Originally Posted February 2016
Edited April 2024
Many investors seek opportunities in real estate as an alternative investment to stocks and bonds.
Commercial real estate in particular can potentially deliver the appreciation and stable returns most investors are looking for, even during times of economic uncertainty.
Whether you’re considering investing in an apartment complex, office space, light industrial or a self-storage facility, here are 5 reasons you may want to consider adding commercial real estate to your portfolio.
1. Cash Flow and Current Income
Commercial real estate investments potentially offer regular income that can be higher than typical yields on dividend stocks and bonds.
Stable income can potentially provide protection and diversification against the volatility of the financial markets and commercial real estate historically does not move in sync with stocks and bonds.
2. Tax Benefits
Commercial real estate investments can potentially provide an array of tax benefits to a real estate investor.
Deductions related to depreciation, interest expense and other items can potentially shelter or defer taxes on cash distributions.
For example: Current cash flow will often be less than the total depreciation and interest expense creating a return similar to a tax-free bond. However, in most cases, these benefits will be recaptured upon a sale of the property.
Depreciation recapture is taxed at 25% while the remaining profit or capital gains is taxed at the long-term capital gain rate.
For example: An office building is purchased for $1,000,000. Of that, $250,000 is allocated to the land. The basis for depreciation is $750,000.
If a real estate investor owns the property for 5 years, about $135,000 can be depreciated. Upon a sale after 5 years, an investor’s basis will be $615,000.
Assuming a sale price of $1,500,000, the gain will be $885,000 ($750,000 gain plus $135,000 in depreciation). The $750,000 will be taxed as a long-term capital gain and the $135,000 will be taxed at the depreciation recapture rate.*
3. Inflation Hedge
For investors worried about how inflation will affect their portfolios, direct investment in commercial real estate can be a great hedge against the effects of inflation.
Over long term holding periods historically, commercial real estate returns outpaced inflation nicely. Over short term periods, commercial real estate returns have been modestly correlated with inflation demonstrating their ‘inflation hedging’ capacity.” But, on a deal-by-deal basis, commercial real estate that is also secured by floating rate debt will also see its interest payment increase in an inflationary economy – and if there is no interest rate cap – result in a reduction of funds available to run and/or develop the property and distributed to investors.
4. Leverage
A major benefit of direct commercial real estate investment is the ability to place debt on the property which can increase the purchasing power of each dollar of equity. This in turn increases the total potential returns of the property, which also increases the risk.
A simple example is a $1,000,000 property. Typically, only $250,000 of equity will be required with the balance funded by debt.
If the property is then sold for $1,250,000 in one year, the cash return would be 100%. If the property was purchased with no debt, the cash return would only be 25%.
5. Hard Asset
Pride of ownership is something that cannot be valued. With direct commercial real estate investment, an investor actually owns an asset that they can see and feel. It is something that they can point out and say “I own that!”
* This hypothetical situation is provided as an example only. We are not tax advisors and we suggest that you discuss your specific tax situation with a professional.