Traditional financial advice on saving for retirement states that an individual should make regular contributions to a tax advantaged retirement account and use these funds to invest in a portfolio of stocks and bonds. Over time, this has proven to be a reliable strategy, but economic conditions can drive periods of intense volatility that can test the mettle of even the most experienced investors. For this reason, many investors can benefit from an added layer of diversification in their retirement portfolio in the form of the commercial real estate (CRE) asset class.
To fully understand why this is the case, it is first necessary to review the stock market’s historical performance.
What is the “Stock Market” and How Has it Performed Historically?
The term “stock market” generally refers to the universe of publicly traded equities on major exchanges like the New York Stock Exchange or Nasdaq. More specifically, these equities tend to be represented by major indices like the S&P 500 or Dow Jones Industrial Average, which are both baskets of the largest publicly traded companies in the United States and easy ways to measure historical returns.
The argument for investing in the stock market is a simple one. For more than 100 years, the long term trend of the stock market (as represented by the S&P 500) has been up. So, an investor with a long term time horizon and a healthy dose of patience can earn a significant return for their retirement nest egg. To illustrate this point, consider the fact that the S&P 500 has provided an average annual return of ~8% since 1957. So, a $10,000 investment that earns 8% annually for 30 years would have an ending value of ~$100,000 assuming no additional contributions. If just $100 is contributed per month over this same time period, the ending value jumps to ~$241,000. This is a very compelling case for investment in the stock market.
However, the stock market does not move in a straight direction. There are periods of economic contraction where there can be significant declines in value. For example, in the financial crisis of 2008, the value of the S&P 500 declined by 38.5% or in the dot com crash of 2000, there were three straight years of double digit declines in value. These types of price fluctuations can test the nerves of even the most experienced investors. To balance them out, it can be helpful for investors to include another asset class in their investment portfolio whose price movements are loosely correlated with those of the stock market. For many, a logical choice is a commercial real estate investment.
Why Commercial Real Estate Can be Complementary to a Stock Market Investment
The basic premise behind portfolio diversification is that it can be beneficial to own multiple asset classes whose price movements are unrelated so that when one goes down, the other goes up or vice versa. When it comes to the stock market and commercial real estate, price correlation can be difficult to measure due to the breadth of investment offerings in both asset classes, but some clues can be obtained by comparing historical price movements between the Russell 3000 Stock index and the NCREIF property index. They have a correlation coefficient of .23, which means that their prices do not tend to move together. For this reason, an investment in commercial real estate can be a good complement to an investment in the stock market.
Benefits of Commercial Real Estate Investment
Broadly, there are a number of benefits that can be obtained from investing in the commercial real estate asset class:
- Diversification: As discussed above, commercial real estate provides an element of diversification for the traditional stock portfolio.
- Low Price Volatility: Commercial real estate values are based on the amount of cash flow generated by the underlying property. As a result, private commercial real estate prices tend to trade on their fundamentals and appreciate slowly over time. In contrast, prices for publicly traded securities may trade on their fundamentals, but they are also driven by things like: market sentiment, news headlines, earnings reports, and macroeconomic conditions, all of which can cause prices to fluctuate significantly.
- High Return on Investment: Historically, commercial real estate investments have yielded a high return on investment from a combination of rental income, asset appreciation, and depreciation. Investment returns can be high in absolute terms, measured by a metric called the Equity Multiple, and they can be high in relative terms when compared to other asset classes.
- Beneficial Tax Treatment: Commercial real estate returns don’t come from property income and appreciation only. They are also driven by two significant tax benefits.
First, an accounting concept known as “depreciation” allows a property 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 reduce the overall tax liability.
Second, upon the sale of the asset, the owner may use a strategy known as a “1031 Exchange” to defer taxes on the capital gain. 1031 Exchange rules can be complicated, but when used correctly, they could potentially allow an owner to defer taxes indefinitely, allowing investment capital to grow tax free.
Commercial Real Estate Investment Vehicles
For many individuals investing for retirement, a passive commercial real estate investment will be their best bet. Broadly, passive commercial real estate investment options can be grouped into two categories, Real Estate Investment Trusts (“REITs”) and Private Equity. Additional information on both is below (NOTE: An investment made on a crowdfunding platform is another example of an indirect investment, but not considered relevant for the purposes of this article).
