June 23, 2022

Investor-Owned Apartment Buildings for Growth, Income and Capital Preservation

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Real estate has long been a preferred investment for those seeking to diversify their holding, capture tax advantage, secure a steady income, and preserve and grow their net worth. In the mid-1800s, John Stuart Mill, a British philosopher and economist, described his view of real estate owners:

"The ordinary progress of a society which increases in wealth, is at all times tending to augment the incomes of landlords; to give them both a greater amount and a greater proportion of the wealth of the community, independently of any trouble or outlay incurred by themselves. They grow richer, as it were in their sleep, without working, risking, or economizing." [i]

Common stocks, a popular asset of most investors, are increasingly volatile, reflecting the turmoil of international tensions, the possibility of a significant market correction, and questions about the future of interest rates. Bond investors receive rates of return below inflation (7% in 2021) and the likelihood of falling values if interest rates increase. Commercial real estate's price stability, investment outlook, and new forms of ownership justify its inclusion in large personal portfolios.

Commercial Real Estate Investment Advantages

High net worth individuals (HNWIs) are considering the advantages of adding commercial real estate properties to their portfolios to protect their capital by adding hard assets. High-end apartment rentals in fast-growing communities offer exceptional values in today's real estate market. In addition to high returns, investors secure "the important diversification benefits that result from adding CRE to portfolios invested in other assets." [ii] 

Reduced Portfolio Volatility

All investments have risks of varying degrees. Risk is measured by its volatility – the disparity between an asset's high and low prices and its average over a period. The higher the volatility, the greater risk. Historically, commercial real estate properties are less volatile than common stocks (S&P 500). The table from the Federal Reserve Bank of San Francisco illustrates the greater volatility of equities over real estate:

The proportion of assets with low volatility to those with high volatility determines the portfolio's total volatility. Investors logically seek the highest return with the lowest risk they are willing to assume. While equity diversification reduces risk, adding CRE housing provides stability and security that paper assets lack.

Inflation Protection

Inflation in the U.S. for the past 20 years has averaged in the 2%-3% range. Since March 2021, monthly inflation rates have tripled from 1.68% to 7.48%.

Commercial real estate ownership, especially multifamily housing, is a historical "hedge" in portfolios against inflation. Rising prices, including rental rates, preserve and increase property values.

Some leases contain automatic increases adjusted for Consumer Price Index (CPI) increases.[iii] By the end of 2021, the country's average monthly rent has reached $1,513 — topping the $1,500 mark for the first time. As demand for rental property pushes rents upward, occupancy is now in line with the all-time highs of the early 2000s. Today's occupancy rate is at 96.5 percent, a figure last registered in the last half of 2000.

Eliot Throne of JLL Capital Markets notes that many portfolio managers are buying CRE strictly as an inflation hedge: "They simply want to place their money in an appreciating asset class in a market where they see further demand providing tailwinds when other factors may force headwinds." [iv] 

Tax Advantage

Commercial real estate owners are entitled to significant tax benefits not available to assets like stocks and bonds. In addition to capital gains treatments, owners can deduct mortgage interest payments, property taxes, property insurance, property maintenance costs, and accelerated property depreciation from their income. In some conditions, investors can exchange one property for another, deferring any capital gain payment.

High Income Potential

Real estate ownership has held a preferred position in family portfolios for generations due to consistent cash-on-cash returns.[v] A real estate "cap rate" refers to the return rate on a real estate investment, calculated by dividing the net income of the property by its cost. For example, a $400,000 net income on a $10 million property would have a 4% cap rate. Cap rates for multifamily properties range from 4.15% to 4.9% in the 4th quarter of 2021.[vi] Returns can be increased through leverage, i.e., mortgaging the property when the cost of debt is less than the investment return.

Property owners also benefit from increases in asset values. Construction costs continue to escalate each year, a factor in the rise in the market value of existing multifamily properties. Valued on a capitalization basis, properties rise in value as rents rise. An additional factor in the previous year affecting prices is the disparity between demand (high) and supply (low). Due to demand for CRE by portfolio managers of pension funds, life insurance companies, sovereign wealth funds, and other institutional investors and their willingness to accept lower cap rates, the prices of attractive properties have increased.

