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Why Does Commercial Real Estate Belong in Your Portfolio?

Prudent investors understand that diversification is a cornerstone of financial stability in any portfolio. Among the various options for diversification, one of the most prominent alternatives to conventional investments - such as stocks, bonds, and cash - is real estate. This asset class offers both current income and long-term wealth generation, and has proven to be an effective hedge against inflation, especially in today's economic climate.

In 2024, with inflation still a concern and interest rates remaining elevated, the inclusion of real estate in a diversified portfolio is more crucial than ever. Here’s why real estate private equity should be a key component of your investment strategy.

Institutional Portfolios Include Real Estate

One of the most compelling reasons to invest in real estate is the opportunity to mirror the investment strategies of the world’s largest institutional investors – pension funds and endowments. These institutional investors typically allocate about 8% to 15% of their assets to real estate, recognizing its value in achieving stable, long-term returns. In contrast, the average individual investor allocates only about 3% of their portfolio to real estate, while high-net-worth individuals tend to invest around 10% to 20% in this asset class. Financial advisors have traditionally recommended that investors allocate 20% to 30% of their portfolio to real estate while ultra-high net worth individuals tend to have even larger real estate allocations.

This discrepancy suggests that many investors are underexposed to real estate, potentially missing out on the diversification benefits and returns that this asset class can offer. For those looking to align with best practices in portfolio management, increasing real estate allocation to match institutional strategies could be a wise move.

Increased Return on Investment

Real estate has historically performed well relative to other investment options. Average 20-year returns for commercial real estate typically range from 7% to 9%, while the S&P 500 has averaged closer to 8% to 10% annually over similar periods. However, real estate offers benefits such as income stability through rental yields, lower volatility, and a hedge against inflation, which can make it an attractive component of a diversified portfolio.

Unlike stocks, which are subject to immediate divestment and market fluctuations, real estate income streams are often secured by long-term lease contracts that offer stability and predictability. In an environment where interest rates are rising, this stability is particularly attractive. Additionally, the inherent illiquidity of real estate helps buffer against the volatility often seen in the stock market, leading to more consistent value appreciation over time. In other words, because it is much harder to quickly sell an asset when a market is trending downward, investors are more likely to hold, which allows the broader market to rebound more quickly.

Real estate investments also offer the dual benefit of immediate cash flow and long-term wealth generation. Rental income provides a steady cash flow, while the value of the property itself appreciates over time as rents increase. This combination of income and appreciation makes real estate an ideal asset for investors seeking both current income and long-term growth.

Multifamily and Senior Housing: Strategic Investments for 2024

In the current economic environment, certain real estate sectors are particularly well-positioned for growth. Multifamily housing and senior housing stand out as strong investment strategies, each benefiting from unique market dynamics and demographic trends.

Multifamily Housing: The multifamily sector remains resilient, driven by ongoing housing shortages and strong rental demand. As of 2024, the national vacancy rate for multifamily properties is estimated to be approximately 5.5% to 6.25%, with rental rates projected to grow at a more modest 1% to 2% annually. These factors contribute to the sector’s stability and make it an attractive option for investors looking to hedge against economic uncertainty. Within the multifamily asset class, HFC tax abatement deals are particularly interesting in the current economic climate given the ability to immediately increase net operating income through a decrease in property taxes – as opposed to renovating and pushing rents.

Senior Housing: The senior housing market, including assisted living and memory care facilities, is experiencing significant growth due to the aging Baby Boomer population. With the senior population expected to increase dramatically over the next decade, demand for senior housing is projected to grow at a compound annual growth rate (CAGR) of 5.5%. In 2024, occupancy rates in senior housing have rebounded to over 83%, reflecting the strong and growing need for these facilities. Alpha Investing’s portfolio with Titan SenQuest is over 90% occupied as of Q2 2024, which provides strong evidence in the effectiveness of implementing institutional management.  Investors focusing on senior housing can benefit from both development opportunities and the acquisition of existing properties to meet the needs of an aging population. With that said, there is significantly less capital chasing acquisitions, which allows a savvy sponsor to create a competitive buying advantage while also generating passive income for investors.

Tax Benefits

Tax considerations are a major factor for many investors, and commercial real estate offers several advantages over conventional investments. For example, real estate depreciation allows investors to defer tax liabilities on profits, reducing their taxable income. Real estate equity investors will typically receive a K-1 tax document each year showing a passive loss created by the pass through of depreciation expense. This passive loss will usually offset any cash flow investors have received during the year, and in some instances where bonus depreciation is available, investors may see K-1 passive losses well in excess of their distributions received. Additionally, expenses related to property maintenance, renovations, and repairs can often be deducted, further enhancing the tax efficiency of real estate investments.

The 1031 exchange is another powerful tool, allowing investors to defer capital gains taxes indefinitely by reinvesting the proceeds from a property sale into a similar property. Moreover, the establishment of Opportunity Zones under the 2017 Tax Cuts and Jobs Act offers significant tax incentives for investments in designated areas, including potential reductions or forgiveness of capital gains taxes.

Diverse Opportunities

The perception that commercial real estate is out of reach for many investors is changing, thanks to regulatory developments like the 2012 JOBS Act. While few real estate sponsors or syndicators actually rely on the provisions of the JOBS Act when raising capital from individual investors, the idea behind this legislation has led to increased access to institutional-caliber commercial real estate investment opportunities with lower minimum investment thresholds, making it possible for more investors to participate in this asset class.

These lower minimums also allow for diversification within real estate, enabling investors to spread their capital across multiple properties and reduce risk. For example, an investor can allocate funds across multifamily properties, senior housing, and other commercial real estate sectors, thereby enhancing their portfolio’s resilience and potential returns.

Prior to 2012, individual investors primarily accessed real estate private equity through friends and family syndications, which were more likely to be with a smaller, local sponsor. Today, investors are able to deploy capital with institutional sponsors through a number of deal structures – e.g., syndications or funds with low minimums tailored to accredited investors.

Important Component of any Well-Balanced Portfolio

While the benefits of real estate private equity are clear, it’s important to recognize that real estate investments come with risks. Unlike stocks and bonds, real estate is not typically covered by professional analysts, meaning that due diligence falls squarely on the investor or their advisor. It’s also important to note that real estate investment opportunities are typically marketed to investors based on forward looking assumptions. As a result, savvy investors should understand the sponsor’s  key assumptions included in their underwriting (and if they’re reasonable) for any given deal.

Finding a reliable, experienced management team to curate and manage real estate transactions is essential to incorporating real estate into a diversified portfolio. With the right expertise, real estate can provide both income and wealth growth, making it an integral part of any well-balanced investment strategy.

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