Many times I hear from friends and clients that they are concerned with today’s stock market. They have concerns over the volatility, the time and energy to monitor, or the costs that they incur to have someone monitor their portfolio for them. An alternative to the stock market is, of course, real estate investments. Real estate investments offer many advantages over the stock market, including: monthly income, tax benefits through depreciation, long term appreciation, and the use of leverage to increase returns.
Most real estate investments are acquired with the idea of income via cash flow. When getting financing on a property, the lender will also underwrite the viability of the investment and the return via cash flow. In today’s market an investor can expect a straight cash flow from their commercial real estate investment ranging from 4.5% to 7.0%. This is assuming they were to pay all cash. In addition, an investor, looking at long term leases for a commercial property can expect annual rental increases averaging between 2.0-3.0%. Assuming an investment initially returns 5.0% cash on cash, no loan, and has annual net rental increases of 2.5%, the actual return, without any appreciation is a compounded 9.0%. Remember this number later when we compare it to average stock returns.
To increase actual cash in the investor’s pocket, real estate also allows for depreciation of the asset, to defer the taxable income, and thus ultimately put more useable cash in one’s own pocket. Take for example the investment returns above. If this were a $1,000,000 purchase of a commercial asset, with approximately 75% of the value in the building ($750,000), an investor would be allowed to depreciate approximately $19,230 a year over the 39 allowable years for depreciating a commercial asset (27.5 years for a residential income property). Assuming the investor is in a 40% tax bracket, this depreciation write off would equate to an additional $7,692 in income through tax savings.
All of the above sounds great, but the biggest return on a real estate investment is typically through appreciation. Appreciation is the increase in value of an asset over time. For instance, in Los Angeles, from 1999 through 2015, real estate values have on average gone up 111.04%, a little more than doubling in value over a period of 16 years (remember these years). If you were to equate that with year over year compounded interest, the equivalent percentage return would be approximately 4.8%. Again, remember these numbers for later.
To capitalize even more, real estate offers a huge advantage over many other types of investments – leverage. By utilizing the debt that is currently being offered and essentially having the cash flow from the property pay off the loan, as well as the interest payments, an investor can dramatically increase returns on a property. For example, using the same example property above that was acquired for all cash, let’s instead assume that the investor now purchased the property with a fixed rate loan of 4.75% with a 40% down payment and a 25 year amortization. The annual loan payments would be about $41,000. With current income at $50,000 a year, the net income to the investor would be approximately $9,000 or 2.25% of their down payment. This doesn’t sound any better than the first example. In fact, it is a lower return, so why would leverage have any benefit? Gain on Equity and appreciation. Gain on Equity is the amount of mortgage payment that is applied to the initial loan. In this case, in the first year it is equivalent to about $12,825 (3.2% of the down payment) of the mortgage that is paid off, with each year this amount would grow.
The biggest gain, however, is from appreciation. Again, using the same example above and using the same appreciation average for Los Angeles real estate, by utilizing leverage the return of the investor would be closer to 12.5%, prior to taking advantage of any tax strategies through depreciation.
Of course, we’ve used averages, some investments may be worse, some a lot better, everyone has heard of the investor who bought a property and sold it for more than double in less than two years, but that is a rare occurrence, just like the lucky fellow that bought Apple stock for $50, or Tesla stock for $30 before selling it for $200 a share. Instead, especially if we are comparing these investments to other alternatives such as the stock market, I think it is only fair to do side by side comparisons of the markets in general. This brings me back to the above reminders. I used 1999 as a base year for one major reason. This is the year that the Dow Jones broke 10,000 for the first time. At time of publication, it is just shy of 18,000. Using these numbers, and averaging it to compounded returns as we did for real estate investments, this would equate to a compounded return of 3.7%.
In conclusion, by using averages, in both markets, the stock market returned about 3.7% compounded annually, a straight forward approach with a cash investment into commercial real estate provides for a 9.0% compounded return, and a 12.5% compounded return using leverage, all before any tax benefits received through depreciation. It seems that the answer, when looking at apples to apples is strikingly clear. But the negatives you ask. Yes, with all investments there are risks, benefits, and drawbacks. The main drawback when comparing real estate investments with the stock market is the liquidity factor. If you need access to your funds quickly you can liquefy (sell off) your stocks much quicker than you might do than with a real estate asset. This can be addressed by taking a two-fold approach to your real estate investments: 1) plan for the unforeseen needs, keep a credit line open on the equity you have in your assets, that you could tap into in case of emergency and 2) diversify your portfolio to minimize risk. Don’t just use real estate as your only investment, but also have a stock and bond portfolio, for example. Overall, a wise investor will look at all investment opportunities and decide based upon what they are looking to accomplish and what is best for them.