Why Adding Commercial Real Estate to Your Portfolio is Good (and Multifamily is Better)
“Ninety percent of all millionaires become so through owning real estate. More money has been made in real estate than in all industrial investments combined. The wise young man or wage earner of today invests his money in real estate.”
— Andrew Carnegie, billionaire industrialist
Many people think of investing as selecting a basket of stocks and bonds and hoping for the best. The reality is that investment portfolios that focus on just stocks and bonds force investors to compromise — either by sacrificing return for lower volatility or enhancing return at the expense of higher risk. Here are some reasons we believe investing passively in real estate is good (and multifamily is better!).
Commercial real estate, which includes multifamily, has almost no correlation to stocks and a slightly negative correlation to bonds. That means the asset classes don’t move together which is the key to diversification.
In 17 of the 20 worst quarters for a 60% stock / 40% bond portfolio, from 1978 to 2012, private real estate (measured by NCREIF index) had positive returns. Why? Commercial real estate returns are largely driven by different economic risk factors than stocks and bonds.
Most Resilient Property Type to Recessions
Multifamily is the most resilient property type to cyclical downturns, according to CBRE Research, as measured by rent changes during and after the past two recessions (2001 and 2008-2009). They found that multifamily rents were in a negative growth trend for a shorter period of time, recovered quicker, and far surpassed the previous highs.
Historical performance isn’t always indicative of future performance, and each recession is different. The amount of oversupply certainly impacts recovery time. It’s reasonable to assume during and shortly after a recession, multifamily rents will likely decline to some degree, but that decline is usually short-lived and followed by a strong rebound and growth beyond the previous peak rents.
In multifamily, after tenants pay rent and property expenses and the mortgage are paid, the remaining cash flow is distributed to investors, usually quarterly. Bonds and dividend yielding stocks provide some yield but it’s low. It’s common in a real estate syndication for passive investors to earn a preferred rate of return in the 6-8% range, plus a majority share of the profits.
For tax purposes, real estate owners can deduct mortgage interest and depreciation from property’s Net Operating Income (NOI). This benefit can be passed on to all investors in a real estate syndication. The result is the investor likely won’t pay any taxes on cash distributions until the property is sold, at which point they will pay a lower blended tax rate than their ordinary income tax rate. It’s important to note that an investment in a REIT, which is a real estate flavored stock, does not provide this tax benefit.
Shorter (and Staggered) Leases Allows Flexibility
Multifamily leases are typically 1 year versus 5+ years for retail, office, and industrial. Short-term leases and staggered lease expiration dates means consistent volume of leasing activity, both new leases and renewals, which often leads to higher average occupancy rates, and steadier cash flow. The shorter-term lease structure gives the owner the advantage of adjusting rents upward more quickly in a tight market or after making value-add improvements to the property.
Diversified Credit Risk
Multifamily properties have many leases, and each lease only represents a small portion of the overall income. The tenant default risk is therefore spread out across many tenants. This gives multifamily a distinct advantage over office, industrial and retail assets, each with much fewer tenants.
Lower Tenant Turnover Costs
Apartment unit turnover requires only minimal investment to get the unit physically “rent ready.” Additionally, downtime between leases can be days or weeks. By contrast, there are significant costs associated with new leases and renewals in office, industrial, and retail (e.g., tenant improvement allowance and leasing commissions). Downtime between a move-in and move-out in those asset classes can be months (or longer!). During that time there is no revenue, which significantly impacts investor cash flow.
Favorable Loan Terms
Loan terms and interest rates are more favorable for multifamily than other property types due to lender comfort with the asset class and its lower volatility. In addition to the banks, life insurance companies, and CMBS lenders who provide debt, the multifamily sector also benefits from the government-backed lending programs (GSEs) not available to other property types. Fannie Mae, Freddie Mac, and the FHA are major sources of non-recourse debt capital and liquidity. The GSEs have an especially strong appetite for lending on properties that are affordable to lower and middle-income families.
Basic Need of Shelter
After the grocery bill, the next thing people pay is rent. Investing in multifamily communities is investing in the basic need of shelter.
Sources: CBRE Research, U.S. Multifamily Research Brief, Multifamily Most Resilient Property Sector to Recessions
Sources: CBRE, U.S. MULTIFAMILY HOUSING: A Primer for Offshore Investors