High net-worth individual investors are currently faced with a dilemma on allocating their portfolio between stocks, bonds and alternative investments, including commercial real estate. The stock market has roared back over the past several years with double-digit returns for most investments based on several economic factors, including confidence that President Trump’s tax policies will be advantageous to investors. However, there are also portfolio managers and investors who feel the stock market may be overheated and time may be due for a correction soon, regardless of how well Trump’s tax policies help the market.
As a commercial real estate professional, I have helped many high net-worth individual investors properly allocate their investment portfolio to commercial and/or investment real estate. According to many wealth management companies and portfolio managers, approximately 25 percent of an investor’s portfolio should be allocated to some other type of alternative investment, including commercial real estate. Commercial real estate is a great investment product to produce cash flow or yield to an investor. Although there are many other benefits such as appreciation, hedge against inflation and depreciation, cash flow is the main reason investors seek to invest a portion of their wealth in commercial real estate. Many lower risk properties can still achieve an 8 percent or higher cash on cash return, regardless of leverage. According to the National Real Estate Investor Magazine’s November/December 2017 issue, the five (5) main reasons high net-worth individuals invest in commercial real estate are listed below.
First is preservation of wealth. To most investors, not putting their capital at risk is the most important consideration when looking for investment vehicles. The cash on cash return is extremely important, but the risk of the investment must be considered in order to get a return of your investment. The most popular Investor of all time, Warrant Buffet, said the number 1 rule of investing is “Don’t Lose Money”. The second rule is “Remember Rule Number 1”. This is a lesson not easily learned in the commercial real estate industry. High leverage from investors in the economic meltdown of 2008 caused many high net-worth investors to lose some or all of their equity in many projects.
Second is income or cash flow. As mentioned previously, one of the distinct advantages of commercial real estate is this investment vehicle is meant to provide cash flow. Appreciation is great, but most Investors look to commercial real estate to provide steady cash flow which comes from the property’s tenants. This is not always the case with other alternative investments and/or the stock market where returns are primarily measured by growth and appreciation.
Third is asset growth and appreciation. Most markets in the U.S. have been on the rise since the great economic recession. Properties in these markets have experienced rental rate growth, which leads to an increase of net operating income (NOI) and appreciation. In addition, interest rates have been the lowest in U.S. history, which has caused cap rate compression. This has greatly affection asset growth and appreciation and many investors have capitalized on this sharp increase in valuations by selling to private equity and institutional investors. Others have held onto their investments and enjoying the high rate of returns from locking into fixed rate mortgages.
Fourth is tax purposes. If there is one thing I have learned after being in the CRE industry for over 20 years is that any person who buys real estate solely for tax purposes will probably lose. However, investment real estate does have tax advantages that other forms of investments do not enjoy, such as depreciation and interest deduction and the ability to transfer taxable gains via a 1031 tax deferred exchange. When purchasing CRE on basic fundamentals, the tax advantages offered for CRE help to boost the overall rate of return to the investor. However, commercial real estate should not be purchased for tax purposes alone.
Fifth is estate planning. Estate planning is usually something that most high net-worth investors don’t consider until they are in their late 50s or early 60s and usually at the point their kids or family members are not interested in becoming a part of the business. However, these investors have been able to build up a sizeable portfolio and enough equity to create generational wealth and the dilemma is trying to figure out whether the current portfolio is the right kind of investment to pass to the next generation. Sometimes transferring these investments into more passive and/or predictable income streams is ideal and can be done using 1031 Exchanges, which allows all taxable gain to be transferred into another CRE investment.
Overall, there will continue to be a shift to commercial real estate as a part of most net high worth portfolio. If done correctly, this can increase cash flow to the investor and spread the risk profile among several types of investment vehicles. Although the most popular property types for HNWIs are multifamily, industrial and medical office, respectively; there are countless other types of CRE investment properties that may be best to fit the HNWIs investment criteria and long range goals.
» BRIAN E. ESTES is president and investment advisor with the Estes Group and can be reached at firstname.lastname@example.org.
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