Generating Income with Commercial Real Estate

Commercial real estate is an asset class that is typically only available to institutional investors but with the advent of technological improvements within the fintech (financial technology) space, this asset class has been opened to both accredited and non-accredited investors. Commercial real estate, along with residential real estate, serves as alternative asset class that helps diversify from the stock/equities market. When comparing stocks and real estate, they each have their own benefits and drawbacks. Stocks are liquid and can be cashed out at any moment, however, stocks tend to be more volatile due to this liquidity benefit. Traditional real estate on the other hand is illiquid and it can take 3-5 years before an exit. Stocks are also relatively cheap when compared to real estate. The transaction costs for most commercial properties are in the millions range and this can make it difficult for the everyday Joe to access the commercial real estate market. Real estate does offer tax advantages such as depreciation that cannot be accessed through stock investing but the use of retirement accounts can also offer tax benefits within the equities market. Most investors see a place for both asset classes in their portfolios.




Real estate is usually thought of as a hedge against inflation and some types of real estate can be recession-resistant. I tend to focus on the cash flows offered by a real estate investment and then after that, shift priority to the tax benefits and future appreciation. The appreciation portion of real estate is not guaranteed as with stocks. It does take some effort to study trends and areas within the country with excellent growth prospects. Platforms such as M1 Finance (my favorite stock investing app) and private fintech companies such as Fundrise and Groundfloor are trail blazers that have opened up both the commercial and residential real estate asset classes to all individuals regardless of income or net worth through REITs and real estate crowdfunding. I have investments in a multitude of deals through Nextseed, Fundrise, Groundfloor, and Worthy BondsThese platforms have offered debt, equity, and revenue sharing agreements as well as opportunities to invest in a Pre-IPO on two of the entities. With one of my 2020 goals being to increase my allocation towards commercial real estate with syndication deals, I am happy to say that I have successfully executed on that goal as of this writing. I was able to liquidate my certificate of deposits (CDs) at no penalty and transfer them into a much higher return asset class.



This blog post is to highlight the the different types of commercial real estate opportunities, pros and cons of commercial real estate investing, how syndication deals are structured, and the typical return profile of an investment. Furthermore, I will discuss the tax benefits of investing in this asset class. I am not a CPA so please consult your tax advisor before making any decisions since I am simply discussing how I plan to use the investments to reduce my personal taxes. To wrap up, I will discuss the seven commercial properties I invested in this year after 50+ deal screenings and my thoughts on how I analyzed them and what made them special.

TYPES OF COMMERCIAL REAL ESTATE

There are seven main types of commercial real estate an investor would be interested in. They span different functions and are as follows:

1. Multi-family: This involves renting out apartment units to individuals and collecting rent typically monthly. You can manage the property yourself or can hire a property manager to handle the day-to-day operations. Multi-family is an extremely popular type of commercial real estate and has gone through many economic cycles. People will always need a place to sleep making multi-family a safe bet. Like the popular quote goes, "Location, location, location," selecting the right apartment to invest is heavily depends on the location and its ability to attract tenants. Multi-family properties typically range between 2-10+ stories high. It is important to note that single family homes are not considered multi-family properties and is therefore classified as residential real estate instead of commercial. Multi-family commercial real estate investing has the ability to attract good returns but it is dependent on managing the property diligently and maintaining a low vacancy year-round.

2. Hotels: This ranges from the nearby airport hotel to the skyscrapers you see around the city. Casinos and resorts also fall under this category. It is all about hospitality for business travelers and tourists. Hotels are typically within a consumer's discretionary budget and due to this it tends to be more cyclical in nature especially as the economy grows or shrinks. This type of commercial real estate is not recession resistant but they do offer good returns during a bull market.

3. Retail: This includes buildings such as Walgreens which are considered single-tenant buildings to large malls. Simon Property Group (SPG) would be an example of a commercial real estate company that owns many retail buildings. In fact, SPG is the largest shopping mall operator in the United States. Investors can purchase the real estate investment trust (REIT) of Simon Property Group (SPG) on M1 Finance (a brokerage account with no trade commissions). Strip centers and neighborhood centers typically owned by Walmart or Target are also considered retail buildings. For retail investing, it is important to consider the product quality of the tenants since you probably would not want a Michael Kors next to a Family Dollar. Finally, restaurants are also considered retail and as you can tell, this type of commercial real estate can be very cyclical and is not immune to recessions so this is something to consider when making a bet in this sector.

