Whether planning for retirement or seeking to maximize returns, traditional financial advice tends to focus on a portfolio that consists of two types of assets, stocks and bonds. While this can certainly be a successful approach, we believe that there is a compelling argument to be made for the inclusion of commercial real estate assets in the traditional stock/bond portfolio.
In this article, we are going to define what commercial real estate is and identify nine reasons why investors should consider allocating capital to it in their portfolio. By the end, investors will have the information needed to determine if commercial real estate is a good fit for their own investment objectives.
At First National Realty Partners, we are a private equity firm who specializes in the purchase and management of grocery store anchored retail centers and, before committing to any transaction, we always use NPV to assess potential profitability. If you are an accredited investor, interested in partnering with a private equity firm to allocate capital to a commercial real estate investment, click here.
What Is Commercial Real Estate?
In order to understand why investing in commercial real estate is beneficial, it is first necessary to understand exactly what commercial real estate is.
Commercial real estate assets are those that are purchased with the intent to generate an investment return through income and/or capital gains. At a high level, there are four generally agreed upon commercial property types:
- Multifamily: Commercial multifamily apartment buildings are those with more than four residential dwelling units within a single building or spread across multiple buildings.
- Retail: Commercial retail properties are those that house a variety of tenants who operate direct to consumer retail businesses. For example, shopping malls, grocery-anchored retail centers, restaurants, or bank branches all fall into the category of retail.
- Industrial: Commercial industrial properties are those that are utilized for logistics and/or manufacturing purposes. For example, a distribution warehouse is classified as an industrial property.
- Office: Finally, commercial office properties are those that contain space used by businesses to conduct their operations. Office properties can be general in nature like those used by accounting or consulting firms. Or, they can be highly specialized like a dentist’s office.
Each of these property types have specific operational quirks and investment nuances. For this reason, real estate investors tend to specialize in just one or two of them. But, the common theme is these properties are leased to other businesses (with the exception of multifamily) and they generate income – two features that set commercial properties apart from residential.
Why Invest In Commercial Real Estate?
While there are many potential benefits from a commercial real estate investment, we want to highlight nine of them in this article.
First and foremost, commercial properties have the potential to produce regular income for their owners. The income is derived from the rents paid by tenants and it is first used to pay the property’s operating expenses like taxes, insurance, maintenance, depreciation, and debt service. If there is anything left over, it is distributed to investors in proportion to their share of ownership.
For example, if a property produced $100,000 in income and had $80,000 in expenses, the remaining $20,000 would be distributed to investors as a dividend. If the property is managed by a third party, this can be passive income.
Historically, commercial real estate price movements tend to only be loosely correlated to price movements in other asset classes like stocks and bonds. As such, it provides an investment portfolio with additional diversification. So when stock market prices are down, real estate prices may be flat or even rise, which benefits portfolio performance as a whole.
Real estate is a “hard” asset, meaning that can be physically touched and seen by investors. For some this is a source of comfort relative to the pieces of paper that signify stock or bond ownership.
There are three major tax benefits to commercial real estate ownership.
First, commercial properties are typically owned in a Limited Liability Company (LLC), which is a single asset vehicle created just for the purpose of owning and operating the property. The LLC is a tax advantaged “pass through” structure that avoids the double taxation commonly seen in a corporation, meaning that profits are not taxed at the entity level. Instead, they “flow through” to investors where they are taxed at the individual level, according to the tax bracket of each individual.
Second, when a property is sold, profits are taxed differently than ordinary income. Each individual’s tax bracket is unique and the tax code is always changing, but the highest long term capital gains tax rate is in the neighborhood of 25% while the highest ordinary income tax rate is in the neighborhood of 37%. In short, capital gains have a lower tax rate than income, which is advantageous to commercial real estate investors.
Third, if an investor is fortunate enough to sell a property for a profit, they have an opportunity to defer capital gains taxes by reinvesting the sales proceeds into another, “like kind” property in a transaction known as a 1031 Exchange. There is no limit to the number of 1031 Exchanges an investor can complete, which means they could potentially grow their capital tax deferred over a long period of time.
While commercial properties produce income, they can also appreciate in value.
The key drive of property appreciation is known as “Net Operating Income” – NOI for short – which is calculated as a property’s rental income less operating expenses. The more NOI a property produces, the more valuable it is. With this concept in mind, there are basically two ways a commercial property can appreciate.
First, a property owner can “force” a property to appreciate by taking steps that impact the amount of NOI produced. For example, they could cut costs and/or increase rents over time and the difference will flow to NOI, making the property more valuable. At a 6% cap rate, every $1 added to NOI creates an additional $16 in value – a very powerful profit generator.
Second, market conditions can cause cap rates to decline, which is a good thing for real estate investors. For example, suppose a property produces $100,000 in NOI. At a 6% Cap Rate, the property has an estimated value of $1.6MM ($100,000/6%). If that same property produces $100,000 in NOI and the market drives the cap rate to 5%, the value increases to $2MM ($100,000/5%), a $400,000 difference.
The optimal condition is that a property owner is able to increase NOI and real estate market conditions drive cap rates lower. When this happens, the appreciation can be significant.
Hedge Against Inflation
Traditionally, real estate performs well in an inflationary environment because property owners can raise rents in conjunction. Doing so causes NOI to rise, which drives the property value higher, which can offset the purchasing power lost through inflation.
But, it should be noted that real estate as a hedge against inflation can be a double edged sword. A highly inflationary environment will typically cause central banks to increase interest rates in an effort to cool the economy. Doing so can both increase the cost of capital for investors and slow down markets. So, this is a risk that investors should be aware of.
Commercial properties are rarely purchased with cash. Instead, they are typically purchased with a mix of cash and debt or “leverage”, which is beneficial for two reasons.
