Why Invest In Commercial Real Estate?
Commercial real estate investments offer many attractive advantages such as long-term capital preservation, return enhancement, reduced overall risk for a portfolio of assets, generous leverage with less exposure than equities, and tax advantages. Unlike most other types of investment opportunities, real estate allows the creation of near monopolistic operating conditions.
1. Long-Term Capital Preservation
Commercial real estate investments provide protection against value erosion during periods of inflation. It achieves this protection through the impact of Net Operating Income on the capitalized value of the property.
Commercial real estate is valued based on net operating income and the current capitalization rates. The ensuing increase in demand produced by increased inflation also increases the property’s Net Operating Income and consequently its value.
2. Return Enhancer
The Modern Portfolio Theory of Finance defines two general types of investment risks; systematic, or general risks that impact all businesses, and unsystematic, or investment specific risk. Some examples of systematic risk include issues such as inflation, changes in interest rates, or economic growth. Unsystematic risk, or investment specific risk, will include issues such as the impact that an increase in the cost of rubber would have on tire manufacturers, or the impact of an increase in the cost of corn would have on beef production. Clearly assets exposed to different unsystematic, or firm specific risk, will be impacted differently, or even in opposite direction.
Since unsystematic risks can be diversified away by owning a portfolio of investments with different or even uncorrelated assets, the theory demonstrates that investors are compensated for the level of systematic risk in their investments and not for the level of unsystematic risk exposure.
Commercial real estate investments carry a greater unsystematic risk weight than systematic risk. For this reason, commercial real estate investments offer better opportunities to create alpha, or greater risk adjusted returns, than other asset classes.
Research conducted by Professor Frank Fabozzi of Yale University, and published in the Journal of Portfolio Management, demonstrates that in the long-term, commercial real estate investments yield higher absolute returns with lower volatility than stocks and bonds.
Sharp Ratio =
Sharp Ratio = Average Portfolio Return – Risk Free Return / Standard Deviation of the Portfolio Return
The above data shows that, over the long term, real estate investments offer a higher risk adjusted returns than either stocks or bonds.
3. Portfolio Diversification
Research shows that real estate can play a significant role in a mixed asset portfolio because imperfectly correlated assets (with correlation of less than 1) included in a portfolio of investments provide an opportunity to increase risk adjusted returns.
Correlation of Real Estate* to Bonds = 0.342
Correlation of Real Estate* to Stocks = 0.650
Correlation of Real Estate* to Cash = 0.255
*Based on the Property and Portfolio Research Index (PPR Real Estate index)
4. Investment Leverage
Investment leverage is a means of increasing rates of returns. Many financing vehicles are typically available to finance commercial real estate investments, providing a usual loan-to-value ratio of 70%. This represents a leverage of 3.33 : 1, which far exceeds the maximum margin leverage allowed for the purchase of securities which is a maximum of 50%, or a leverage ratio of 2 : 1.
To appreciate the impact of this difference in available leverage, consider the impact on a $1 million investment in real estate and in equities (stocks), both delivering equivalent rates of returns (assumed at 5% per year), and assuming all else equal (i.e. the carrying cost of the debt being covered by operating income of the real estate investment and by the dividend yield in the case of the stocks). The result of this simple model shows a return on investment of 92% on the real estate investment and 55.26% return for equities. This is a 66% higher return for the real estate investment, and this is achieved with 35% less risk than the investment in equities.
While real estate leverage carries a foreclosure risk in the event of non-payment of the loan agreement, mortgage loans are not subjected to margin calls when the market value of the property temporarily falls below the mortgage balance, so long as mortgage service continues. Other assets purchased with leverage, as in the case of securities, require posting additional collateral or the liquidation of securities in order to maintain the margin balance requirements. Another major difference between the risks associated with leveraged securities as opposite to real property is the fact that a real estate mortgage represents an implied call option on the property. Most mortgages are secured only by the value of the property; therefore, the owners’ risk exposure is limited to their original investment. If the value of the property falls below the mortgage balance, the owner has the option to put the property back to the lender without further liability, as indeed occurred often during the recent financial crisis.
5. Tax Advantages of Real Estate
Investments in real estate through limited partnership or limited liability company investment entities may provide many tax related benefits including:
Potential for property appreciation over time
Favorable long-term capital gain tax rates upon sale
Possible tax-deferred distributions from excess mortgage refinancing proceeds
Distributions that may be partially tax sheltered resulting in increased after-tax returns
Tax deferral of gain on sale when proceeds are re-invested in other real property under 1031 like-kind exchange rules
Investment tax credits on qualifying expenditures for properties that undergo extensive improvements
Estate tax savings attributable to minority interest valuation discounts based on IRS acceptance of lack of marketability of non-publicly traded limited partner interests in real estate investments.
Not all securities sponsored by NIGMA Capital & Finance, LLC provide tax advantage benefits. There is no assurance that there will not be legislative or administrative changes in the tax laws that may adversely affect the tax benefits of real estate investments. Investors considering an investment in any of our securities should seek the advice of their financial advisors, accountants, and attorneys.
6. Opportunities for Product Differentiation
No two pieces of real estate are identical. This is the characteristic that allows unique differentiation advantages in real estate. Research by Michael Porter of Harvard Business School has shown that differentiation is a means of gaining competitive advantages; but more importantly, that it is the competitive strategy that provides the highest rates of return. It is not a surprising that Warren Buffett’s investment strategy seeks businesses that have a protective moat against existing and new competition.
Real estate provides many opportunities for differentiation and for building protective competitive moats through the selection of its location, limitation of available supply, cost, design, use, and combination of services offered. In effect, real estate provides opportunities to create monopolistic positions in specific markets due to lack of available sites or other resources that legally limit the degree of competition and produces higher returns.
In summary, commercial real estate Investments offer a number of unique advantages for investors:
Long-term capital appreciation through its use of NOI/Capitalization rates which automatically stabilize the property’s value by increases in NOI caused by higher demand and increased NOI due to inflation.
Higher risk adjusted return due to its higher unsystematic risk weight, which allows higher alphas and opportunities for lower risk.
Highly reduced correlation to other asset classes, allowing significant portfolio diversification benefit and higher risk adjusted returns.
The use of 50-80% leverage, which increases total returns. The maximum leverage available in the equity markets is 50%.
Potentially significant tax and estate planning advantages.
Potentially significant differentiation and price maker business opportunities that generate near monopolistic pricing opportunities, and significant protection from new competitors.
Other Investment Considerations
Diversifying your portfolio with investments in real estate can provide enhanced returns and more stability to overall portfolio performance.
All investments, including those in real estate, involve risk, which may include property market and interest rate fluctuations and illiquidity. Therefore, a comprehensive evaluation and detailed review of all investment documents, including the private placement memorandum, which is the sole means for offering any NIGMA Capital & Finance, LLC sponsored investment to qualified and accredited investors registered with NIGMA Capital & Finance, LLC, should be undertaken before deciding whether to make such investment.
Each investor should review his or her tax situation to determine if a contemplated investment is appropriate. Finally, because tax laws are subject to change, your accountant or tax adviser should be consulted before proceeding with any investment.