Direct participation in commercial real estate (CRE), private investments via pass-through vehicles, as opposed to publicly-traded REITs, has long been a key asset class for most larger portfolios. Online marketplaces such as RealtyShares have now made CRE available to accredited investors generally.
These investments provide meaningful diversification to any portfolio. The Yale Endowment, for example, in its 2016 report notes that real estate’s “steady flow of income with equity upside creates a natural hedge against unanticipated inflation without sacrificing expected return.”
Direct participation in commercial real estate make up a unique asset class, one that acts and behaves differently from many other investment classes like stocks or bonds.
Investments can produce both current income and appreciation (value changes). A key feature of commercial real estate investment is that a significant portion of total investment return is derived from income flows (pass-throughs of current excess rental income), as opposed to price appreciation. This income component can provide some degree of protection during periods of stress in the financial markets, and real estate can be notably different from other investable assets in this respect.
Current income is important. With the stock market, for example, dividend yield has arguably accounted for almost half of stocks’ total returns. So, when inflation is taken into account, the dividend component represents an even greater portion of stocks’ annual investment return.
The income component of commercial real estate also generally helps to temper its volatility as compared to asset classes like stocks, where price movements constitute a bigger portion of overall return rates.
As can be seen from the above table, over time direct commercial real estate has (despite the occurrence of the Great Recession) generally exhibited relatively good stability, with less volatility than stocks or even publicly traded REITs, even while delivering returns that are comparable to those of stocks. This is due in part to direct real estate investments not being publicly traded, and thus less subject to news headlines and macroeconomic events. Long-term rental arrangements also generally drive relatively steady operating income, which again represents a much larger portion of total commercial returns than for equities.
Real Estate is a Hard Asset
Real estate is a “hard” asset that has meaningful intrinsic value. Not only do the buildings have value – so does the land itself. Well-chosen properties can provide some security that some value will be retained even if the property does not reach its full potential.
Hard assets are typically a strong inflation hedge, and are also valued because they can often be used to produce other goods or services. In these respects, real estate is generally considered a relatively strong store of value. Banks are more willing to lend against real estate than they are against stock portfolios, for example.
Potential Hedge Against Inflation
As prices of goods and services increase in the broader economy, real estate can benefit, since rising wages and profits generally increase the amount that tenants are willing to pay for space. Those same factors also contribute to rising construction costs, so that replacement values tend to increase – driving existing commercial real estate prices higher as well. Rent escalation clauses in many leases, in addition to organic rental growth, can also provide an inflation hedge.
Commercial real estate offers two ways to diversify your investment portfolio:
The return correlations of commercial real estate compared to other asset classes has historically been low. A drop in the stock market does not necessarily correlate to a fall in real estate. Commercial real estate is a longer-term play; extended lease terms, sensitivity to development activity, and other factors give commercial real estate a meaningful ability to reduce portfolio volatility through diversification.
Diversification can also be found within commercial real estate. Each major commercial property type has its own set of economic drivers; offices are affected by job growth, multi-family apartments are driven by demographics, and business and leisure travel factors into success of hotels. Properties in different geographies can also help diversify a commercial real estate portfolio. Finally, investors can often participate not only in equity opportunities but also in lending investments, where investors act in many ways like a bank.
The tax benefits of direct participation interests in commercial real estate can be attractive. If properly structured, deductions related to depreciation, interest expense, and other items help to defer the taxes on cash distributions. These shelters can permit investors to receive a return similar to a tax-exempt bond except that real estate returns have historically been substantially higher. Most of these tax benefits may be recaptured at the time of the property’s sale, but in the meantime investors may have tax-free use of the distributed cash.
Direct investments in real estate still carry significant risk. Ongoing disclosure requirements are negligible. The investments are also illiquid, with undetermined holding periods and no real preset liquidity terms. These offerings are also only available to accredited investors, so the illiquid nature of any investment is heightened – further emphasizing the differences of these securities compared to registered, publicly-traded securities.
Despite the risks, however, commercial real estate is (ignoring cash) the third largest asset class in the United States. Commercial real estate has unique characteristics, and its ability to provide current cash flow, low volatility, a hedge against inflation, diversification, tax benefits, and its nature as a hard asset all argue for its inclusion in an investment portfolio.
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Lawrence Fassler, an attorney and real estate investor, is Corporate Counsel of RealtyShares. You can reach him at firstname.lastname@example.org.
**Neither RealtyShares, Inc. nor North Capital Private Securities Corporation, as institutions, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance. All of the investments offered by RealtyShares are private offerings, exempt from registration with the SEC, and the disclosures are less detailed than would be expected from a registered public offering.**