Real Estate Investment Trust
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Because REITs are formed as corporate entities, investors are able to purchase shares in them, providing access to the rental income and profits produced by the underlying commercial properties. In addition, there are some tax benefits to the REIT structure as long as it meets certain requirements. REITs can be publicly traded, which allows investors to buy and sell shares like stocks or mutual funds, providing a high degree of liquidity. Or, they can be private, which provides less liquidity, higher management fees, and a longer term commitment.
Generally, commercial real estate investors seeking passive income can choose from one of four REIT types:
- Equity REITs: Equity REITs are publicly traded companies (their shares can be bought and sold in the stock market) that own or operate income-producing real estate for the purpose of distributing dividend income to their shareholders. The majority of REITs fall into this category and are considered attractive because of their liquidity and high dividend yields. REITs can specialize in specific property types like apartment complexes, office buildings or single-family homes.
- Mortgage REITs (mREITs): Mortgage REITs (mREITs) provide financing for income-producing real estate by originating mortgages or purchasing mortgage-backed securities. They earn income from interest on the loans and/or dividends from security investments.
- Public Non-Listed REITs: Public, non-listed REITs (PNLRs) are registered with the SEC but do not trade on national stock exchanges. However, they follow the same philosophy of investing in income-producing properties for the purpose of distributing dividends to their shareholders.
- Private REITs: Private REITs are exempt from SEC registration requirements and their shares do not trade on national stock exchanges. To invest in a private REIT, an investor must meet income and/or net worth hurdles or demonstrate that they are sophisticated enough to understand the risks of investing in non-publicly traded securities.
Given the number of REIT categories, there are enough options to meet the needs for nearly all investors. However, one of the major drawbacks to investing in a REIT is that an individual has little to no say how or where their capital is deployed. They just contribute funds to a “pool” and it is up to the asset manager to choose the properties and/or loans for investment. For those individuals who want to know exactly what property they are investing in, a private equity commercial real estate investment may be a better fit for their objectives.
Private Equity
Private Equity Real Estate firms and REITs have a similar mandate, to pool investor money and deploy it into real estate assets. However, the securities offered by Private Equity Real Estate firms are not publicly traded and they are only available to accredited investors.
Because they aren’t bound by the same regulations as publicly-traded REITs, private equity real estate companies have wide latitude to invest in a variety of real estate asset classes, which may or may not include income-producing rental properties. In addition, the legal structure may differ significantly from a REIT and they are not required to pay out a high percentage of their income in dividends. Instead, the majority of private equity returns are derived from profitable investment exits in the form of capital gains and carried interest.
A private equity investment comes with a series of impressive benefits:
- Acquisition and Operational Expertise: The identification, selection, acquisition, and operation of a commercial real estate asset requires deep expertise and significant experience, which a private equity real estate firm specializes in.
- Tax Efficiency: Private Equity Real Estate investments are structured in a tax-efficient manner, allowing investors to reduce taxable income through depreciation.
- Flexibility: Because they aren’t as heavily regulated, private equity firms can be flexible in their investment strategy, giving them the freedom to pursue profitable deals where available.
- Incentive Alignment: Because private equity firms themselves are also invested in their deals, their incentives align with those of the investor in that they both want a profitable outcome.
- Exit Plan: Private Equity Real Estate firms enter an investment with the exit in mind giving investors a roadmap to a successful outcome.
- Clear Fees and Compensation: The fee and profit participation structure is clear from the outset and closely correlated to performance, which means that all parties are working together towards a profitable outcome.
Like REITs, there are different types of private equity real estate passive investments that an investor can choose from. There are two main categories to be aware of:
- Fund vs. Deal: Some private equity firms offer “blind fund” investment opportunities that are similar to a REIT in the sense that an investor contributes capital to the private equity firm and the firm decides where, when, and how the capital will be deployed. Or, and this is the case with our firm, an individual can invest in a specific real estate deal. In such cases, they would be able to know exactly which property is going to be purchased, where it is, who the tenants are, what the income statement looks like, and what the business plan is post-purchase. We believe this is the superior option for most individual investors.
- Specialization: Commercial real estate is a broad category so asset managers tend to specialize in certain segments of it. For example, some firms specialize in industrial space, some in office space, some in multifamily, or, as is the case with us, retail assets. There are enough options that an individual can choose one that aligns with their investment objectives, risk tolerance, and time horizon.
The bottom line is this, an investment in the stock market alone is a time tested strategy for building wealth into retirement. However, there is a strong argument to be made that commercial real estate deserves an allocation of investment funds due to the loose correlation of its price movements relative to the stock market.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, 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 are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
