Why consider Commercial Real Estate Investing?
For a long time until recently, commercial real estate (CRE) investments has mostly been reserved for the largest portfolios or the top 1%. In fact, a 2017 study by UBS and Campden Wealth revealed that the ultra-wealthy invest an average of 15% of their portfolio into real estate.
Today, online marketplaces (link) are changing the game by opening up direct CRE investments to a whole new market of investors.
And for those looking to diversify their portfolio and potentially generate additional income and find some tax advantages, the opportunities are worth exploring.
What is commercial real estate (CRE) investing?
There are a few ways that investors can participate in the CRE market. In all cases, your dollars are funding investments in commercial real estate properties such as office buildings, retail centers, hotels and multi-family housing. However, how that investment occurs varies depending on the investment vehicle.
Common ways to invest in CRE
Here are four of the most common ways to invest in CRE:
Outright property ownership. In this case, investors purchase a CRE property, after which they own and operate it.
If you can afford to buy a property on your own, these investments present a considerable opportunity to potentially obtain both steady income and appreciation. But given the high cost, buying a CRE property outright is often not realistic. It also requires a significant amount of effort. Ask yourself: Do I have a workable business model? Am I prepared to be a landlord?
Traditional direct investing. In this case, investors purchase a debt or equity stake in a CRE property, usually by pooling their funds in a limited liability company (LLC).
By combining resources, direct investing offers a way for multiple investors to access CRE, and the minimum investment amount is often significantly less than outright property ownership. That said, it is still considerable, often around $100,000, and finding these opportunities tends to require a lot of legwork.
Publicly traded REITs. In this case, investors buy shares in real estate investment trust (REIT) that owns a range of income-producing CRE properties. They then receive a portion of the properties’ earnings on an ongoing basis.
REITs offer a simple, liquid way for investors to add CRE to their portfolios. But because public REITs can be bought and sold at will, their performance tends to track more closely with the performance of stocks and bonds. Also, investors don’t have control over what properties the REIT invests in.
Online direct investing. Sometimes referred to as “real estate crowdfunding”, online direct investing allows you to hand-pick individual real estate projects that align with your financial goals, along with a pool of other investors.
The fact that these projects are listed in online marketplaces generally makes it easier to find opportunities, especially opportunities outside your home city. By the same token, real estate project sponsors are able to raise capital from persons outside of their immediate friends-and-family circle. Minimum investment amounts can be as low as $5000, increasing access to the asset class and making it easier for investors to diversify—not to mention the possible tax advantages.
With both traditional and online direct investing, the LLC structure may provide important tax advantages, depending on the investment type and an investor’s personal tax situation.
As investment vehicles, the LLCs allow for the “pass-through” of depreciation, interest expense, and other deductions. In addition, the payout structures with direct investments are usually designed to align the interests of the investors with the sponsoring real estate company.
6 Reasons to Invest in Commercial Real Estate
Whether you’re looking to save more for retirement, give your kid’s college savings a boost or simply diversify your investment portfolio, there are many reasons to explore commercial real estate.
Consider these six advantages of investing in CRE:
1. Additional diversification
As an asset class, CRE behaves very differently from stocks or bonds. In fact, CRE has a historically low correlation with the stock market, which means a drop in the global equity markets doesn’t necessarily impact your investment.
This is an especially interesting benefit to consider given the continued predictions that we may be shifting toward bear market. While the asset class is different from the traditional equities market, investors can also differentiate within CRE as well. Because there are different demand drivers for types of commercial property, a diversified portfolio can potentially mitigate risk with investments in various CRE projects. For instance, job growth usually correlates to a need for office space; meanwhile, an increase in household formations may lead to a need for more apartment complexes.
Additionally, there is a considerable body of research suggesting that illiquid assets, when compared to more liquid stocks, bonds and even REITs, can provide higher returns as they’re not subject to the so-called liquidity discount.
2. Improved cash flow
CRE investments have the potential to provide a win-win for investors in that they offer income in the present as well as the potential for a return based on the asset’s future appreciation.
A key feature of direct CRE is that a significant portion of the total investment return comes via current cash flows from rental income.
The potential for steady income plays a big role in investor objectives and returns. Consider the fact that, perhaps surprisingly, dividend yield has accounted for almost half of stocks’ total returns. Accounting for inflation, dividends represent an even larger part of stocks’ annual investment return.
The regular cash flow also has the potential to provide a “stabilizer” to the volatility of equity prices otherwise sometimes seen with stocks valued solely on the basis of their long-term appreciation prospects. CRE investments can function the same way, providing a portion of current income inside a broader portfolio.
