Benefits of Commercial Real Estate
There are three main benefits associated with real estate investments: stable cash flow, asset appreciation, and tax benefits which come from the deferred depreciation. Apart from these, there are multiple additional benefits. These are as following:
An important characteristic of commercial real estate investing is the ability to carry leverage which is several times higher than the original equity. This provides investors with flexibility to buy more assets with less capital and significantly increase their equity as mortgages are paid down, thus building wealth rapidly.
Most commercial properties are purchased with only 20% to 30% in cash down, not 100%. For instance, imagine you bought a commercial property for $1 million with a down payment of $200,000 and 80% LTV. Assume over the holding period the rents on your property increased by 50% and you were able to sell the property for $1.5 million due to the increase in rents. Net profit on this deal is $500,000. However, instead of a 50% return on investment, you were able to achieve a 250% return because the $500,000 gain compares to only a $200,000 initial down payment. Thanks to leverage, investors are able to achieve much higher returns than any other form of investment.
Hedge Against Inflation
Commercial real estate investments have the highest correlation with the inflation rate over time compared to other asset classes. When inflation goes up, the price of real estate assets, particularly multi-tenant assets with a high ratio of labor and replacement costs, will also increase.
The main reason for the flexibility of property values to the changes in inflation is that the rents in commercial lease agreements are linked to inflation. In the majority of cases it is agreed upfront with a tenant that their rent will be adjusted to the change in inflation upon an annual review of the lease terms. However, in times when there is negative inflation (deflation) the rent is not changeable. This gives any commercial landlord an upside opportunity with downside protection. The correlation between commercial real estate investments and inflation is historically 100% which is not a benefit of any other asset class.
Commercial real estate is an asset class with intrinsic value as it is a tangible asset. The land has value as well as the structure on a property. So by choosing both location and asset quality wisely, you have the security that even if there are no tenants, the property itself still has the potential to generate value. This is opposite to the stock market where there is always a risk that the value of a share can go to zero over time. Because of its tangibility, investments in commercial real estate are considered to be much more stable than investments in the stock market.
Compared to the residential market, the commercial real estate market has a lot less competition. While in the residential market there is a rush to get into the deal or it will be lost in no time, this is not the case for the commercial real estate market. Here, fewer investors are interested. Investing in this asset class requires a lot of effort that many do not want to make.
Additionally, there are many commercial property types available on the market as well as numerous sub-types to choose from. Thus, the commercial real estate market offers less competition and more opportunities for higher returns for those willing to put forth the effort. Furthermore, even though the commercial market is more expensive, banks are much more willing to give a mortgage for a well-performing commercial property than for a residential one.
The US tax code provides multiple benefits to real estate owners. Owning real estate allows for the deduction of mortgage interest as well as depreciation of the property which decreases the income tax owing. In addition, distributions to investors are not taxable on a property level but rather individually for each investor. The commercial real estate market also provides relatively low capital gains taxes compared to stocks for example. While the capital gains tax for stock investments may reach 35%, the tax on gains from commercial real estate investments will not be higher than 20%. There is an additional opportunity to make use of the section 1031 exchange which allows to defer payment of the capital gains tax during the sale of your investment if the proceeds from the sale are reinvested.
Having a stake in commercial real estate can be a passive investment while the property management, accounting, etc. is outsourced. Even though investors pay a very insignificant operating role, the expected returns are higher than other investment types like stocks or bonds.
Tenants of the commercial space are businesses, and real estate properties are usually owned through an LLC and operated as a business. The relationships between the landlords and tenants are therefore business-to-business and more professional than residential real estate. The interactions, lease negotiations and agreements are more straightforward and efficient. Additionally, because lease terms are long, the tenants usually take care of the place as their own and do their best to maintain a professional look.
Historically Strong Returns
Commercial real estate investments are characterized by higher yields in the long term. The returns from real estate are much more attractive than those of more traditional asset classes as stocks or bonds. For example, REITs have outperformed the stock market every year since 2000.
First of all, there is no direct correlation between the commercial real estate market and other asset classes, rendering commercial real estate a great diversifier. Furthermore, the commercial property market in particular offers a huge variety of asset types, geographies, and investment strategies to choose from to allow for further diversification within the property portfolio.
Favorable Return/Risk Profile
The commercial real estate market has one of the most profitable return/risk profiles. The total annualized return compared with the annualized risk taken on by investors has been highest for this asset class for the last 20 years.
Easier to Obtain Large Sum of Capital
There is a lot of capital involved in commercial real estate investing. For residential real estate investors there are not so many alternative financing options available: only individual investors such as hard money lenders. Not even small amounts of money are easily arranged for residential investing. In the commercial real estate market, on the other hand, obtaining a large sum of money is easier as there are more financing options available including hedge funds, investment groups, and private equity firms.
In commercial real estate investing, investment properties are valued on the basis of the income that they generate. The higher the income generated by a commercial property, the higher its value. Thus, investors have an opportunity to force appreciation of an asset by finding ways to generate more income whether by increasing rental revenue or more carefully managing expenses.
Commercial real estate business models are usually simple and transparent as the property market is there in order to serve basic needs of businesses, i.e. provide comfortable space to set up and run their businesses. If we look at the stock market for example, business models are often fairly complex and uncertain. Additionally, the Price-to-earnings (P/E) ratio in the stock market often reaches 100 or more, but in the commercial real estate space the P/E ratios are 10 or less. The lower the P/E, the lower the risk associated with an investment.
Objective Price Evaluations
It is often much easier to evaluate property prices of commercial real estate projects than residential ones because professional income statements are easily accessible for commercial properties, allowing for the objective price estimate to be derived from these numbers. Prices for residential properties are more emotionally driven and based on recent sales nearby rather than actual income potential of a property.
Higher Flexibility in Lease Terms
Consumer protection laws govern commercial leases to a lesser degree than residential, as many state laws that control the residential property market, such as security deposit limits and termination rules, do not apply to commercial properties.