Most investors believe in the value of diversification. Among the major asset classes, for example, it’s often the case that stocks, bonds, and property values do not always move in tandem. During the dotcom bubble in stocks, for example, both housing and bonds looked relatively cheap.
The stock market’s wild gyrations in August were enough to put knots in the stomachs of many investors. For those who believe that equities are getting frothy, there certainly is some supporting evidence available. A Yale survey, for example, shows that “valuation confidence” is at historical low levels. Robert Shiller has pointed out that a Cyclically Adjusted Price Earnings ratio (CAPE) is still well above the historical average.
At such times, investors might well want to look again at whether their portfolio’s asset allocation is appropriate. Commercial real estate (CRE) has always been a key asset class for most larger portfolios, and crowdfunding sites have now made CRE available to accredited investors generally. Commercial real estate is a unique asset class that acts and behaves differently from many other investment classes like stocks or bonds – and real property valuations are thought to be only at average levels.
Many have earlier discussed the salient features of investing in commercial real estate, but the primary points are worth reviewing again during these turbulent times.
A key feature of commercial real estate investment is that a significant portion of total investment return is derived from income flows as opposed to price appreciation – nearly 80%, according to some sources. This income component can provide some degree of protection during periods of stress in the financial markets, and real estate is notably different from stocks in this respect.
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 offers two ways to diversify an 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. Finally, at crowdfunding companies like the one I work with, investors can participate not only in equity opportunities but also in lending investments, where investors act in many ways like a bank.
As mentioned earlier, investments can produce both current income and appreciation (value changes). Investments with a significant income component, like commercial real estate, often tend to be less volatile. Compared to asset classes like stocks, where price movements constitute a bigger portion of overall return rates, commercial real estate has a substantial income component that generally helps to temper its volatility.
Despite occasional corrections in the real estate markets (and here we can’t, of course, forget the Great Recession), commercial real estate has generally exhibited relatively good stability, as can be seen from the above chart. Indeed, its volatility is more akin to bonds than to stocks or even publicly traded REITs. The income component is the primary driver here; rental lease terms, for example, generally help to mitigate economic fluctuations and their impact on income.
Potential Hedge against Inflation
Commercial real estate has 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.
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 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. Most 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.
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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.
RealtyShares offers equity securities through WealthForge, LLC, member FINRA/SIPC. RealtyShares as an institution does not provide tax, legal or investment advice, and this article should not be construed as such. Before making any investment, investors should consult with their own attorneys, accountants or other investment advisors.
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