No matter the asset class, one of the bedrock principles of investing is that diversification is key ingredient in the recipe for a well balanced portfolio. Historically, conventional wisdom has suggested that a “basket” of stocks and bonds contains all the diversification necessary for a well balanced portfolio. While this is true, there’s another asset class — private real estate — whose risk profile and return history suggest that it also deserves inclusion in the traditional stock/bond portfolio.
What is Private Real Estate?
Private commercial real estate is characterized by ownership of physical real estate in one of four asset classes: office, retail, industrial, or multifamily. The word “private” suggests that real estate ownership was acquired through non-publicly traded means and there are two ways to do it, directly or indirectly.
An active investor may work alone or with a small group of partners to purchase (and manage) real estate directly, which also allows them to benefit directly from the income and profits produced by the property. But, it also exposes them to portfolio concentration risk because individual investors and small groups may only have the resources to purchase one or a handful of properties.
On the other hand, a passive investor may prefer to gain exposure to real estate by deploying their capital through an asset manager, syndicator, non-publicly traded REIT, or private equity firm. Doing so outsources property identification, acquisition, and management to professionals and provides an opportunity to acquire fractional ownership in institutional quality assets not normally available to individuals. In addition, an indirect purchase increases portfolio diversification because funds are pooled with other investors and spread across multiple properties. But, expertise comes at a price and indirect investment also comes with fees, which may affect return.
Whether purchased directly or indirectly, private commercial real estate ownership can yield significant, material benefits.
Benefits of Private Commercial Real Estate Investment
There’s no question that, when handled correctly, private commercial real estate ownership offers several tangible benefits.
High Return on Investment (ROI)
When an investor decides to deploy capital into an asset, they do so with the belief that they’re going to earn a positive return. Historically, an investment in commercial real estate has yielded a high return on investment through a combination of rental income, depreciation, and capital appreciation.
The return on investment can be high in absolute terms, as measured by a metric called the Equity Multiple1, but it can also be high in relative terms when compared with other asset classes. It’s tough to find an exact proxy for the “commercial real estate” asset class, but a widely used measure — the Vanguard Real Estate Index Fund2 — has returned ~212% over the past decade, which has outpaced other asset classes over the same time frame.
1 Equity Multiple is defined as a property’s total cash distributions divided by the amount of money invested. For example, a $10,000 investment that returns $20,000 yields an equity multiple of 2.00x.
2 Ticker VGSLX
Low Price Volatility
If the goal of an investment is the maximum possible return with the lowest possible price volatility, then private commercial real estate is an option worth exploring. Historically speaking, private commercial real estate prices tend to appreciate slowly over time, based on the cash flow of the underlying property. In contrast, prices for publicly traded real estate securities may trade on the fundamentals of the underlying property, but they’re also be affected by things like: market sentiment, news, or earnings reports.
Low Price Correlation
One of the things that makes private real estate ownership a good complement to the traditional publicly traded stock/bond portfolio is that, in addition to low price volatility, price movements also tend to have a low level of correlation to that of stocks and bonds. This means that prices for stocks/bonds and prices for private commercial real estate tend to move opposite each other. For example, if stock prices are falling, private real estate prices may be flat or rising. Or, if prices for stocks/bonds are rising, private real estate prices may be flat or declining. This is the principal of portfolio diversification at work.
Beneficial Tax Treatment
Lastly, and perhaps most importantly, private commercial real estate comes with a host of benefits related to favorable tax treatment3.
First, depreciation allows a property’s owner to expense a portion of the asset’s value each year to account for its physical deterioration. The expense offsets income, which serves to lower the amount of taxes paid.
Second, upon the sale of the asset, the owner may use a strategy known as a “1031 Exchange” to defer taxes on a gain. Repeated use of a 1031 Exchange may allow an owner to defer taxes indefinitely, which serves to boost overall returns.
But, a private commercial real estate investment isn’t without risk. There are several to be aware of.
Private Commercial Real Estate Risk
The primary risk associated with private commercial real estate is the lack of liquidity. In many cases, a private real estate investment, especially those of the indirect variety, require that an investor’s money be tied up for five or more years.
In addition, indirect private real estate investments can be expensive, returns can be affected by management and acquisition fees, and prices may be driven by macroeconomic factors like job creation or interest rates that are completely out of the owner’s control.
Finding the Right Investment Strategy
Every investor’s risk tolerance, time horizon, liquidity needs, and individual preferences vary, which underscore the need to find the right investment fit for each. Luckily, within the world of private commercial real estate, there are a myriad of choices that make fulfilling this requirement possible.
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets – including middle market service oriented retail shopping centers – well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our middle market retail investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.