Investors consider real estate because it offers both current income as well as long term wealth generation. It’s also a proven inflation hedge. While there are many reasons to include real estate in a portfolio, here are are some that we find most important:
Institutional Portfolios Include Real Estate
One of the most often cited reasons for investing in real estate is to mimic the investment strategies of the largest investors in the world – pension funds and endowments. Mirroring these funds is adopting what’s considered investment best practices. On average, this vast institutional cadre invests 10% of their assets in real estate and yet the average investor overall has only 3%. This low average indicates that a lot of people have no real estate investments, while the average high net worth investor has an allocation of 12% of their portfolio in real estate.
Increased Return on Investment
Commercial real estate has historically performed well relative to other investment options. Average 20-year returns in the commercial real estate sector slightly outperform the S&P 500 Index. With these enhanced returns comes greater stability.
Whereas stocks and other tradable assets are subject to immediate divestment and to the whims of the market, real property income streams are often secured by long term lease contracts that provide stability and predictability.
Furthermore, real estate is inherently less liquid than stocks – it cannot be sold at a moment’s notice – so the worst excesses of stock market swings are evened out for real estate, allowing for more consistently sustainable value appreciation.
Real estate also beats out conventional investments because it can provide both immediate cash flow as well as longer term wealth generation. Current income streams come from the excess cash flow generated by rents, while the buildings’ overall value increases over time as rents increase, building wealth.
For many people looking to put their money into investments, tax issues are a major concern. The good news is that commercial real estate offers a number of tax advantages over conventional investments.
For example, buildings begin to depreciate after acquisition, and the tax code permits for this depreciation to defer immediate tax liabilities on profits. In addition, renovations, repairs, and other associated expenses that come with keeping a commercial property well maintained can also be tax-deductible. Under certain circumstances, capital gains tax obligations can be deferred indefinitely through like kind reinvestment in real estate, through what are known as 1031 exchanges.
The passing of the Jobs and Tax Act in 2017 provided for the establishment of Opportunity Zones where taxes due on capital gains can be substantially reduced or even completely forgiven. This includes both long- and short-term capital gains, as well as capital gains accruing from any source – including even the sale of art, for example.
Due to the expense of buying a commercial property outright and a decades long prohibition from general solicitation which made commercial real estate investment the prerogative of a small minority, investors can be forgiven for thinking that commercial real estate is out of reach.
With changes in regulations, specifically the 2012 JOBS Act, investors now have access to vetted, institutional caliber commercial real estate investment opportunities with small minimum investment thresholds. These small minimums mean that diversification within real estate is possible. By not needing to invest a large proportion of one’s net worth in an individual transaction, investors can mitigate risk and enhance returns further by diversifying within the real estate asset class itself.
Important Component of any Well-Balanced Portfolio
While all of these are good reasons for holding commercial real estate in a portfolio, recognizing that there is substantial risk investing in real estate is also important. Unlike stocks and bonds, real estate investments are not usually covered by professional analysts. Examining the details becomes the obligation of the investor or their advisor.
Finding a reliable, experienced management team to curate transactions is a good start in the process of incorporating real estate into any portfolio seeking diversification.