Issue 29: 2015

Specialty Asset Management

Direct Real Estate Investing

Commercial real estate offers the potential for attractive yields, capital appreciation and valuable tax benefits.

Mare Magnum/Getty Images; Datacraft Co Ltd/Getty Images

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Historically, commercial real estate has delivered strong real returns in terms of both cash yields and capital appreciation, along with the potential for valuable tax benefits. “Direct investments in the asset class can be an attractive addition and valuable complement to investment portfolios,” says Andrew Tanner, national private business group and real estate services executive at U.S. Trust.

Moreover, direct real estate investment risk and return patterns have not been highly correlated with stocks and bonds, meaning they can enhance overall portfolio diversification. They can also provide an effective inflation hedge.

Diversification, asset allocation and real estate

In general, greater diversification of a portfolio results in lower volatility and greater risk-adjusted returns. And asset allocation — how investments are distributed among the various asset classes — can enhance diversification. It can also drive long-term portfolio return potential. In fact, numerous studies have shown that asset allocation is the single most important determinant of the variability in portfolio returns.

Direct ownership is the purest way to make a real estate investment.

“Investment success is less about market timing than it is about time invested,” says Tanner. “Being allocated in the right sectors for the right period of time through the right times of your life — that’s what drives your overall investment return.”

Traditionally, asset allocation has focused on stocks, funds and cash, but today, Tanner says, comprehensive asset allocation for most investors should expand to consider alternative investments, including exposure to commercial real estate.

Commercial real estate structures

“Clients have long made indirect investments in commercial real estate through REITs and funds to gain exposure. There is, however, a trade-off,” says Tanner. “While these structures offer broader diversification within the sector, they also tend to exhibit higher correlations to other asset classes like equities and fixed income.”

Direct ownership is often the purest form of real estate investment since it maximizes the benefit from depreciation while remaining free of some of the unique tax and distribution characteristics of funds and REITs. From a liquidity standpoint, REITs are usually the most liquid investment option while funds have the longest mandatory hold time.

Potential tax benefits

A direct investment in commercial real estate may offer attractive after-tax yields and may provide a powerful vehicle to defer capital gains taxes in the event of a sale. With respect to a property’s income statement, a direct investment in real estate may qualify for depreciation, a noncash expense item recorded over the useful life of the improvements, thereby reducing the taxable income on the property. With respect to capital gains taxes, Section 1031 of the Internal Revenue Code allows an owner to sell a qualified property and reinvest in a like-kind property while deferring taxes on the capital gains from a sale of the property. This is in essence a “tax-deferred” swap of one income producing real estate asset for another, providing very specific rules are followed.

Different property types and lease arrangements

Property types include office, industrial, retail, multifamily and specialty types such as hotel, medical and self-storage. “Each has unique characteristics and risk elements that produce differing investment return profiles,” Tanner says. “Those return profiles are further influenced by the local demographics and economic conditions of a property’s submarket and regional location, as well as local supply and demand.”

For all of these, primary income comes from leases with tenants. Properties may be leased to a single tenant or to multiple tenants, potentially with staggered lease expiration dates. This can smooth the property’s cash flow and provide an opportunity to reprice rentable space to potentially hedge inflation or adjust the mix of tenants.

In addition, many leases contain contractual escalation or percentage rent provisions, which help provide a potential inflation hedge and can enhance returns. There are three basic lease types:

  • A gross lease: The tenant pays you rent, but you have responsibility for insurance, tax and maintenance.
  • A triple net lease: The tenant is responsible for the property tax, the insurance and the maintenance.
  • A ground lease: You own and rent only the ground under the building. “These are almost always very long-term, and there’s very little risk or moving parts associated with them,” Tanner says. “Also, whatever improvements are made to the property — say, the tenant builds an industrial plant — revert back to the landowner when the lease ends.”

Direct real estate investment compared

with other asset classes

Certain combinations of property types and leases can resemble traditional investments. “Let’s say you own land and you arrange a ground lease to a manufacturer for 100 years,” says Tanner. “Every year for the next 60 years, the manufacturer is going to give you $500,000. When the lease is up, you get the land back free and clear. It looks a lot like a long-term corporate bond. You get the annual interest and that’s it. Now you can sell a long-term corporate bond whenever you want, and with the ground lease, you can sell the land to somebody else who wants the annual income. But what you get with real estate that you don’t get with that corporate bond is the potential for appreciation of that land’s value over time. All you get back at maturity with the bond, beyond the periodic income, is your redemption value. And that cash is not likely to have the same purchasing power it had on the day you bought the bond.”

On the other hand, you might have some development land on the edge of a city that is expected to grow. That land provides negligible return today, but it may have significant upside if certain events occur, making this asset similar to a small business.

Certain combinations of property types and leases can resemble traditional investments.

