Why Commercial Real Estate Deserves a Place in Your Portfolio

Crowdfunding companies have brought to accredited investors opportunities in commercial real estate, a unique asset class that acts and behaves differently from many other investment classes like stocks …

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Crowdfunding companies have brought to accredited investors opportunities in commercial real estate, a unique asset class that acts and behaves differently from many other investment classes like stocks or bonds. Major investment institutions generally allocate a significant portion of their investment capital to commercial real estate.

Commercial real estate can provide many benefits to investors, but it’s only with crowdfunding that these opportunities have become more accessible to individual investors. We’ll discuss here some of the benefits of this asset class.

Cash Flow

Investments can produce both current income and appreciation (value changes). The better crowdfunding companies often focus on properties producing current income — cash flow – because it’s believed that stable income can provide some degree of protection during periods of stress in the financial markets. Real estate is different from stocks in this respect – the income component accounts for a much larger portion of total returns than it does for stocks, for example.

Recent low interest rates have made real estate income properties that much more attractive. Government bond yields are near all-time lows, and even corporate bonds don’t generally match the cash-on-cash returns available from the better real estate investments.

Commercial Real Estate Income Returns vs. Other Asset Classes (Q1 2013)

Commercial Real Estate Returns

 

Low Volatility

The income component of commercial real estate generally helps to temper its volatility as compared to asset classes like stocks, where price movements constitute a bigger portion of overall return rates. Despite the Great Recession, commercial real estate business cycles are often less pronounced — rental lease terms generally help to mitigate economic fluctuations and their impact on income. Over time, commercial real estate has generally exhibited relatively good stability — more akin to bonds than to stocks or even publicly traded REITs.

Commercial Real Estate Income Generally Leads to Lower Volatility
(Chart Measures Q2 1983 to Q1 2013)

Commercial Real Estate Income

 

Real Estate is a Hard Asset

Real estate is a “hard” asset that has meaningful intrinsic value. Not only does the structure have value – so does the land itself. Well-chosen properties can provide some security that some value will be retained even if the property does not reach its full potential.

Hard assets are typically a strong inflation hedge, and are also valued because they can be used to produce other goods or services. In these respects, real estate is generally considered a relatively safe store of value. Banks are more willing to lend against real estate than they are against stock portfolios, for example.  

Potential Hedge against Inflation

Commercial real estate has often been found to have a high degree of correlation to inflation as compared to other asset classes. As prices of goods and services increase in the broader economy, real estate can benefit, since rising wages and profits generally increase the amount that tenants are willing to pay for space. Those same factors also contribute to rising construction costs, so that replacement values tend to increase – driving existing commercial real estate prices higher as well.

Commercial Real Estate Offers a Good Hedge against Inflation
(correlation factor)

Commercial Real Estate As Inflation Hedge

 

Diversification

Commercial real estate offers two ways to diversify your investment portfolio.

The return correlations of commercial real estate compared to other asset classes has historically been low. A drop in the stock market does not necessarily correlate to a fall in real estate. Commercial real estate is a longer-term play; extended lease terms, sensitivity to development activity, and other factors give commercial real estate a meaningful ability to reduce portfolio volatility through diversification.

Diversification can also be found within commercial real estate. Each major commercial property type has its own set of economic drivers; offices are affected by job growth, multi-family apartments are driven by demographics, and business and leisure travel factors into success of hotels. Properties in different geographies can also help diversify a commercial real estate portfolio. 

Tax Benefits

The tax benefits of direct participation interests in commercial real estate can be attractive. If properly structured, deductions related to depreciation, interest expense, and other items help to shelter or defer the taxes on cash distributions. These shelters can permit investors to receive a return similar to a tax-exempt bond – except that real estate returns have historically been substantially higher. Some or all of these tax benefits may be recaptured at the time of the property’s sale, but in the meantime investors may have tax-free use of the distributed cash.

Commercial real estate is the third largest asset class in the United States, representing nearly 10 percent of the country’s overall invested assets. No investment is guaranteed, of course, and a commercial real estate investment can lose value just like any other investment class. Commercial real estate has unique characteristics, however, and its ability to provide current cash flow, low volatility, a hedge against inflation, diversification, tax benefits, and its nature as a hard asset all argue for its inclusion in an investment portfolio.

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