Investing Merits Of Commercial Real Estate

The ultra-wealthy family offices and institutional investors like university endowments and private investment funds don’t flip houses. That’s because the returns from flipping houses come from a single source:  appreciation - the difference between the purchase and eventual sale price.

Sophisticated investors are interested in far more than appreciation when it comes to real estate investing. They seek multi-dimensional returns - returns derived from growth and income and - in a roundabout way - from tax savings. That is why sophisticated investors gravitate towards commercial real estate.

What is commercial real estate? Commercial real estate (CRE) is income-producing real estate. It’s a property designed to make money.

The six primary CRE asset classes include:

• Multi-family.
• Office.
• Industrial.
• Retail.
• Hospitality.
• Development.

Why commercial real estate and what are the investing merits of CRE that drive sophisticated investors to pour billions into this asset class every year?

Here are the principal merits of investing in CRE that I have discovered from my own experience:

1 - PROVEN COMMODITY.

Billionaire Andrew Carnegie famously said that 90% of millionaires got their wealth by investing in real estate. The top 10 real estate billionaires in America made their fortunes acquiring, developing, owning, and operating commercial real estate.

2 - HIGH RETURNS.

Compared to residential property, CRE properties leverage the power of scale. Instead of collecting rents from a single tenant from a single-family property, CRE properties offer the potential to collect income from multiple tenants.

Multi-tenant properties also lend themselves to economies of scale to reduce costs on a per-unit basis. The multiplier effect on the income side, along with the economies of scale effect on the expenses side, is how investors can achieve higher returns from CRE compared to residential properties.

3 - LARGE INVESTABLE UNIVERSE.

Not only are there six CRE asset classes to choose from, but investors also have investment options based on a property’s location, condition, and tenant profile (A-D) and by investment strategy (Core, Core-Plus, Value-Add, and Opportunistic). In other words, there are countless opportunities to make money in the CRE space.

4 - TAX BENEFITS.

To the ultra-wealthy, saving a dollar is just as valuable as earning an extra dollar. The wealthy don’t care where that extra dollar is earned, whether from tax savings or income generation.

CRE investments - and in particular passive investments structured as partnerships - offer many tax benefits, including business deductions, regular depreciation, bonus depreciation, long-term capital gains treatment, avoidance of self-employment taxes like FICA, tax deferral through 1031 exchanges, etc.

5 - LEVERAGE AND SCALING.

Commercial real estate loans allow investors to leverage their capital across multiple properties instead of a single property. Instead of sinking $500,000 into a single property, sophisticated investors will use the $500,000 as down payments on loans to acquire five properties. Leverage allows for scaling unique to CRE, allowing for superior returns compared to single properties - even when accounting for debt servicing.

6 - DIVERSIFICATION.

Holders of multiple CRE assets are better insulated from market downturns and recessions than investors in other asset classes like public equities because CRE allows for diversification beyond the diversification across multiple stocks practiced on Wall Street. When the whole market sinks, diversification won’t save your portfolio.  

CRE lends itself to a different type of diversification - a type more well-suited for weathering financial storms.

Diversification through various elements, including geographic market, asset segment, property type, investment strategy, compensation structure, and security type, is an ideal hedge against downturns. That’s because not every asset will be equally affected by a downturn.

Income from certain performing investments can compensate for underperforming assets to help your portfolio ride out a storm.

7 - RECESSION AND INFLATION HEDGE.

Investments in the right CRE segments with a demand that doesn’t waiver in the face of recession or inflation are ideal portfolio insulators. Historically, the segments deemed to be essential-have weathered downturns and inflation the best.

For example, multi-family - especially in the mid to affordable range - have performed well during the recession and inflationary periods as consumers downsize or allocate their resources to more affordable options.

The COVID-19 pandemic bore out multi-family’s resilience. According to CBRE, multi-family weathered the 2020 recession better than most property sectors, and market deterioration was far less than in previous recessions.

Multi-family is also expected to rebound quicker than other sectors, with a return to normalcy is expected as soon as by the end of this year.  

8 - INSULATED FROM THE MOB.

The relatively high barrier entry, investor sophistication, qualification requirements, and illiquidity associated with CRE insulates it from the risk of market volatility posed by mob mentality and the madness of the crowds.

Liquid markets with low investment entry points open the door to wild market swings not seen in CRE. You’ll never see CRE lose 50% of its value within only a matter of a month, as bitcoin and other cryptocurrencies have recently experienced.

Investing in CRE can be highly rewarding, as many self-made billionaires and millionaires have demonstrated, but not all CRE segments are created equal. Some are more resilient than others, and some are trending upwards (multi-family) more than others (retail).

Investments in the right CRE segment with positive trending data that thrive even in downturns offer maximum ROI potential from consistent, reliable income, long-term growth, and tax benefits.