With the recent volatility that the stock market has experienced, people are looking for alternative investment opportunities. Investing in real estate is a popular choice, but many don’t realize all that it encompasses. Today we chat with Frank Black, Senior Vice President at Premier Development Partners, about investing in commercial real estate and how you can minimize your investment risk.
The conversation below has been edited for length and clarity. The content references an opinion and is for informational purposes only; you should not construe any such information or other material as legal, tax, investment, financial, or other advice.
Why is diversification with real estate important?
With any investment, diversification is important for investors to reduce overall risk. Since real estate has a low correlation to the stock market, due to fixed income streams driven by contractual lease obligations, it’s less likely to be affected by market uncertainties that cause stock prices to fluctuate.
Does the illiquidity of real estate make it a poor investment?
It depends on your investment objective. Compared to stocks and bonds, real estate investments are bought and sold in less efficient private markets with lower volumes and higher costs. However, one could argue real estate makes an excellent investment choice since it is a unique asset class that experiences less volatility. If an investor is worried about liquidity and wants to diversify their portfolio with real estate, purchasing shares of a REIT can offer the best of both worlds.
What benefits does investing in commercial real estate offer people?
Although the barriers to entry may be high through the initial investment, investing in real estate provides a unique combination of benefits you don’t get with stocks and bonds. The most commonly recognized are, a hedge against inflation, leverage, tax depreciation, cash flow, and principal paydown. Of these, principal paydown and tax depreciation are often overlooked. Principal paydown is a very steady benefit. Suppose you have a fully amortized loan stretched over 20, 25, or 30 years; if you continue to lease the property, you will eventually own it free and clear as the debt is paid down. The benefits are recognized by either increased cash flow or a liquidity event, i.e., sale or refinance.
Tax depreciation can be a complex subject. One of the main benefits is that an investor can recover a portion of their investment over time through annual deductions on their taxes. As an accounting convention, there are several ways the IRS allows you to depreciate real estate, either straight-line, accelerated, or bonus. No matter which method is selected, the annual depreciation is a paper loss taken against gains from a property’s cash flow and gets reported on a K-1. Investors with K-1 gains from other businesses can use these paper losses to offset gains and save taxes in other areas of their investment portfolio. One thing important to note is depreciation is NOT tax elimination; taxes will have to be paid through recapture if the property is sold. There are ways to avoid this, but that is another complex subject beyond the scope of this conversation.
In down markets like we are experiencing now, is there a risk of negative leverage in investment real estate?
Great question. As we enter a new real estate cycle with increasing interest rates, negative leverage can be a real risk depending on how an asset is structured or where you are in the process of either acquiring or developing a project. In a real estate investment, debt is placed on an asset to help increase its cash flow; the spread between the cap rate and the interest rate is what investors earn. If interest rates rise relative to in-place underwriting or project assumptions, negative leverage can occur when the cap rate is less than the cost of debt or debt constant; therefore, the cash-on-cash return will be less than the cap rate. One way to hedge against this is to not over-leverage a project; a lower loan-to-value can provide a cushion if the market moves in the wrong direction.
What can happen if investors find themselves in a negative leverage situation?
As interest rates and inflation continue to rise, lenders are slowing things down by tightening underwriting and reducing proceeds. This places pressure on transaction yields and makes achieving a return on investment more difficult. If rents rise and interest rates stay flat, the scenario can work itself out over time. However, if this is not the case, it may result in a distressed sale or force investors to plug holes in their financing structure.
Frank Black has over 15 years of experience and serves as Vice President of Premier Development Partners, where he is responsible for identifying, analyzing, and originating ground-up development and value-add investment opportunities. Frank is also engaged in complex contract negotiations, market analysis, underwriting, due diligence, financial modeling, leasing, asset acquisition, and disposition. Prior to joining Premier, Frank served as a corporate portfolio manager leading cross-functional teams in asset optimization and rightsizing throughout Europe, The Middle East & Africa, and North America.