Three Not So Obvious Reasons for Owning CRE
Appearing on the broker list. This post originally appeared on Doug Marshall’s Blog Marshall Commercial Funding Blog and is republished with permission.
Why should you invest in real estate, especially since there are many other types of assets to choose from? There is one overpowering reason to do so, but before I tell you what it is, I want to explain the benefits of owning commercial real estate.
Four Well-Known Reasons
When comparing commercial real estate to owning most other types of investments, there are four distinct advantages:
- The positive cash flow from real estate is a major advantage over owning most other types of investment. Stocks and bonds can also provide positive cash flow from their dividends. Bonds much more so than stocks, as an average dividend yield on the New York Stock Exchange is about 2 percent. But well managed CRE should generate significantly better cash flow, conservatively 6 to 8 percent and higher is not uncommon.
- 1031 exchanges on the sale of investment properties allow investors to defer capital gains taxes for decades. But if you sell another type of investment, you pay the capital gains that year.
- Depreciation on real estate shelters income, reducing the investor’s income tax burden. No such tax benefit exists for owning other asset classes.
- Using debt to buy property substantially increases an investor’s cash-on-cash return. How this happens will be explained in greater detail later in the book, but for now realize that modestly leveraging a property with debt can significantly improve its return on investment. This is a huge advantage of owning CRE over other types of investments.
These four reasons for owning real estate are commonly known benefits. However there are also three not so obvious reasons why investing in real estate is far superior to owning other types of investment assets. In my comments below, I will specifically focus on comparing real estate to owning stocks, because for many investors that is the logical alternative investment to owning real estate. But I believe this comparison is true of most other types of investments, not just owning equities.
Three Not So Obvious Reasons
1. The Concept of Efficient vs Inefficient Markets
The first less obvious reason to invest in real estate rather than owning stock has to do with the concept of efficient vs. inefficient markets. In an efficient market, everyone has the same financial information.
And you buy at whatever the price is. The stock market is a good example of an efficient market. Investors know the value of each stock. They have no legal way to buy a stock below the established market price.
The real estate market, on the other hand, is a perfect example of an inefficient market. The price of a piece of property is determined by what the seller and buyer agree upon. It has very little to do with the market at large. You make me an offer, and if I agree to it, we have a deal. It’s as simple as that.
It is far more advantageous to invest in an inefficient market because you may have information that the seller doesn’t, and this can make your investment worth much more than what the seller thinks it is worth. This happens all the time. The buyer sees a for-sale listing through a different set of eyes than the seller. He sees the property, not as it is, but for what it has the potential to become. Now the seller has decided it’s time to sell, for whatever reason. He doesn’t see the property’s potential. Instead he sees the issues that plague his property. Who has the more accurate assessment of the property? No one knows with certainty, even when the sales price is agreed to between seller and buyer. But over time, the property’s true potential will become readily apparent.
So the first not so obvious advantage of owning real estate over owning common stock is that it’s possible to buy real estate at a bargain price. You can never buy stock at a bargain, only at what is considered the market price.
2. RE Owners Can Influence the Outcome of Their Investments
The second not so obvious reason to invest in real estate rather than owning other types of investments is that real estate owners have considerable influence on the outcome of their investments. They can:
- make capital improvements to tired properties,
- change management for those properties that are poorly managed, an
- re-tenant properties with better quality and higher paying tenants.
As an owner of stock, you’re a passive investor with no influence whatsoever on the value of your investment. You are truly a passive investor. You are at the whim of the emotions that control the stock market. Your particular stock might be doing well right now. But if the market takes a downward cycle, your stocks are going down in price with the rest of the market.
But the successful CRE investor is actively engaged with considerable influence on the value of his investment through a variety of ways. In commercial real estate, you actually have quite a bit of control over your investment and its potential for growth.
3. No More Need for Retirement Calculators
Finally, the third less obvious reason to invest in real estate versus stocks is no more need for retirement calculators. Yes, you heard me right, and here’s why I say this. You’ve likely seen the television commercials where people are asked how much money they think they need to save over their lifetime in order to retire comfortably. Their response is typically a shrug of the shoulders, a bewildered look, a financial guess, a “beats me,” or something equivalent. If your investments are in stocks, bonds, undeveloped land, precious metals, or other commodities, then a guess is about the best answer you can give. Who knows where these markets will be in ten years, twenty years, or thirty? It’s anybody’s guess, including the investment banking firm that produced the TV commercial.
But this is not so with commercial real estate. You can make a reasonable estimate as to how much you’ll need to have accumulated in real estate in order to retire comfortably. All you need to know are the answers to these three basic questions:
- How much annual income before taxes do you need to retire comfortably?
- When you retire, how much are you expecting to receive annually from social security or other pensions you will receive?
- What is the current cash-on-cash return you’re receiving on your real estate investments?
Here’s an example
For example, let’s assume that you want $100,000 a year in income before taxes to live comfortably. As you get close to retirement age, the Social Security Administration sends you an annual letter stating what you will receive from them when you retire. Let’s assume you and your spouse will receive a total of $40,000 annually from social security.
Now, to determine your current cash-on-cash return on your real estate investments, add up all owner disbursements you received last year on your rental properties and then divide by the total initial cash investment in all of your properties. Depending on how good an investor you are, that could be anything, but I believe a 6- to 8-percent cash-on-cash return is a conservative estimate on well managed properties. So for discussion purposes, let’s assume your commercial real estate portfolio had a 6 percent cash-on-cash return last year. Now, let’s do the math:
Dividing $60,000 by 6 percent results in $1 million you will need to invest to make up the shortfall from your social security checks. In other words, over your lifetime, you will need to slowly grow your real estate investments until you have $1 million invested. If you are just starting out investing in real estate, this sounds like an enormous sum. But in reality, with prudent investing, this amount is attainable, in fact, quite likely to reach.
The good life – living off your rental property cash flow
So, in this example, in order to live comfortably, you will need to have invested $1 million in real estate generating on average a 6 percent cash-on-cash return. If you do, you will never have to worry about running out of money as long as your properties are generating 6 percent annually.
What happens if high inflation hits? If your rents over time increase with the rate of inflation, you’ll be fine. Living off the cash flow of your real estate portfolio means you never need to sell your properties to maintain your lifestyle. In fact, over time, your properties will continue to appreciate, increasing your equity even further in the years ahead.
Those are my thoughts. I welcome yours. What do you see as the primary advantages of owning CRE over another type of investment?
Sources: “Dividend Yield for Stocks in the S&P 500,” IndexArb, February 26, 2014, http://www.indexarb.com/dividendYieldAlphasp.html;“9 Reasons Why Investing in Real Estate Is Awesome (and Better Than Stocks!),” by Mark Ferguson, BiggerPockets, November 10, 2013, https://www.biggerpockets.com/renewsblog/2013/11/10/9-reasons-investing-real-estate-awesome-better-stocks. “Real Estate Is Better Than Stocks—Fact, Not Opinion,” by Ben Leybovich, BiggerPockets, November 19, 2013, https://www.biggerpockets.com/renewsblog/2013/11/19/real-estate-better-stocks.