Why invest in real estate?
As a multitrillion-dollar industry and the third-largest asset class in the United States, commercial real estate has always been a viable option for investors. However, over the last several years we have seen an acceleration of interest in this asset class.
In fact, the best long-term investment in Gallup’s annual survey has been real estate every year since 2013.
Increased interest means increased demand for real estate investments. Unfortunately, few investors know where to turn for the most reliable information.
In my position as Director of Investor Education, I have had the unique privilege of speaking with thousands of prospective clients.
Certainly, every investor has his or her own story. However, there is a commonality of responses I hear as to why they chose to invest in apartment buildings.
What follows is some of the most common reasons I hear from people in response to the question, “Why invest in real estate?”
#1 – Current Income
With the onset of the information age, rapid globalization, and the threat of automation investors have been seeking investments that provide yield. Being able to secure passive income outside of their job is vitally important in today’s world.
They see passive income as the answer to the question, “Why invest in real estate.” Unfortunately, the yield they seek has been hard to find.
For years savings accounts, money market funds, and CD’s have suffered offering little to no returns. Government bonds haven’t fared much better. In fact, until recently, this has been the lowest government bond yields in history.
Some have opted to chase yield by pursuing higher-risk investments like high-yield corporate bonds. Others have found direct ownership of commercial real estate, especially multifamily, to provide higher yields without the added risk.
#2 – Equity Growth
While our investors want yield, they don’t want to sacrifice growth. They tend to take a long-term total return outlook. Multifamily real estate is prized for its ability to create multisource income with equity growth coming from two sources.
The first is in the form of amortization. As the residents pay down the mortgage, the investor’s equity grows. Additionally, the ability to force appreciation can accelerate that equity growth in stable Cap rate markets.
The formula for calculating value in commercial multifamily real estate is:
Value = Net Operating Income (NOI) / Cap rate
By increasing revenues (rents, fees, or other forms of income), decreasing expenses, and or increasing retention smart operators can grow net operating income and force appreciation. The unrealized gains from amortization and appreciation can be taken either at the time of a sale or through refinancing the property.
#3 – Tax Sheltering
Our high net worth clients almost universally identify high taxes as one of their primary financial concerns. As such, the highly tax-advantaged nature of real estate attracts many to this asset class.
Depreciation is the cornerstone of this tax efficiency. The depreciation schedule for commercial real estate is 39 years. However, it’s 27.5 years for resident-occupied real estate, like multifamily.
To illustrate that, let’s look at a hypothetical apartment building valued at $34,500,000. It will be depreciated over 27.5 years. The first step is to subtract out the land value from the building, as land is not depreciable. In this example, let’s say the land is valued at $7,000,000. Therefore the building is worth $27,500,000.
$27,500,000 / 27.5 years = $1,000,000 in annual depreciation for the next 27.5 years.
Additionally, depreciation can by frontloaded using a cost segregation study. This is a process by which all of the non-structural elements and exterior land improvements get identified and depreciated on a shorter schedule (typically over 5, 7, and 15 years).
Given the depreciation, it’s typical for investors to reap tax-deferred yield for many years. Their annual tax reporting falls under a schedule K-1 that reflects a passive activity loss despite the actual gain.
Since many of our clients have other business investments that create K-1 passive activity gains, they get the added benefit of using our passive activity losses to offset those gains from other sources.
Avoiding Capital Gains Tax
Furthermore, real estate offers a mechanism for harvesting equity gains without triggering a capital gains tax. Since direct ownership of real estate typically represents a long-term investment, equity tends to accumulate.
Unfortunately, there is no return on “lazy” equity. Having the ability to harvest a percentage of it through a refinance while avoiding the drag of taxation, allows one to redeploy into a new asset. This accelerates yield returns by putting more money to work for the investor.
In cases in which the liquidity event is not a refinance but a sale, section 1031 of the tax code allows investors to exchange their property for a “like kind” property without taking a tax hit. This is a highly effective tax deferral strategy.
By deferring the capital gains tax, our investors have significantly more money working for them than they would have had if they sold a non-qualifying asset like stocks.
While many of the tax benefits inherent in real estate investing are tax deferral, both depreciation recapture tax and capital gains taxes can be eliminated through advanced tax strategy.
Owning the property until death allows for one’s heirs to inherit the property on a stepped-up basis. This eliminates those taxes and resets the basis to current market value.
#4 – Diversification
Most investors understand the need for diversification. Many have the bulk of their money in high volatility asset classes. They are searching for investments with lower volatility and low correlation to the stock market.
Many are unwilling to hold bonds in what has been a prolonged low-yield environment. Instead, they’ve turned to alternative investments. What many cite as the reason for turning to apartment investing is the desire to hold a hard asset that is centered on the basic need of shelter.
To many, this asset class makes sense as a diversification tool for their portfolio given its low correlation with the stock market.