That kind of perspective can be helpful if real estate is your family business, and as you’re approaching retirement, and focusing on income needs and limiting risk through retirement.

“At U.S. Trust, we would work with you in viewing your real estate portfolio in terms of traditional asset classes,” Tanner says. “The next step would be to compare this implied asset allocation with your current return requirements and risk tolerance. This process would reveal the steps necessary to keep your assets in sync with your investment objectives.”

Or maybe the most you desire is a shift from more aggressive, labor-intensive property (say, multifamily residential) into more passive investments (triple net or ground leases). “Adopting a flexible approach can help to organize and allocate your various real estate investments; it can also help to position real estate appropriately within an overall investment portfolio that includes multiple asset classes,” Tanner says.

Thoughtful entry and exit

At U.S. Trust, the investment process is team-based, building on the collaboration of real estate investment professionals and portfolio managers to develop an allocation that reflects clients’ investment needs. “Whether we’re talking about establishing a real estate allocation from scratch or dealing with mature real estate portfolios,” says Tanner, “the process always begins with detailed discussions with your advisor about your particular situation and investment needs. At that point, we can begin to establish a target real estate allocation, including the types of commercial properties, if any, that might be worthy of direct investment for you.”

The allocation that reflects your needs then drives both initial investment and the reevaluation of existing properties.

Other factors include co-ownership and involvement of family in the CRE enterprise. If it is desirable to shift from one type of property to another, sophisticated mechanisms such as 1031 exchanges and UPREIT transactions can be evaluated to manage tax exposures.

When selecting property classes and lease types, and identifying properties to purchase, expertise is crucial. Real estate is a unique asset class for many reasons, including the potential to add value through active and professional management. An understanding of local and regional markets, combined with an investment management focus, exposes opportunities to improve value. In addition to the financial aspects, physical aspects are critical to an investment. Locations that support property value because of population and demographics, economic trends and traffic patterns are as important as the quality, condition and functionality of the improvements.

Says Tanner: “The bottom line is that we think most investors benefit from some degree of commercial real estate exposure within their overall investment allocation, and U.S. Trust’s portfolio managers and real estate professionals stand ready to gain these real estate exposures on your behalf.”

Photo: Robert Götzfried/Getty Images

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust and its representatives nor its advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Other Real estate investment trusts (REITs) involve a significant degree of risk and should be regarded as speculative. They are only made available to qualified investors under the terms of a private offering memorandum. Holdings in a REIT may be highly leveraged and, therefore, more sensitive to adverse business or financial developments. REITs are long term and unlikely to produce a realized return for investors for a number of years. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties, such as rental defaults.

Historically, commercial real estate has delivered strong real returns in terms of both cash yields and capital appreciation, along with the potential for valuable tax benefits. “Direct investments in the asset class can be an attractive addition and valuable complement to investment portfolios,” says Andrew Tanner, national private business group and real estate services executive at U.S. Trust.

Moreover, direct real estate investment risk and return patterns have not been highly correlated with stocks and bonds, meaning they can enhance overall portfolio diversification. They can also provide an effective inflation hedge.

Diversification, asset allocation and real estate

In general, greater diversification of a portfolio results in lower volatility and greater risk-adjusted returns. And asset allocation — how investments are distributed among the various asset classes — can enhance diversification. It can also drive long-term portfolio return potential. In fact, numerous studies have shown that asset allocation is the single most important determinant of the variability in portfolio returns.

Direct ownership is the purest way to make a real estate investment.

“Investment success is less about market timing than it is about time invested,” says Tanner. “Being allocated in the right sectors for the right period of time through the right times of your life — that’s what drives your overall investment return.”

Traditionally, asset allocation has focused on stocks, funds and cash, but today, Tanner says, comprehensive asset allocation for most investors should expand to consider alternative investments, including exposure to commercial real estate.

Commercial real estate structures

“Clients have long made indirect investments in commercial real estate through REITs and funds to gain exposure. There is, however, a trade-off,” says Tanner. “While these structures offer broader diversification within the sector, they also tend to exhibit higher correlations to other asset classes like equities and fixed income.”

Direct ownership is often the purest form of real estate investment since it maximizes the benefit from depreciation while remaining free of some of the unique tax and distribution characteristics of funds and REITs. From a liquidity standpoint, REITs are usually the most liquid investment option while funds have the longest mandatory hold time.

Potential tax benefits

A direct investment in commercial real estate may offer attractive after-tax yields and may provide a powerful vehicle to defer capital gains taxes in the event of a sale. With respect to a property’s income statement, a direct investment in real estate may qualify for depreciation, a noncash expense item recorded over the useful life of the improvements, thereby reducing the taxable income on the property. With respect to capital gains taxes, Section 1031 of the Internal Revenue Code allows an owner to sell a qualified property and reinvest in a like-kind property while deferring taxes on the capital gains from a sale of the property. This is in essence a “tax-deferred” swap of one income producing real estate asset for another, providing very specific rules are followed.