4. Industrial: Ever wondered where Amazon stores its goods before it gets shipped? Yes, that is correct, in warehouses which is what is classified as an industrial commercial real estate property. Research and development labs are also within this same classification as well as manufacturing plants. These properties are typically on the outskirts of urban cities. Industrial storage properties are also popular near the coast as imported or exported goods can be stored there before being distributed. Due to the increasing demand for e-commerce and online shopping, industrial properties should enjoy decades of growth. It should also be able to stand tall through recessions since technological improvements have made it easy to order anything online with one click of a button.

5. Self-Storage: A self-storage facility is one of the most prominent recession resistant commercial real estate investment one can make. Similar to the analogy that people will always need a place to stay, people will also always need a place to temporarily store items as they down-size during a downturn. Self-storage facility is similar to multi-family in the sense that location is key. It is extremely important that these properties are within a city or within a customer's reach so the demand can keep up with the supply thereby maintaining a low vacancy and creating a consistent cash cow.

6. Senior Housing: Just like the name sounds, senior housing is a real estate asset class that involves owning independent/assisted living communities and nursing homes. It is no secret that the life expectancy of the US population has increased by almost 10 years between 1960 and 2015. With this statistic in mind, senior housing should continue to have a need for in society. Residents of the US who are 55+ years qualify for independent living and this opportunity attracts a class of investors who are willing to bet on the life expectancy of baby boomers. Again, based on the statistics over the past decades, that seems like a good bet.

7. Office: Finally, the last commercial real estate type that an investor should consider is office. Similar to the name, this asset class involves investing in office buildings that is then rented by small or large companies. Rental income is realized from such investments. Steady cash flows can be expected if the building is leased by credit-worthy companies. The benefit of an office type investment over a residential type investment is due to the fact that companies who lease office space sign long term contracts (typically 5 years), so it would be easy to lock-in a steady stream of income for that term in the case of an economic collapse. I do have equity in two commercial office properties in the mid-west (about 10% of my net-worth) that have performed well over the past few years due to the fact that it is occupied by credit-worthy tenants and both properties have a low leverage ratio which minimizes any unforeseen circumstances. Both properties also have cash reserves that can be tapped into in the short-term in the event of an economic downturn.

PROS OF COMMERCIAL REAL ESTATE

Commercial real estate investing offer investors benefits that sometimes cannot be accessed in the public equity markets. We all know real estate is inherently inefficient due to the difficulty in accessing information within seconds. Unlike the public equity markets (where everything can be found easily after a couple of google searches), private real estate investments do take some leg work to source the right deals and raise capital. The main benefits of commercial real estate investing are:

1. Steady income: Real estate investments especially commercial real estate can produce a consistent cash-on-cash return that is stable. Unlike single family homes where the rental income is solely dependent on the single family living there, commercial real estate buildings typically have more than one tenant and are able to absorb any losses if one tenant decides to not renew his lease. This is one of the reasons why multi-family always beats single family real estate and is generally more favored within the investment community. With this in mind, I selected two investments in college towns which are located near large colleges in Urbana, IL and Radford, VA. These investments should be able to generate a steady cash flow. One of the investments has an interest rate swap in place which suppresses the risk of significant changes in interest rate within the first two years of the investment. The other investment is a new construction in which the land was purchased at a very attractive cost basis.

2. Ability to use leverage: Ever wondered how some real estate investments can generate 20+% returns or in other words, double you capital after 5 years? Well, it is due to the use of leverage. Entities can borrow cash from a bank at typically less than a 80% loan-to-value (LTV) ratio and with the help of appreciation, those entities can generate superior returns by building equity with the banks money. It is important to note that too much leverage is typically not good and advisable to seek investments with less than a 75% loan-to-cost (LTC) ratio. The two commercial office buildings I invested in have an aggregate average LTC of 55% which makes it attractive for a longer term investment and offers down-side protection in the event that things go south.

3. Tax advantages through depreciation, 1031 exchanges, and opportunity zone investments: This is one of the reasons why real estate might be more favorable than stocks. As one increases his W-2 income, real estate can provide investments that can make use of depreciation since buildings are assets that depreciate through time (similar to your car). There are guidelines by the IRS on what type of depreciation can be applied for each type of commercial real estate but the beauty of depreciation is that on paper, it might seem like the property lost money after accounting for depreciation but in fact, the property might have made a boat-load of cash flow that year. 1031 exchanges offers a way to defer taxes paid on the gain of a property through investing the principal and gains of a particular property (if sold) into a higher valued property, thereby deferring the taxes on such an investment. Finally, due to the Tax Cuts and Jobs Act of 2017, opportunity zones within the US have been designated. Some areas in the country which have been under-invested in historically were grouped into this "opportunity zone." Opportunity zones are classified as economically distressed communities by definition. Fundrise provides a map of opportunity zone areas within the US and they also provide access to real estate investments that historically have been reserved for institutional and accredited investors. The tax benefits of opportunity zones can rival 1031 exchanges in the sense that realized capital gains between now and 2026 can be re-invested with taxes deferred till April 2027. Also, if an opportunity fund investment is held for at least 10 years then all the capital gains from appreciation is tax-free. With this in mind, I picked Albuquerque as an opportunity zone investment with plans to hold for at least 10 years.

