Why I Invest in Commercial Real Estate
In Part 1 and 2 of the my introduction, I presented my financial goals, mindset philosophy, and personal financial history. In this post, I will make a case for commercial real estate and why it is an attractive asset class. I truly believe real estate is an overlooked asset for many investors.
We’ve been conditioned by the general media and financial institutions to accept stocks, bonds, and mutual funds as the best and only way to wealth and retirement. Everything else is labeled “alternative investment”. If everyone says it’s true then must we accept this as fact? I think people have a duty to themselves to discover what is in their best investing interest that fits their risk/reward profile. I believe real estate is one of the best ways to build wealth. It’s been around before paper assets became popular. Real estate is a tangible, hard asset. And now more than ever, technology has enabled regular investors to participate in real estate investing. You can even invest through a self directed retirement account.
As a disclaimer, I am not a professional real estate investor or a commercial real estate developer. I am a full time physician and a part time private investor.
After investing for over a decade in traditional stock and bond holdings, I set out to discover what large institutions like endowments, pension funds, and insurance companies invest in. What I discovered to be a common denominator was private commercial real estate. Many endowments and institutional investors favor real estate and have been increasing their portfolio allocations to this asset class. What you won’t find is the conventional 80/20 equities and bond portfolio. The famous Yale endowment, totaling over $25 billion, and led by David Swenson has had over 20% allocated to real estate (currently 13%). More surprising, only 10% is allocated to domestic equity and greater than 50% allocated to other alternative investments.
Some family offices, which are private wealth management firms that serve ultra-high net worth clients have over 50% allocated to alternative investments.
Private core commercial real estate investments have been one of the top performing asset classes over the past 20 years. This is accompanied by significantly less risk and volatility than other conventional asset classes like stocks. Now, commercial real estate overall can be divided into many subtypes with their own risk profiles. There is core, core-plus, value-add, and opportunistic. As an example, ground-up development is much riskier than class A stabilized office building. We are talking about core commercial here.
CRE is attractive because it packs a one-two punch. The first punch is the stable bond-like yield. The second punch is the equity-like upside.
Let’s look at the first punch: Bond-like yield
Private core holdings can be considered as stable as bonds,
Chart 1 illustrates the risk and return profiles of major asset classes. Core real estate, as represented by the National Council of Real Estate Investment Fiduciaries Property Index, (NPI), tends to have similar annualized risk to corporate and government bonds with a higher return over the long term. Large Cap stocks, small Cap stocks, REITS, and commodities have relatively higher risk. Note the risk free rate is the 10-year US Treasury note yield.
Chart 2 shows the Sharpe ratios by asset class over time. A higher Sharpe ratio indicates a higher rate of return per each unit of risk. It shows that over time, core CRE’s Sharpe ratio has fallen between that of stocks and bonds. This supports premise of CRE having both bond and equity-like features.
Total return / volatility
Between 1977 and 2012, private core real estate has generated total returns between those of fixed income and equity as shown below.
Again, private CRE is significantly less volatile than equity markets.
In addition, annual yields are typically higher from CRE core properties than from stocks and bonds.
From this graph, you can see that U.S. bond holdings yield around 2%. Stocks yield around 3-4%. Private core real estate yield around 6-7% which is 3x of bond income.
Furthermore, investors can be confident that the yields are stable over time.
The yields (shown in blue) have remained relatively stable even in times of market stress (shown in black). This is largely in part because tenants are locked into multiyear contracts with built in periodic increases in rent over the lifetime of the contract.
Secondly, appreciation is also relatively stable with only two periods in a 34 year span where negative appreciation overcame the current yield to result in an overall negative return. The cash flow of real estate can overcome a lot of problems.
Let’s look at the second part of the one-two punch: equity-like upside compared with bonds.
During times of economic prosperity, indicated by GDP growth, real estate cash flow increases.
In this graph, since 1978, in years where US GDP growth exceeded 4%, real estate performed better than bonds but trailed equities.
In addition to the one-two punch of core real estate, there is another aspect yet to discuss; low correlation with equity markets.
The chart above was a real shocker for me. It shows the twenty worst quarters for a 60/40 U.S. stock/bond portfolio paired with the corresponding performance of private real estate over the same quarters. In 17 of the 20 quarters, while the 60/40 portfolio is negative, private real estate returned positive numbers. Three of the quarters where real estate was negative were all during the Great Recession. This was truly a black swan event where nearly all asset classes fell together. In truly extreme and rare market drops, this diversification may not help, but in general, the equity and real estate markets are uncorrelated. When one zigs, the other zags.
There are certain tax advantages to investing in commercial real estate. Investors can participate in the depreciation of an asset. In many cases, the depreciation can be accelerated by an accounting technique called cost segregation. This technique can increase immediate cash-flow and is an example of the general principle of “a dollar today is worth more than a dollar tomorrow”. This depreciation can be used to “shield” cash flow from rental income. The depreciation is of course recaptured when the property is sold, but it is taxed at the Section 1250 gain rate of 25%.
In addition, when the property is sold and there is a true capital gain, the gains are taxed at the long term capital gain rate which is usually lower than the ordinary income rate.
How To Invest In Commercial Real Estate:
There are several ways for an individual to invest in commercial real estate. One is to directly buy a property, but this is expensive and most investors don’t have the capital of a million dollars or more lying around to pull it off themselves. Also, you’d be putting all your eggs in one basket. In addition, as an individual, it would be very difficult to compete with professional companies to properly source, due diligence, purchase, and manage individual properties.
A second way for most public investors is through REITS (real estate investment trusts). These can be publicly traded, non-traded or private. Note that this is an indirect investment in real estate property. The investor actually purchases shares of a company which in turn purchases commercial real estate. This method is a popular option for both non-accredited and accredited investors.
The third way is through private real estate companies. Investors pool their money together and directly own shares of the actual property or properties. Minimum investments can start as low as $5000 per investment through crowdfunding platforms. This also allows diversification into multiple properties and sponsors. Until recently, these offerings were only available to high net worth investors who were friends and family or had existing relationships with the private equity companies and the minimum investment amounts were high, starting at $100K and up. Now, since the passage of the JOBS act in 2012, and crowdfunding regulations, private equity real estate investing has been democratized and is more accessible to the general public. This is largely due to legalization of general solicitation of the offerings through the JOBS Act Title II 506c ruling. However, the majority of these offerings are still only available to accredited investors.
In summary, commercial real estate investing can make sense as part of a well-diversified portfolio. Clearly, institutions and the super wealthy see value in real estate and use them to a large extent in building their empires. Ask any ultra-high net worth individual and you’ll likely find a substantial real estate allocation in their portfolio. I am a believer in diversifying my total portfolio to include some commercial real estate for the above stated reasons. Even though these are illiquid investments, they have the potential to juice a total portfolio return, with less volatility and correlation to the stock market. In future posts, I will be detailing my personal investments which include individual deals and funds.
Until next time,
Invest in Life.
Do you invest in real estate? What is your opinion on real estate? How has your experience been? I’d love to hear from you. Please comment below.