3. Less volatility
In the same vein, the long-term rental arrangements common to commercial real estate also contribute to that steady operating income. Tenants often sign lease agreements for 3 to 5 years, with some leases extending for several more years. This ongoing rental income has the potential to mitigate risks associated with broader economic swings.
In addition, direct investments in commercial real estate have shown less volatility than stocks or even publicly traded REITs.
The fact that direct real estate investments aren’t publicly traded means they are less impacted by short-term news and events, and that helps smooth valuations.
4. Investment in a hard asset
Real estate is a hard asset, which means it’s a physical thing that has intrinsic value both in the building and the land. This value is reflected in many ways. For example, hard assets can often be used to produce other goods or services, which accounts for the increased price of the property.
Because of these factors, commercial real estate is generally considered a relatively strong store of value.
Case in point: the U.S. Commercial Price Property Index, which tracks CRE property values at the time of purchase, has more than doubled in the past decade.
5. Hedge against inflation
As the prices of goods and services increase in the broader economy, real estate often benefits.
That’s because increasing wages and profits also generally increase the amount that property owners can charge for space, as well as what tenants can afford to pay.
The property appreciation that has occurred since the last recession offers a prime example, with CRE prices increasing at a significantly higher rate than inflation. Data from the Federal Reserve Bank of St. Louis, for example, shows CRE prices increasing by at least 5% every quarter between 2012 and 2016.
The Consumer Price Index—the measure of inflation or growth in consumer prices—stayed at or below 2% during the same time period. Rent escalation clauses in many leases provides another inflation hedge, in addition to organic rent growth.
6. Potential tax benefits
Many investors are also incentivized by the tax benefits of direct CRE investments.
If properly structured, you may be in a position to claim deductions related to depreciation, interest expense, and other items help to defer the taxes on cash distributions.
For instance, the IRS allows CRE investors to deduct some of a property’s depreciated value to account for the cost of maintenance and upkeep. The overall result is that CRE-related tax advantages may help investors to defer some taxes in a way that is not available with most other investments.
Worth noting: The tax benefits received an added boost from the new law tax laws that went into effect this year. The law now allows for a 20% deduction of income received through pass-through entities such as LLCs.
The Big Question: Commercial or Residential?
This is an excellent question, especially given that most investors have some experience with residential real estate from purchasing their own home.
There are certainly some similarities between CRE and residential: both are hard assets can provide income from rents and leases in addition to appreciation. But CRE, as noted above does offer some unique benefits that can play an important role in a diversified portfolio.
Besides the larger valuations usually seen with commercial properties, the biggest differentiator between residential and commercial is the diversification of income streams inherent in most commercial properties.
Commercial properties generally have multiple tenants—sometimes hundreds—that help mitigate the risk of defaulting or otherwise non-paying single tenants. With residential properties, though, investors are often dependent on a single tenant, which presents investors with increased risk.
With online real estate platforms, investors can often enjoy relatively small minimum investment amounts even while participating in larger CRE investments.
The ability to pool investments into LLC, as we described, allows you to scale your investment power to participate in projects that you wouldn’t be able to access on your own.
That said, it’s important to note that real estate investments carry risk and are not guaranteed, so they may not perform according to our expectations. You run the risk of losing invested capital, up to all of your original investment.
It’s important to consider an investment’s risk profile, especially as it relates to your own financial goals, your risk tolerance, and your investing timeline. A good rule of thumb is to never invest money that you cannot afford to lose. (article continues below)
How do I start investing in CRE?
While there are many ways to invest in CRE, the rise of online platforms makes direct CRE investments much easier for accredited investors.
In the past, investors often needed a minimum of about $100,000 to even dip a toe into a CRE investment. But online direct investing platforms opened up this asset class by allowing groups of investors to come together to fund real estate purchases. Now, investors can begin investing in CRE projects via online marketplaces with minimums of as low as $10,000.
Questions to ask before you get started
Interested in CRE as a new asset class for your portfolio? Check out an online CRE marketplace to review potential projects, and ask these questions before you invest:
What are your overall investment objectives?
What primary role do you want CRE to serve in your portfolio (diversification, tax benefits, income, etc.)
What percentage of your portfolio should/can you devote to CRE?
What types of projects capture your attention and address your objectives?
What kinds of due diligence does the online marketplace perform when reviewing projects?
What kind of returns can you expect from different project types?
CRE offers a host of opportunities for investors interested in looking beyond stocks and bonds for diversification, tax advantages and a steady source of income.
Review the potential benefits and consider how you can put CRE to work—and reach your own financial goals that much faster.
Disclaimer: All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. We suggest that you consult with a financial advisor, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity.