The above graph looks at the twenty worst-performing quarters for a 60% stock/40% bond portfolio between Q1 1978 through Q1 2012 (note the downward deflected black bars). During those same quarters, real estate was also down only three of the twenty. The other seventeen quarters real estate was up showing its low correlation to the stock market. Make no mistake; commercial multifamily real estate continues to be an attractive asset class for diversification.
Additionally, any conversation about diversification would be incomplete without mentioning correlation coefficients. Correlation coefficients measure the degree to which two variables are associated and move in relation to one another.
As you may already know, these range between -1.0 and 1.0.
- 1.0 indicates a perfect positive correlation (they move in tandem)
- -1.0 indicates a perfect negative correlation (mirrored movement away from each other)
- 0 means they are uncorrelated (move unrelated to one another)
So a correlation coefficient of 0.79 indicates a much higher correlation between two investments than one that is 0.41. To better understand the degree to which the stock market (S&P 500), direct ownership of commercial real estate (NPI), and REITs are correlated, look at the graph below.
Source: University of New Hampshire
As you can see, NPI has a long history of having a low correlation to the stock market. However, keep in mind that the NCREIF Property Index (NPI) factors in more than just multifamily. It also includes industrial, retail, office, and hotel. If you just looked at multifamily alone between 1983 and 2012 the correlation coefficient is even less at 0.13. This makes commercial multifamily highly uncorrelated to the stock market and ideal in many situations for diversification.
Achieving a similar degree of diversification from REITs has not been possible. If you look at the REIT-stock correlation between 1972 and today. You will find that the correlation coefficients range between 0.56 and 0.72. It did dip down in the mid to late 1990s but has been showing an alarming trend upward even above its historical average. While it has dropped some since its peak of 0.89 it still remains remarkably more correlated to the stock market than direct ownership of commercial multifamily real estate.
#5 – Safety/Stability
Our investor network knows that all investments have risk, but those investments don’t all have the same risk. The volatility of the stock market has made them wary and they want more stability in their portfolio. Therefore they look to multifamily to provide that.
Direct ownership of commercial real estate has the best risk adjusted return (Sharpe ratio) over the last twenty years in comparison to other asset classes. Keep in mind that NCREIF property index (NPI) reflects all categories of commercial real estate.
When commercial multifamily is examined by itself, the 20-year return is higher and the annualized risk is lower. That combination creates an even higher Sharpe ratio.
Given this fact, it should come as no surprise that adding direct ownership of real estate to a paper asset portfolio has had the effect of increasing returns and enhancing stability.
Examine the charts below to see how adding a 10% allocation into commercial real estate over the last 20 years would have resulted in higher returns, lower volatility, and a better Sharpe ratio than a portfolio made up of entirely paper assets. Increasing it to 20% would have created incrementally better stability and returns as well.
This fact is particularly important given that many professional investors believe the U.S. stock market is overvalued. Note the all-time high reflected in the 2017 Bank of America Merrill Lynch fund manager survey. More and more professional investors are becoming wary of the stock market.
Another key point that our investors consider is the commercial banking industry’s due diligence and performance. For example, the mortgage bankers association (MBA) keeps track of 60-day delinquencies rates for commercial multifamily real estate.
Since 1998, those conforming to strict underwriting standards (commercial Fannie Mae, Freddie Mac, and Life Insurance Companies) have enjoyed 60-day delinquency rates well below 1.0%.
Direct ownership of real estate has long been a favored alternative investment for many high-earning/high-net-worth individuals. In the wake of the financial recession a low yield, high volatility economic environment emerged. Leery of stock market volatility, many investors are looking for more stable alternatives.
Unfortunately, until recently bond yields have declined to historic lows leaving many wondering where to turn. Perhaps J.P. Morgan Asset Management said it best when they said:
“…the reality is that investment portfolios focused on the “Big Two Traditionals,” bonds and equities, are forcing investors to compromise – either by sacrificing return for lower volatility or enhancing return at the expense of higher risk. Real estate may offer a way out. This is why we believe real estate is increasingly being viewed, not as an alternative, but as an essential portfolio component.”
I couldn’t agree more.
Why Invest in Real Estate? The Answer is Clear
I speak with investors every day who see apartment investing as that way out. After all, it can provide tax-advantaged multisource income from an asset class with low correlation to the stock market.
When investors weigh those facts with the current demographic trends they come to the same conclusion as the Urban Institute. After their major demographic study authored in 2015, they concluded, “We are not prepared for the growth in rental demand.”
They call it, “A perfect storm of factors” causing the decline in the homeownership rate. They go on to say that, “From 2010 to 2030 we’ll see five new renters for every three new homeowners.”
While homeownership peaked in June 2004 at 69.2%, it was down to 65.1% in 2010. The Urban Institute estimates it will continue to drop to 62.7% by 2020 and to 61.3% in 2030.
That decline in homeownership, along with several other factors, has fueled impressive rental demand.
Factor in the large supply of 20-34-year-olds (cohort that rents the most) and it’s easy to see why commercial multifamily real estate is so appealing.
If you’re not investing in commercial multifamily real estate, the better question is, “Why not?”