Commercial Real Estate: as an investment, not as it relates to the stock market
Hi all, I know this is a website/game/blog devoted to stocks and stock picking and stock markets and the like... but... There are other investments available, and one of the most common (at least in my area) is rental property. Commercial Real Estate. CRE. I have met many more people here that invest in some kind of rental property than people who invest in equities, bonds, and other niceties that the capital markets and yahoo finance give us access too. Now, my area of the country may be an exception, as its rather conservative and I maintain (and may test this later, and have tested it in the past) that if you went to the local pub and found a pretty girl around my age and mentioned, in a sentence, the S&P 500 you'd be overwhelmingly unlikely (near zero, running bet with some chums) to ever find one who knew what its value was, if even what it was at all. The Dow is of course more common. So far in said running bet: zero, ever, have known what the Russel 2000 was. Not one time. A tiny handful had heard of the S&P, none new its closing level or even an approximation of its closing level.
This is how I humor myself on days when I have a bad attitude. On days when I have a good attitude I (I swear to goodness) go out and just tell people I work at some store in the mall. Its just a whole lot easier than explaining what I do for a living to people.
But enough about my quasi-complaints and ongoing amazement at how oblivious to investing in stocks the world directly around me is... (this and the nearest city with 10k+ people have like the lowest unemployment in the country. All that obliviousness and the conservative demeanor it belies are not without their advantages). One last comment: number of people who, after asking what I do for a living, have told me that stocks are gambling or to "be careful, you can lose it all just like that" in stocks outnumber the number of people who know what a price to earnings ratio is by 17 to 2.
Anyway, to contrast the massive ambiguity in the equity markets of my locale, there are tremendous numbers of people with their fingers in rental property. A longtime friend (former college age girl-chasing drinking buddy, now in management at a local car dealership) owns a couple of four-plexes, another friend of mine owns a 3-plex, another friend a 10 plex, (and these are not necessarily, or even at all, rich people). Asking prices for rental properties in the area are typically north of what the properties can cash flow if you mortgaged them with 20% down.
I myself, a while back, bought some shares in an LLC that was formed to own a piece of CRE. As of today this represents about 2% of my overall investment portfolio. I have since given a great deal of consideration to CRE and its potential as an investment, and I have come up with a fairly long list of thoughts on the matter. I see a laundry list of both pro's and con's.
1. Think of it as dividends without taxes. Say you bought a commercial real estate property, like some rental office space, and you made an 8% cash-on-cash return. The property pays a mortgage and delivers rent revenue. It makes the payments and after your 10 or 20 or whatever percent down delivers an 8% return. You bought, say, a $1mil building. You put, say, $200k down. You make, say, 8% cash-on-cash, so about $16k return. You can depreciate the building over 27.5 years. So about $36-37k/year of tax write-off. So you make not 8% but actually more because you can show a loss while still making a profit. This is huge. The dividends from, say, T, or VZ, or LLY, or MO cost you about 20%/year in taxes. The dividends from ARCC or other BDCs or most REITs may cost you closer to 40%/year in taxes. 0% taxes on the "dividends" from a properly rented and performing piece of CRE.
2. Real estate is the only asset that isn't stocks that has appreciated more than inflation over the course of recorded history in the US. Its not nearly as good as stocks, but at least its something. Commodities haven't (just periodic fits of supreme outperformance followed by decades of poor performance), bonds haven't, etc. Real estate has, so provided you didn't buy into a bubble thats a plus.
3. CRE carries with it a certain visibility and sort of status/notoriety. "I own the Ramada" means something to people, "I own 80,000 shares of Ashland Chemical" means nothing to anybody.
4. CRE has reasonably predicatble and widely available leverage. You buy stocks on leverage you take on far more risks than buying real estate on elverage. Real estate, quite literally, is basically always bought with leverage. And massive infrastructure (banks) exist in our society to provide leverage (mortgages) for real estate. Leverage with stocks is both probably riskier and less available and generally available on less favorable terms. Literally anybody can lever 3 or 4 or 5 to 1 on real estate. This leverage brings with it the potential for greater returns. Your total return is the sum of (cash on cash return + appreciation return + debt paydown return). You buy said piece of rental property for $1 mil, putting $200k down, with a 20 year mortgage on the other $800k, and the property pays for itself... you are banking 8% (cash on cash) + $40k (average over the life of the mortgage) or 20% debt-reduction return + whatever the appreciation of the property is. This creates the potential for honestly good returns. Buffetesque returns. Better than teh long term average of the stock market returns.
5. CRE, in your mind, is less volatile than equities. Imagine I began investing around the turn of 2008/2009 with stocks. (true). Imagine I bought in to the point where I was bascailly all in US equities (true). Imagine I started with 10 bucks (not true, but for this discussion its fine). I was down to 7 bucks at the march bottoms. Up to 21 bucks at the May or June 2009 highs, down to 16 bucks at the July 2009 lows, I hit $30 bucks in September 2009 and today stand at around $38 bucks, up from $31 bucks at the February 2010 lows. The volatility is insane. And that volatility is a source of some stress. That piece of CRE you own, in your own mind, is not as volatile. Its always worth $1 mil or a little more.