First, debt is widely available from real estate lenders at generally favorable terms. Depending on the property type and condition, lenders can range from banks, government agencies (e.g. FNMA), insurance companies, or private lenders who specialize in real estate debt.
Second, the addition of debt to a transaction can boost returns for investors. For example, say a property has a purchase price of $1,000,000 and produces $50,000 per year for investors. If this property is purchased with cash, the cash flow generates an annual return of 5% for investors ($50,000/$1,000,000).
Now suppose this property was purchased with $750,000 in debt and $250,000 in equity. The addition of loan payments reduces the cash available for distribution to $20,000 each year, but investors only put in $250,000 in cash. So, their annual return increases to 8%.
However, investors should carefully study the dynamics of adding debt to a deal. There is a situation that occurs, when interest rates are higher than cap rates, that the resulting “negative leverage” can actually drive returns lower.
Again, the point of commercial real estate space is that it is leased to business tenants, which produces cash that can be distributed to investors.
These cash distributions generate a “yield” on the original investment, which both allows investors to earn a return and allows them to recover a portion of their upfront commitment with each payment. Because rental rates tend to increase over time, it can also result in an increasing yield, especially when market conditions are strong.
Commercial real estate investment opportunities exist on a spectrum of risk. At the high end, land, restaurants, ground up development, or hotels are examples of higher risk investment properties and their returns can be both high and have a high degree of volatility. These options tend to be a good fit for investors with a high risk tolerance, a long time horizon, and significant amounts of investable capital.
At the lower end of the CRE risk spectrum are properties like grocery-anchored retail, single tenant triple-net leased assets, certain real estate investment trusts, class A office buildings, or multifamily. While these assets may provide an overall lower return, they also tend to be far more stable, akin to a corporate bond. These lower risk-type investments tend to be a good fit for investors who prioritize preservation of capital over earning the highest possible returns.
The point is, there are certainly commercial real estate investment options that provide both the benefits of ownership and the ability to preserve capital in a safer, income producing investment.
How To Invest In Commercial Real Estate
If investors determine that commercial real estate is a type of investment that they would like to allocate capital to, there are four potential ways to do it.
The first, and most obvious way, to allocate capital to a commercial rental property is to purchase it directly.
In such a scenario, an investor or group of investors, creates their own LLC and uses it to purchase a property directly. In doing so, they are able to control the property, make all necessary management decisions, negotiate lease terms, and get 100% of the income stream produced.
The downside is that they have to be fairly well capitalized to come up with the necessary down payment, bear 100% of the risk for all investment decisions, and have to spend the time needed to manage the property – which can be significant.
A direct purchase of a commercial real estate property is typically a good fit for experienced investors who have the capital needed to buy the property and the experience and time needed to manage it.
Real Estate Investment Trust (REIT)
A Real Estate Investment Trust – REIT for short – is a specialized type of tax advantaged entity that owns, operates, or finances commercial investment properties. Investors can purchase shares in a REIT (which can be publicly traded or privately held) which entitles them to their proportionate share of the income and profits produced by the property portfolio.
The benefit of buying REIT shares is that investors are able to outsource all property management, financing, and property selection tasks to the experts who run the REIT. In addition, the REIT is not taxed at the entity level as long as they meet certain criteria, which leaves more money eligible for investor distributions.
The downside of purchasing REIT shares is that investors don’t really have any say in which properties their capital is used to purchase, nor do they have any input into investment management decisions. In addition, publicly traded REIT shares can have volatile price swings that do not reflect the value of the underlying assets while non-publicly traded shares can be difficult or very expensive to liquidate if funds are needed immediately.
REITs tend to be good options for investors who want exposure to a diverse portfolio of investment properties and a regular stream of income. They may also be a good fit for beginners or those with a shorter investment time horizon because publicly traded REIT shares can be liquidated easily.
A syndication is an investment structure where a group of investors (the “syndicate”) pool their money together to purchase and operate a commercial property. Typically, a syndication has a deal leader, referred to as the General Partner, who takes responsibility for finding the property, completing the due diligence, and arranging the financing. They will also manage the property once the purchase is complete.
In a syndication, the investors are referred to as the Limited Partners and their role is largely passive – they provide capital and leave the rest up to the General Partner.
Syndications tend to be a good fit for Accredited Investors who meet SEC defined minimum income/net worth requirements, those with long investment horizons, and those with at least $25,000 – $50,000 of investable capital.
A crowdfunded real estate investment is a type of syndication, but there is one key difference between it and the type described above. In a traditional private equity syndication like the type we offer, capital is raised through a network of previous investors, broker-dealers, and our own outbound marketing efforts.
In a crowdfunded syndication, capital is raised through an online platform that provides investors with the ability to “shop” for the deals that they are interested in. These platforms handle all of the investor due diligence and provide General Partners with many tools to manage distributions and communication.
In some cases, crowdfunded real estate investments have lower minimum investment amounts than a typical syndication and may even provide ways for non-accredited investors to get involved.
Summary of Why Investors Should Consider Commercial Real Estate
Commercial real estate is a class of real estate assets that are purchased and operated with the intent to earn a profit through regular income and/or price appreciation.
At a high level, there are four types of commercial properties, industrial, retail space, office space, and multifamily. Each has their own operational quirks, which is why investors tend to specialize in just one or two of these categories.
There are a number of reasons why investors should consider investing in commercial real estate including income, price appreciation, tax benefits, capital preservation, and protection against inflation.
For those who decide to invest, there are four ways to do so – purchase a property directly, buy REIT shares, invest in a syndication, or invest in a crowdfunded deal.
Investors should always perform their own due diligence on potential real estate investments and choose those that are a good fit for their own risk tolerance, time horizon, and return objectives.
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.