Commercial Real Estate Syndication
A commercial real estate syndication is a deal structure that allows an individual investor to purchase a fractional share of a larger property. In a typical deal, a “syndicator” or deal leader does all of the hard work of finding, analyzing, financing, and closing on a suitable property while, as part of the financing effort, individual investor contribute a share of the total capital needed to get the deal closed. Once purchased, the deal leader also does the hard work of operating the property on behalf of their investors in return for a share of the profits.
The primary benefit of a syndication is that the income stream is truly passive – because the syndicator does all of the hard work. In addition, there is always a chance for capital gains, the income tax treatment for syndicated investments can be very favorable, and investors are typically able to get into a higher quality property than they could afford to purchase on their own.
The downside to the syndication approach is that it often requires investors to tie up their money for a long period of time (5-10 years), and the syndicator charges fees which can eat into profits.
The syndication approach is typically best for those who want to have exposure to commercial real estate assets, but don’t have any desire to be involved in the day-to-day operations.
Method #3: Invest in REITs
A REIT – short for Real Estate Investment Trust – is an investment option that is similar to a syndication in the sense that it allows individual investors to make a fractional commercial real estate investment, but there is one key difference. A syndication typically involves investing in one property only while a REIT involves investing in a diversified portfolio of properties that have a common theme. For example, National Retail Properties is a REIT that specializes in the purchase of triple net leased properties while Camden Property Trust specializes in multifamily apartments.
The major benefit of a REIT is its liquidity. Many, but not all, REITs are publicly traded on national exchanges which means that investors with a brokerage account can buy and sell shares at will. Other benefits include lower minimum investment amounts, favorable tax treatment, and the diversification that comes with a multi-property portfolio. For example, National Retail Properties has 3,271 properties in 48 states with 370+ different tenants. This is far more diversification than is typically offered in a single property syndicated investment opportunity.
The downside of a REIT is that the share price can be volatile (for publicly traded REITs) and investors really don’t have any say in which properties their capital is used to purchase. In addition, REIT managers may charge a high fee for their services managing the portfolio.
In general, REITs tend to be a good fit for investors who have a shorter term time horizon and who prioritize liquidity over stability.
Benefits of Investing in a Real Estate Annuity
As described in the section above, there are a number of benefits to investing in a commercial real estate asset that produces annuity-like regular payments. The biggest ones are described below.
Benefit #1: Passive Income
Passive income is money earned with little or no effort. In the structures above, both syndications and REITs are great investment vehicles through which to produce passive income. For investors who have demanding day jobs or little time to devote to managing a property on their own, passive income can offer the benefits of real estate ownership without the hassle.
Benefit #2: Favorable Tax Treatment
In each of the three structures above, IRS rules provide favorable tax treatment for real estate investors. The main form of favorable tax treatment is through the use of depreciation, which is a non-cash expense that lowers the amount of taxable income produced by a property. The exact amount of depreciation produced by a property is a function of the value and the estimated useful life. IRS rules dictate exactly how it is calculated, so this part is best left up to a CPA or tax attorney.
Benefit #3: Appreciation
Perhaps the biggest benefit of a commercial real estate annuity-like investment strategy is that the property price has a chance to appreciate over the long term. When it does, investors get the benefit of regular monthly payments plus a lump sum payout at the end when the property is sold. If the property appreciates enough, the payout can be significant and really give the overall rate of return a boost.
How Real Estate Annuity Payments Work
In a typical deal, a commercial property purchase is financed with some combination of debt and equity. The debt comes from a bank, financial institution, or real estate lender and the equity comes from individual investors, each of whom contributes a share of the total amount needed.
Once the purchase is closed, a commercial property operates much like a small business. Income is produced from rents paid by tenants and it is used to pay the operating expenses associated with managing the property – like insurance, property taxes, and maintenance. Income, less expenses equates to a figure known as Net Operating Income, which is then used to pay the monthly payments on the loan. If there is any money left over, it is distributed to investors in proportion to the amount of shares that they own.
Depending on the issuer/syndicator, payments are issued on a monthly or quarterly basis and are summarized at the end of the year in the investor’s tax return.
Determining if a Real Estate Annuity Investment is a Good Option
When considering a potential investment, investors often fall into the trap of looking for the “best” investment. Our belief is that investors should be looking for the most suitable investment. To determine this, investors should focus on five key points:
- Risk Tolerance: Some investors have a higher risk tolerance than others, which should be taken into account when selecting an investment. For example, those with a higher risk tolerance may be more comfortable with the price swings of the stock market or mutual funds, while those with a lower risk tolerance may be more comfortable with the stability (but lower returns) of the bond market.
- Time Horizon: Certain investments – like a syndication – require a five to ten year time horizon during which time investors typically aren’t able to access their funds. Others, like a REIT are highly liquid and can be bought and sold in the short term according to an investor’s capital needs.
- Investable Capital: Some investments like certain annuity products and syndications require large minimum investments, sometimes $50,000 or higher. Others like stocks, bonds, and mutual funds have a smaller minimum required investment and can sometimes be purchased for $100 or less. In addition, investors should consider the source of their capital. Some may have it in a taxable account while others may have it in a retirement account or IRA.
- Return Requirements: Risk and return are highly correlated. Investors seeking a higher return must be willing to accept higher levels of risk. Conversely, investors who are comfortable with a lower return, can afford to take far less risk.
- Individual Preferences: Some investors just have individual preferences for certain types of investments. Some may like real estate, others may like gold or commodities, while others may prefer art or collectibles. Each individual has their own investment beliefs and preferences
To determine which opportunity is the most suitable, investors should take stock of where they stand on each of these factors and choose the option that is the best fit.
Summary of Real Estate Annuity
An annuity is a term that can be used to refer to an insurance product that offers a fixed income over a certain period of time. Or, more casually it can be used to refer to a type of investment that produces regular cash flow like a bond or real estate investment.
There are three ways to invest in real estate assets that produce annuity-like returns – a real estate syndication, REIT, or buying a property independently.
There are three major benefits of investing in a real estate asset that produces annuity-like cash flows. They include passive income, favorable tax treatment, and the potential for price appreciation.
Investors often like to look for the “best” investment, but they should really look for the most suitable. To find it, they should consider their risk tolerance, time horizon, investable capital, return requirements, and individual preferences.
Interested In Learning More?
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.