Real Estate Investing
A Comparative Analysis of Alternative Investment Returns
The purpose of this document is to explore the various traditional and alternative investment classes, and to illustrate how real estate, as an investment, can offer substantial after-tax returns for the most prudent investors. Obviously, any investment carries an element of risk, however, aligning any investment with a professional team of advisors can substantially mitigate such risk. Consequently, when analyzing the investment opportunities for private real estate investing, this thesis is presented with the assumption that the transaction structuring, due diligence, underwriting and asset management is performed by a proven and successful sponsor.
Most sophisticated investors are seeking exposure to alternative assets, which are generally defined as investments outside of the traditional equity markets, fixed-income or cash. Further, most prudent investors seek to carry a diversified portfolio of equities, fixed income, fixed assets, cash and some level of alternative investments such as venture capital, or other high growth opportunities.
Investing in alternative assets, however, often requires buyers to lock up their money for three to five years, which is why engaging a professional and proven asset manager / sponsor is essential. During the investment horizon, investors may not see current distributions, and liquidity is also limited as fund or asset managers cannot easily buy or sell holdings like a traditional stockbroker. Therefore, a longer-term investment horizon is required. Conversely, many alternative investments do not have the vagaries of the ups and downs that frequently accompanies a pandemic, economic crisis, geopolitical incursions, trade wars, etc. Yes, all investments are subject to the economic conditions of supply and demand, yet having a fixed asset such as real estate in one’s portfolio, remains generally immune to the similar market conditions which can adversely affect the emotional investment swings of a public stock market.
In fact, many types of alternative asset classes are not correlated with stocks and are expected to perform best when equity returns are flat or down. As a benchmark, the average annual return since adopting 500 stocks into the S&P 500 index in 1957 through 2019 is roughly 8%.
The top five alternative investments can best be divided into the following categories:
Private equity invests in non-publicly traded companies, and the investment is generally invested through an investment fund. Investors’ money can be unavailable for as long as 10-years as they wait for the private equity fund to sell the holdings in an initial public offering or sell to a strategic or financial buyer. Transparency can be an issue, as buyers often commit to investing in a blind pool. In fact, nobody really knows what the investments are going to be until the fund manager actually finds the compelling opportunities. Research by Harvard professor Josh Lerner and the consultancy Bain & Co. published in February of 2020 showed that investors who had placed money into professionally managed private equity made an average annual return of 15.3% in the 10 years ending June 2019.
Venture capital is a sub-category of private equity, as the investment fund will generally invest in early-stage companies that have the potential for outsized growth or are looking to expand rapidly in a new or innovative space. Unfortunately, there are winners and there are losers and there is a high chance for failure since many of these companies may not have revenues or profits yet, but also high reward if the firms succeed and become a unicorn that is the next Apple, Google, Amazon, etc.
One of the attributes that accompanies this investment space is that private equity and venture capital may require investors to make additional capital calls. For example, if an investor commits $200,000 to a fund, but the managers may take money in $50,000 tranches over two years as, if and when they find the “would-be” unicorn. If investors don’t have the earmarked funds available when the manager needs it, they can pay enormous penalties. Therefore, the investor has to be prepared to have that built into their financial plan as if the cash has already been invested in the entire amount. Based on detailed research from Cambridge Associates, the top quartile of professionally managed VC funds have an average annual return ranging from 15% to 27% over the past 10 years. However, if you invested in one of the bottom quartile VC funds over the past 10 years, your returns are mostly in the low single digits.
Many strategies around hedge funds attempt to offer some sort of return and to be a buffer when traditional assets fall. One common strategy is equity long-short. Managers will invest in a company which has the potential to appreciate, but they may also sell short, or bet against the company and would profit if the value goes down. Hedge funds may use absolute return strategies, also known as “all-weather strategies,” investing in many different asset classes and strategies to generate returns no matter what traditional markets are doing.
A study by Yale and NYU Stern economists suggested that during the same 10-year period, the average annual return for offshore hedge funds was 13.6%. Even worse, the rate of closure for funds rose to more than 20% per year, so choosing a long-term hedge fund is trickier than even choosing a stock investment.
Commodity trading is the exchange of different assets, typically futures contracts, that are based on the price of an underlying physical commodity. With the buying or selling of these futures contracts, investors make bets on the expected future value of a given commodity. If they think the price of a commodity will go up, they buy certain futures or go long and if they think price the commodity will fall, they sell off other futures’ or go short.
Commodities are mostly natural resource investments, such as crude oil, precious metals, corn, coffee, etc. Being real assets, they are often considered an inflation hedge. Commodity trades are implemented in the futures market and have set times during the year when contracts mature. Of course, many stocks pay dividends, and most bonds pay interest, but commodities don’t inherently generate any interest or dividends. The value of commodities depends purely on global production, commercial demand, and speculation, whereas a stock represents ownership in a business that is designed to grow in value over time. For example, gold prices have inflation-adjusted annual real returns of just 0.6 percent compared to 6.7 percent for stocks.
Real Estate Investment Trust (REIT)
Real estate is considered an alternative asset when people buy investment property such as office buildings or residential apartments. Investors who may not want to be landlords can use a broker to buy into private real estate investment trusts, or REITs, as the publicly traded REITs are listed on stock exchanges. The public real estate investment trusts have some characteristics of real estate, but oftentimes are considered to be very equity-oriented, because they are traded on exchanges.
The average annual returns in long-term real estate investing vary based on a number of factors, including the asset class. According to the National Council of Real Estate Investment Fiduciaries (NCREIF), the average 10-year return for real estate investment trusts (REITS) outperformed the S&P 500 Index with an average annual return of 10.5%.