4. Appreciation: Similar to growth stock investing, real estate investments can enjoy the benefits of appreciation. However, this is where location, location, location becomes very important again because historical booming industries, migration patters, demand, and job growth have been the main catalyst for appreciation gains (think San Francisco, CA). There are current trends that indicate Austin, Denver, Nashville, Dallas, and a couple of other cities would enjoy such benefits. With this in mind, I made two investments in Austin and Dallas which should hopefully benefit from this. My thesis is that the Texas Triangle would be a major "appreciation" area within the next 3-8 years. This is also the main reason I do not plan on selling my residential rental property in the near term. It also helps out that one of the investments is a triple net lease meaning the tenant is responsible for insurance, maintenance, and property taxes.




CONS OF COMMERCIAL REAL ESTATE

Commercial real estate, similar to any form of investment, also has its negatives. It is important for the investor to carefully consider and weigh the pros and cons before making an investment decision. The cons of commercial real estate investing are:

1. Illiquid nature: Commercial real estate, unlike public stocks, do not trade on a stock exchange and cannot be easily liquidated within seconds. It typically takes a 3-5 year hold period and sometimes longer before the capital gains from a commercial real estate investment can be realized. Due to this fact, this sort of investment is not recommended for those who need to access the capital invested within a short period of time. Some commercial real estate deals can be refinanced to cash out the equity but those are usually done 2-3 years out after the initial purchase.

2. Daily operations and maintenance issues: For those that do manage the property, it can be a headache sometimes having to deal with tenants especially when there are maintenance issues that are needed to be fixed. Some commercial real estate funds typically hire a management company to run the day-to-day operations and if issues arise, they can always provide the capital needed. It is possible for a real estate investment to go south if the operational costs are higher than expected especially coupled with the interest that needs to be paid to the debt holders.

3. High capital cost: Commercial real estate is notorious for requiring a high amount of capital. The world trade center in New York cost $3.8 billion when it was built in 2012. If you adjust for inflation, in 2020, that same building would cost $4.3 billion. That is not a small number given that the amount had to be gotten from somewhere. There are ways where the capital cost can be shared among a couple of investors and this is called real estate syndication. Syndication is really popular nowadays but they do require high minimums with a typical range being $25k-$50k. Platforms such as Fundrise and Groundfloor have made it possible to invest in real estate crowdfunding for as low as $500 and $10 respectively. There is also a current real estate syndication hotel deal on Nextseed with a $5,000 minimum in which I am personally invested in.


HOW REAL ESTATE SYNDICATION DEALS ARE STRUCTURED

Due to the high initial cost of commercial real estate, real estate syndication has become the norm and not an exception. Investors get together and pool funds together to purchase a commercial real estate property. In such a deal, there is typically a general partner (GP) and a limited partner (LP). The limited partners consist of wealthy individuals and pension funds who contribute capital for a piece of equity in the property. The general partner is in charge of managing the investment and is the point of contact who seeks to exit the investment for a good return in the near future. The general partner is paid a management fee and a performance fee. In order to incentive the general partner to perform well, the limited partners typically requires a hurdle rate paid to them before the general partner can be awarded the performance fees. Typical hurdle rates are between 7-9%. After this preferred return and the return of invested capital, the general partner is paid the performance fee through a catch-up contribution. Once the general partner is caught up, any other remaining cash flow is then split between the limited partners and general partner at an agreed upon split.

TYPICAL RETURN PROFILE

The performance of a commercial real estate investment can vary from the loss of capital to exceptional returns in the high 50's, but the common annualized rate of return ranges between 15-20%. This range includes both the regular rental cash flow and any appreciation. The regular cash flows account for 7-10% of the annualized return. As far as the return profile goes, the first year of a new construction has no distributed dividends since it takes 12-18 months for construction. In year two, the building is then rented out and the rental income starts coming in. The rental cash flow stabilizes right after in years 3-4. Some deals go through a refinance to return the invested capital to the equity holders so that affects the cash yield calculations for the years after that. Most funds tend to want to exit after the 5th year and can then rollover over the gains and principal into a new investment and repeat the process based on the discretion of the equity holders. Assuming a 20% average annualized return, a 5 year period would double the investment. As you can imagine repeating this process one more time would lead to a 4x in year 10 and then doing it again would further improve the multiple substantially.



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