6. You can probably extract cash from it at some point if need be. Imagine that you bought said piece of CRE and in 10 years you'd paid down some of the loan, so you now had $500k of equity. And the stock market crashed october of 2008 style... you could probably take out an equity loan on the property to invest in distressed equities,... that access to cash is a huge plus. its not certain, but it is potentially a huge plus.
These upsides are contrasted with some downsides, some of which I have not before seen discussed in print:
1. Its an illiquid asset. Only in boom/bubble times is CRE actually liquid. In normal times selling it may take months, or years, if it can be done at all.
2. The recent (30 year) history of CRE prices is not likely to repeat itself over the next 30 years. Interest rates and bonds have been in a 30 year bull market. Interest rates have reached all time lows, record lows, and are likely to, at some point in the near future, begin trending higher. This can have some unexpected consequences for the value of CRE. For example, take our case above where one buys a $1 mil CRE property with $200k down, and expect 8% cash on cash return... Imagine interest rates were 50% higher than today and you would expect to pay 8% on the mortgage instead of just over 5%. In that case, ... bank CDs would be paying 5% and treasuries would be paying 5-6% and two things would happen. A) your 8% cash on cash return would now be a tiny loss. the mortgage payments would go up enough that instead of taking in $16k/year, you'd be putting in $1k/year. B) potential buyers would not be likely to accept an 8% cash on cash return. Today thats more than 2x the yield on the 10 year treasury. It would be only 2% more than the yield on the 10 year in this case, and buyers may require a 10% cash on cash return to make the "risks" of CRE worthwhile. Basically, folks, every investment is expected to yield more than the 10 year besides bank CDs. I doubt buyers would line up for an 8% cash on cash return for rental property if they could get 6% from treasury notes that have, practiacally, no risk. So say that a potential buyer expected a 10% return, cash on cash. With 8% instead of 5.2% interest rates. And assuming the prospective buyers were epxected to put 20% down, just like you... The properties sale value would be literally 25% below todays.
The massive, monstrous bull market in real estate over the last 30 years (which has seen 2 bubbles and busts) has been hugely fueled by falling interest rates. A rising rate environment will not be bullish for real estate investments, period. Be it houses or investment properties, rising rates are bearish for real estate. Higher rates, plain and simple, mean that real estate prices will fall, all else equal. That isn't a prediction for falling prices, its a note that "ceterus paribus" rising rates are not conducive to higher real estate prices.
Nobody talks about this when they talk about CRE ... but we are almost certainly in for a period of flat to rising interest rates. And ... a great deal of teh bullish aspects of real estate as an investment over the last 25-30 years have been falling rates. Plain and simple. Rising rates are bearish for real estate.
3. its an illquid asset. Imagine you are long 100,000 shares of BAC, 25% through shares and 75% through long term options. It takes about a minute, maybe 10, to go to cash. Thats a fair amount of options (750 contracts) and EVEN THEN, you can get to cash in about an hour, probably, without flattening the market. You may face years, or months in a good case, before you can exit a CRE investment. I cannot possibly explain how important that is.
4. The market isn't actually a market and it isn't actually non-volatile. My mental-comfort of point 2 is actually a fallacy. CRE markets have/will fall by as much as equities over the last -2 to +1 years. And what your building is "worth" is actually only what someone would actulaly buy it for. You may wind up stuck with it for a very, very long time.
5. Real estate, unlike equities (for now) comes with considerable carrying costs. Property taxes (anywwhere from a couple to many percent of the value per year) and maintenance (wildly variable, potentially significant). So far our wildly socialist leaders have not tried to institute a "holding tax" on equities. Some day they will, trust me, as a way to further punish hard working successful people in their neverending effort to attain teh votes of lazy welfare cases (which outnumber said hard working successful people many times over, therefore are more important to our democratically elected leaders).
6. Real estate, unlike equities, take work to hold. You or somebody will have to chase down late rent and evict delinquent tennats and so forth.
7. If you can't rent it its worthless. No guarantee your property will sit at 100% occupancy at the rents you desire forever.
8. It may be more work than you'd ever believe. Buying T or VZ or MO is not alot of work. It takes 30 seconds and selling takes 30 seconds and in between there isn't alot to worry about. The market may crash, yes, but... you can always sell. The CRE market may also crash and you may console yourself mentally by saying "my building is worth a million bucks", but it isn't unless someone will pay you for it. And MO, T, VZ are probably less likely to lower their dividends than any given piece of CRE is to give you trouble over projected rent income... and competition for the big boring dividend stocks isn't really higher than for CRE rental. And storms can't kill your MO, they can ruin your rental property. And you never have to go to T headquarters to yell about getting your dividend, it just comes, but you may well have to go yell at somebody to pay their rent. Taht may ultimately be more trouble to you than you think ahead of time.
And that ends my summary. My main argument against CRE as an investment is #2, and #1/#3. Rising interest rates may spell trouble for CRE valuations for decades to come, and its long history of outpacing inflation may take a (temporary) detour.
And the illiquidity is considerably concerning.
If any of you are considering CRE as a potential investment, maybe these thougts will help. And don't let #2 of the "pros" (the mentally comforting percieved low volatility) outweigh the downsides. It may be the best investment in any given case, but it is far, far, far from without considerable downsides.
And in a rising interest rate environment I just don't know what to think of it.