Ownership Options

Before the passage of the 2012 Jumpstart Our Business Startups Act (JOBS), a person interested in a commercial real estate investment could 

  • Go at it alone - Find, purchase, and manage the property personally. This option is only available to those with significant capital, real estate expertise, contacts throughout the real estate market, and the time to devote to the acquired real estate.
  • Participate in a private syndicate - Becoming a partner of an investment group to acquire single or groups of CRE. While more passive than going it alone, the investor has little security protection afforded to regulated transactions and may be personally liable for acts of the syndicate or its members depending on the terms of the syndication contract. 
  • Purchase shares in a publicly traded Real Estate Investment Trust (REIT) - While offering some benefits of real estate ownership, a passive investor in a publicly traded REIT cannot typically deduct REIT losses from their ordinary income. In addition, regulations prohibit REITs from acquiring properties for development or resale like other real estate principals. Investors in non-traded REITs assume risks of liquidity, valuation, and conflict of interest. [vii]

Traditionally, an investor's access to the commercial real estate market was dependent on what they knew, whom they knew, and how much funds they had to invest. Real estate crowdfunding allows passive investors to select real estate property without relying on someone else to make their investment choices. The regulations enable a sponsor to form groups of investors to acquire a particular property or portfolio of properties, including a collection of different CRE types. Crowdfunding is highly regulated, including the types and frequency of information available to investors. Some offerings may have relaxed minimum net worth requirements for entry.

Crowdfunding allows individuals and small groups to compete with institutional investors for desirable properties. 

Final Thoughts

The future for traditional stock and bond investments is uncertain, if not predominantly negative. The Covid pandemic shattered global supply lines, necessitated a rise in government debt unprecedented in non-war economies, and accounted for an estimated $16 trillion of losses.[ix] Unlike most investments, research suggests that historical pandemics trigger short-term declines in housing and rent prices but revert to their initial price patterns after six months.[x]

Spreading risk through diversification is one of the more effective methods to reduce portfolio risk by diluting the impact of the loss on a single investment. Adding multifamily assets to investment portfolios in this period of growing inflation is warranted. As Greg MacKinnon, research director of the Pension Real Estate Association, noted, "If the economy is doing well, real estate will do well, no matter what happens with inflation. Inflation is not critical in itself for commercial real estate."

If you would like to invest in real estate and obtain more information, please email us at invest@infinity.re.

[i] Mill. J. (1848) Principles of Political Economy with some of their Applications to Social Philosophy. London: John W. Parker, West Strand., V.II.28. Access through https://www.econlib.org/library/Mill/mlP.html?chapter_num=67#book-reader

[ii] Ghent, A. C., Torous, W. N., & Valkanov, R. I. (2019). Commercial real estate as an asset class. Annual Review of Financial Economics, 11, 153-171. Access through http://www.andraghent.com/research/CRE-GTV.pdf

[iii] Grosso, A. (2021) Three Ways That Commercial Real Estate Protects Against Inflation. Forbes magazine. (October 15, 2021) Access through https://www.forbes.com/sites/forbesbusinesscouncil/2021/10/15/three-ways-that-commercial-real-estate-protects-against-inflation/?sh=46d87a4955ff

[iv] Throne, E. (2021) Inflation's Influence on Multifamily Buyers. Multihousing News. (November 10, 2021. Access through https://www.multihousingnews.com/how-inflation-influences-multifamily-buyers/

[v] Lander, S. (2021) Return on Investment Guidelines for Multifamily Rentals. ZACKS Finance. (2021) Access through https://finance.zacks.com/return-investment-guidelines-multifamily-rentals-11710.html

[vi] Painter, T. (2022) Multifamily Apartment Cap Rates. Apartment Loan Store website. (February 11, 2022) Access through https://apartmentloanstore.com/loan-product/cap-rates

[vii] Staff. Real Estate Investment Trusts (REITs). Investor.gov. U.S. Securities and Exchange Commission. Access through https://www.investor.gov/introduction-investing/investing-basics/investment-products/real-estate-investment-trusts-reits

[viii] Staff (2019) Real Estate Crowdfunding Market By Investors (Individual Investors and Institutional Investors) and By Property Type (Residential and Commercial): Global Industry Perspective, Comprehensive Analysis, and Forecast, 2018 – 2027. Facts & Figures Research. (November 2019. Access through  https://www.fnfresearch.com/real-estate-crowdfunding-market-by-investors-individual-investors-182

[ix] Cutler, D. M., & Summers, L. H. (2020). The COVID-19 Pandemic and the $16 Trillion Virus. JAMA, 324(15), 1495–1496. https://doi.org/10.1001/jama.2020.19759.

[x] Francke, Marc & Korevaar, Matthijs. (2021). Housing Markets in a Pandemic: Evidence from Historical Outbreaks. SSRN Electronic Journal. 10.2139/ssrn.3566909. Access through https://www.researchgate.net/publication/340505512_Housing_Markets_in_a_Pandemic_Evidence_from_Historical_Outbreaks/citation/download

Nason is responsible for identifying and assessing real estate development and acquisition opportunities. He has experience acquiring and managing over $500m of opportunistic real estate investments along the east coast.

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