Passive Real Estate Investing with a Proven Sponsor
As seen above, the overall investment return in alternative investments can vary significantly based on the track record and professionalism of the sponsor, or manager. Not only does the sponsor perform due diligence on the potential acquisition, it also has the market intelligence to seek out and review literally hundreds of opportunities, in seeking to find the ideal candidate which can offer attractive returns for its investors.
Benefits of Passive Real Estate Investing
There are various reason as to why Investors choose to invest as a limited partner in multifamily asset over being a sole owner of single-family, residential investment property. For most investors, it is the ability to truly invest in a passive nature and let the professionals, such as MSC, handle daily operations, tenant issues, vacancies, maintenance headaches, etc. Multifamily assets also allow investors to diversify risk due to the nature of having multiple tenants to produce revenue and cover expenses, as opposed to relying on a single tenant. As such, the value of a traditional multifamily asset is predominantly based on a return on investment, internal rate of return and capitalization rates, as opposed to the values based on construction cost and a simple supply and demand curve based on a single-family home.
Passive real estate investing, unlike many other investments, including investing in a public REIT, has four ways to make an investor money. The four ways are as follows:
Appreciation is how much the property value increases over time. After all, inflation affects construction costs, operating costs, cost of living, etc., and therefore, the real cost to replace a multifamily development continues to escalate each year, which causes upward pressure on the value of existing real estate. According to Case-Shiller, which is a Standard and Poor’s real estate index, real estate has appreciated at about 3% a year at a national level over a 100+ year time frame. Keep in mind, that this is the average appreciation per year. Some years saw worse (even negative) and some years saw better. Most experts agree, however, that they should expect appreciation in their rental properties as inflation will never go away.
Out of the four ways of making money in private real estate, investors are most familiar with cash flow. In short, Cash flow = Rent – Expenses – Mortgage payments. Much like owning an equity investment in a stock, as the professional management team can grow revenues and reduce expenses, the resulting dividends, or cash flow, can be distributed to the owners.
Debt Pay Down
Investors only get the debt pay down benefits if they finance their rental property. If the investors pay cash, they will not get this return. However, very few multifamily property investors buy properties with cash because the returns are higher when using leverage (debt). Paying down the principal is actually building more equity in the property. Equity is like money in the “real estate bank”. Every time an investor pays down the principal and build equity in the property, the investor is getting a return. More importantly, it is actually the tenants who are paying down the debt, and the tenants are buying the investor more equity in the property.
The quote “It’s not about how much money you make, but about how much you keep” by Robert Kiyosaki, the author of Rich Dad Poor Dad, is a concept that is embodied by the tax benefits that multifamily operators and investors enjoy. The following are some of the tax benefits that multifamily assets provide:
- Reduce taxable income due to allocated non-cash depreciation and interest. Depreciation, up to 90%, can come from cost segregation analysis that professional operators, such as MSC, can perform on the asset.
- Pay lower capital gains taxes on sale, as opposed to higher, ordinary income taxes.
- Defer taxes for multiple years due to gain exchange opportunities, such as 1031 Exchange.
Overall Passive Real Estate Returns
To get a complete return on investment for private real estate, a passive investor simply needs to add each of the foregoing sources of investment returns. Some of these are current returns, and some are longer term returns that are safely tucked away in the property’s equity. As a result of the many bites at the proverbial apple for returns, the passive investor can realize an investment return on both a pre-tax and after-tax basis which outperforms both the traditional and alternative investment opportunities.
For example, MSC has successfully acquired, developed and managed approximately 15-investment opportunities for its passive investors. Some of these investments are still ongoing, yet a full third of its investments have gone full cycle and have actually been sold. Based on this track record, MSC has been able to generate a pre-tax internal rate of return of approximately 28% throughout this portfolio. Again, much of overall return has been sheltered from immediate tax payments, which enable the investor to realize an after-tax internal rate of return that is disproportionately higher when compared with other traditional and alternative investments.
By way of example, the following is a high-level (pre-tax) forecasted return analysis done on two MSC property acquisitions and developments which were completed in 2020.
Value-Add Acquisition- NRG Portfolio – 25% IRR
Ground-Up Development – Spot @ Anderson – 31% IRR
MSC Annual Returns Compared to Traditional and Alternative Investments
As seen above, the forecasted pre-tax internal rate of return for these two 2020 investment opportunities, is projected to realize a return which is consistent with what MSC has realized throughout its entire investment portfolio. Obviously, actual performance in the past can not be relied upon as a guarantee for the future, nevertheless, investing with a proven sponsor such as MSC in private real estate, can offer a passive investor a superior overall return when compared with other traditional and alternative investment opportunities.
A side-by-side analysis is as follows:
Some examples of alternative investments would include private equity, hedge funds, art, commodities and derivatives contracts. Real estate is also at times classified as an alternative investment.
The most common types of alternative investments are real estate, collectibles, commodities and private equity.
Written by: Thomas Mathew
Director of Finance and Accounting
MarketSpace Capital, LLC is a Houston, Texas-based private equity real estate development firm focused on ground up developments and value-add investments throughout the United States.
Disclaimer: *For sold properties, actual sales price is reported. For active investments, the Estimated Current Value is based on the Managing Member’s estimate of current value. Recent acquisitions are generally valued at the acquisition price. Values may be internally prepared. This web-page/website is for informational purposes only and is qualified in its entirety by reference to the Confidential Private Placement Memorandum (as modified or supplemented from time to time, the “Memorandum”) of any offering of MarketSpace Capital.