Posts by Bruce Warner
Perhaps the most discussed trend in commercial real estate in recent years has been the Millennials, the age cohort who are changing work and living arrangements across the nation. A relatively less covered demographic trend of greater size and perhaps importance is the aging population. According to data from the U.S. Census Bureau and analyses by the Lakemont Group, the overall population in the United States is forecast to grow by 11.55% in the next 15 years while the population above the age of 75 is forecast to grow 69.21%. In fact, those over 75 years old will represent almost 10% of the population by 2030 (those above 65 will be over 20% as well).
While many real estate market participants correctly use these statistics to justify the need for more senior housing, there are actually many other real estate opportunities to service this growing segment of the population. Market rate apartments with features and locations this demographic wants, can use, and can afford is one such example. Properties to house medical services and activity retail is another.
We encourage investors to think long-term when making acquisition, disposition, and asset management decisions. This is one long-term trend that could shape demand for many property types for decades into the future.
Are We In a Commercial Real Estate Bubble?
The most meaningful indicator of a potential bubble or overpricing of commercial real estate is the spread between cap rates and underlying treasury rates. According to RCA, cap rates averaged 6.5% nationwide during 2015, while the 10-year treasury rate averaged in the low 2% range for most of 2015 and early 2016.
This implies a spread of over 4% (or 400 basis points). Today’s spreads are significantly higher than those observed pre-crash where they averaged slightly below 200 basis points and even below 100 basis points for class A assets in top markets according to the commercial real estate economics researchers at the Lakemont Group.
In summary, the market is not presenting the same risk/return profile observed before the 2007 peak of pricing. Further, debt availability is far more constrained post crisis with total leverage utilization down significantly (in fact, the percentage of all equity transactions in many markets is staggering) and therefore the risk of default is relatively low for most investors and deals. Thus, we believe pricing in commercial real estate markets does not represent a new bubble or other significant source of risk.
Average annual returns in long-term real estate investing vary by the area of concentration in the sector. Average 20-year returns in commercial real estate slightly outperform the S&P 500 Index, running at around 9.5%. Residential and diversified real estate investments do a bit better, averaging 10.6%. Real estate investment trusts (REITS) perform best, with an average annual return of 11.8%.
The S&P 500 Index’s average annual return over the past 20 years is approximately 8.6%. By any measurement, the real estate sector has outperformed the overall market, even factoring in the drastic collapse in housing prices during the 2008 financial crisis.
The real estate sector is divided into two main categories: residential and commercial real estate. Within either category, there are vast and varied opportunities for investors, such as raw land, individual homes, apartment buildings, and large commercial office buildings or shopping complexes. Investors can choose to invest directly in residential or commercial real estate or invest in real estate company stocks or bonds. There are also mutual funds and exchange-traded funds (ETFs) available that track the real estate sector.
Reasons Why Real Estate Is Better Than Stocks
- You Are in Control: Real estate is an investing business that you can manage or delegate management to professionals. You may assess where and how to invest, make asset improvements, cut costs, deduct owner expenses (travel and home office), raise rents and market your services. You directly make your own wealth-building choices. You can also create a property legacy and leave it to your family.
- Leverage Other People’s Money: The benefits of real estate price appreciation are magnified due to the use of bank funds for about 3/4ths of the investment. You can earn a return on your own investment and a cash flow margin on the debt-financed portion of the investment. Your renters pay down or pay off the debt for you. Over time, the value of debt declines due to inflation (you pay off the liability with cheaper dollars) while the asset appreciates.
- Tax Advantages: You can deduct all operating costs, and deduct interest paid to banks, and some otherwise personal expenses through proper planning. You can deduct a non-cash item called depreciation of the entire investment. You may accelerate this depreciation benefit by segregating the costs of the investment into components. You can also indefinitely defer tax on the sale of your investments through Section 1031 exchanges. Cash you actually receive from the investment during the operating period will likely be shielded from all taxation. Upon sale of the investment (if an exchange is not used) you will pay taxes at favorable capital gains rates. If you are a real estate professional, you may offset other types of income with real estate losses each year. If you refinance the property, you may receive cash from the investment without having a tax bill. Your heirs may receive your real estate investments at a stepped-up market value that they then may also depreciate and manage.
- Asset You Can Touch: Real estate is an asset you can see, touch, improve and evaluate. You can insure your title rights. Real estate is very difficult to steal due to the legal environment that surrounds it. Real estate exists in limited quantities; and there are barriers to entry. Since real estate is not a commoditized asset, you can potentially benefit from its imperfect economic pricing characteristics.
- Multiple Sources of Return: Real estate investors benefit from cash flows, price appreciation, debt leverage, tax advantages and operational opportunities.
- Control the Investing Market Place: With real estate you may choose the most favorable markets and specific properties that are available in the marketplace. You can evaluate the expected risks and rewards, rather than leaving those choices to others.
- Favorable Downside Protection: Your bank can’t force you to come up with cash or move out of your property as long as you are paying the mortgage. You may have optionality and inflation protection if financial conditions get difficult. Your real estate may insulate you against adverse economic events that may occur on the world stage or in regions around the country. Remember that housing is an economic necessity to your tenants.
Reasons Why Stocks are Better Than Real Estate
- Stocks are more liquid than real estate. They may be turned into cash within a few days.
- While volatile, U. S. stock markets over the long haul have a good return track record.
- Stocks have lower transaction costs than real estate. Real estate marketers still expect commissions of about 6 percent (or less, depending on the type of asset).
- Stock investments do not require management attention by investors.
- Stock investments come in a wide variety of styles, colors and results and are available from national and international markets.
- Stock investments may result in favorable tax rates on dividends and capital gains.
You May be Well Suited to Multi-Family Real Estate Investments if:
- You believe wealth is concentrated in real assets not paper investment products.
- You have been uncomfortable with stock market volatility and investment scandals.
- You do not trust big business.
- You tend to buy and sell your investments too often. High transaction costs would discourage this behavior if you owned real estate.
- You would enjoy interacting with others about and have pride in your properties.
- You like to feel in control of your own life and investments.
- You are willing to plan for real estate to be a part of your life.
- You like the feeling of providing necessary housing to others.
You May be Better Suited to Stock Investments if:
- You are happy to give up control to others who should know better.
- You can psychologically handle investment volatility.
- You have discipline not to chase market rallies or to sell during market downturns.
- You like to trade investments.
- You enjoy studying economics, politics and researching investments.
- You have a limited amount of investment capital.
- You must have liquidity and immediate access to your assets.