Different property types and lease arrangements

Property types include office, industrial, retail, multifamily and specialty types such as hotel, medical and self-storage. “Each has unique characteristics and risk elements that produce differing investment return profiles,” Tanner says. “Those return profiles are further influenced by the local demographics and economic conditions of a property’s submarket and regional location, as well as local supply and demand.”

For all of these, primary income comes from leases with tenants. Properties may be leased to a single tenant or to multiple tenants, potentially with staggered lease expiration dates. This can smooth the property’s cash flow and provide an opportunity to reprice rentable space to potentially hedge inflation or adjust the mix of tenants.

In addition, many leases contain contractual escalation or percentage rent provisions, which help provide a potential inflation hedge and can enhance returns. There are three basic lease types:

  • A gross lease: The tenant pays you rent, but you have responsibility for insurance, tax and maintenance.
  • A triple net lease: The tenant is responsible for the property tax, the insurance and the maintenance.
  • A ground lease: You own and rent only the ground under the building. “These are almost always very long-term, and there’s very little risk or moving parts associated with them,” Tanner says. “Also, whatever improvements are made to the property — say, the tenant builds an industrial plant — revert back to the landowner when the lease ends.”

Direct real estate investment compared

with other asset classes

Certain combinations of property types and leases can resemble traditional investments. “Let’s say you own land and you arrange a ground lease to a manufacturer for 100 years,” says Tanner. “Every year for the next 60 years, the manufacturer is going to give you $500,000. When the lease is up, you get the land back free and clear. It looks a lot like a long-term corporate bond. You get the annual interest and that’s it. Now you can sell a long-term corporate bond whenever you want, and with the ground lease, you can sell the land to somebody else who wants the annual income. But what you get with real estate that you don’t get with that corporate bond is the potential for appreciation of that land’s value over time. All you get back at maturity with the bond, beyond the periodic income, is your redemption value. And that cash is not likely to have the same purchasing power it had on the day you bought the bond.”

On the other hand, you might have some development land on the edge of a city that is expected to grow. That land provides negligible return today, but it may have significant upside if certain events occur, making this asset similar to a small business.

Certain combinations of property types and leases can resemble traditional investments.

That kind of perspective can be helpful if real estate is your family business, and as you’re approaching retirement, and focusing on income needs and limiting risk through retirement.

“At U.S. Trust, we would work with you in viewing your real estate portfolio in terms of traditional asset classes,” Tanner says. “The next step would be to compare this implied asset allocation with your current return requirements and risk tolerance. This process would reveal the steps necessary to keep your assets in sync with your investment objectives.”

Or maybe the most you desire is a shift from more aggressive, labor-intensive property (say, multifamily residential) into more passive investments (triple net or ground leases). “Adopting a flexible approach can help to organize and allocate your various real estate investments; it can also help to position real estate appropriately within an overall investment portfolio that includes multiple asset classes,” Tanner says.

Thoughtful entry and exit

At U.S. Trust, the investment process is team-based, building on the collaboration of real estate investment professionals and portfolio managers to develop an allocation that reflects clients’ investment needs. “Whether we’re talking about establishing a real estate allocation from scratch or dealing with mature real estate portfolios,” says Tanner, “the process always begins with detailed discussions with your advisor about your particular situation and investment needs. At that point, we can begin to establish a target real estate allocation, including the types of commercial properties, if any, that might be worthy of direct investment for you.”

The allocation that reflects your needs then drives both initial investment and the reevaluation of existing properties.

Other factors include co-ownership and involvement of family in the CRE enterprise. If it is desirable to shift from one type of property to another, sophisticated mechanisms such as 1031 exchanges and UPREIT transactions can be evaluated to manage tax exposures.

When selecting property classes and lease types, and identifying properties to purchase, expertise is crucial. Real estate is a unique asset class for many reasons, including the potential to add value through active and professional management. An understanding of local and regional markets, combined with an investment management focus, exposes opportunities to improve value. In addition to the financial aspects, physical aspects are critical to an investment. Locations that support property value because of population and demographics, economic trends and traffic patterns are as important as the quality, condition and functionality of the improvements.

Says Tanner: “The bottom line is that we think most investors benefit from some degree of commercial real estate exposure within their overall investment allocation, and U.S. Trust’s portfolio managers and real estate professionals stand ready to gain these real estate exposures on your behalf.”

Photo: Robert Götzfried/Getty Images

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust and its representatives nor its advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Other Real estate investment trusts (REITs) involve a significant degree of risk and should be regarded as speculative. They are only made available to qualified investors under the terms of a private offering memorandum. Holdings in a REIT may be highly leveraged and, therefore, more sensitive to adverse business or financial developments. REITs are long term and unlikely to produce a realized return for investors for a number of years. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties, such as rental defaults.