WHY REAL ESTATE?
In order to build a resilient portfolio strategy that can stand the tests of extreme economic events, savvy investors look to add asset classes backed by commercial real estate. Economic swings are inherently difficult (or functionally impossible) to predict, therefore a proper allocation of carefully chosen investments in real estate can offer a safe haven against the damage of a downturn shielding capital and income.
Investment is Secured and Backed Real Estate
One of the primary reasons real estate investments can have greater resilience against a market panic is their inherent illiquidity.
Stocks and other securities can be quickly converted to cash; land and buildings cannot. This feature removes much of the panic selling from real estate, which helps investors ride out the storm amid volatility in the securities market. Without strategically selected real estate holdings hedging risk in a portfolio, even moderate negative market shifts can result in considerable losses for investors. Which real estate asset class should investors take into consideration? An obvious choice is the multifamily sector, which offers superior elasticity to other assets such as retail outlets and office buildings. Instead of being secured by a paper stock certificate, investments in real estate are backed by land and solid structures. In the case of apartments, these are real tangible buildings made of concrete and lumber with intrinsic value built to last over time shielding value and income.
Invest for Cash Flow
Multi-unit rental properties such as apartment buildings offer more income stability and diversification than investments in other real estate asset types.
When a tenant vacates a single tenant retail, industrial or hospitality building, the vacancy is immediately 100%, producing no income to the owners. The same would be true of a single-family home. The retail side of commercial real estate has been hit hard by the forces of e-commerce (Amazon), limiting landlord options for rent collections and escalations. In contrast, when a tenant moves out of a multi-unit property, income is still derived from the other multiple rent paying tenants. In addition to a near constant income stream, in any economic environment there is a constant need for affordable housing, as “people have to live somewhere.” In a poor or struggling economy, there is always an increased need for affordable housing.
This is especially true when the process of home ownership is more expensive or simply unattainable due to limiting factors such as income, credit and down payment requirements. Class B Middle-Market Apartments provide shelter to some 65 million Americans (and growing), giving multi-family real estate a considerable reliability advantage over other investment types. Therefore, apartments tend to be more recession resistant given that multi-family rental units offer the affordable housing choice to the masses as opposed to other real estate investment options.
Make $$ While You Sleep
One of the keys to wealth building is to generate $$ in your sleep. Acquiring cash flowing assets that produce consistent income without heavy lifting from the owners is the key.
Quality multi-family properties utilize professional management that employs a careful tenant screening and selection process. A focused and competent property manager will tend to the immediate needs of tenants (service and maintenance requests) and conduct key marketing efforts to bring in new tenants when required. Apartment managers watch market conditions closely and can utilize shorter-term leases, and adjust rental rates based on market shifts in real time.
Rental rates can be flexed quickly to retain occupancy and income during a down market, and then increased back to the mean as markets rebound. Every property will have a certain amount of fixed costs, and as the size of the building increases, the scale of fixed costs per unit decreases as a percentage of revenue. An experienced property manager controls these fixed costs, and also plays a vital role to reduce maintenance and repair expenses. This increases Net Operating Income (NOI), thereby maximizing real asset cash flow returns to the investors.
Return on Equity
Equity creation, or “forced equity,” is created by increased revenue or decreased expenses of the multi-family asset (5 units or greater).
Both ultimately increases the profit known as Net Operating Income (NOI) of the property. For every additional dollar of profit created in NOI, equity is increased (forced) through the higher value created through the multiple of the market capitalization rate (valuation multiple) when the property is appraised or sold.
For example, one specific asset Cornerstone recently acquired, the General Partners uncovered a significant value opportunity. The in-place property management company overcharged tremendously for their management fee. After fully vetting and hiring another local property management company at a market rate management fee, we switched and saved the investor group $50,000 in annual expenses thereby increasing the market value by $1,000,000.
Tax Free Investing
It is not widely known that the US government rewards people through tax incentives in order to create economic growth. The tax code is simply a tool the government uses to stimulate the economy. In fact, the US government gives tax incentives to businesses to create jobs, real estate investors to create affordable work force housing, for oil and gas exploration, farming & agriculture, and for green energy.
As a reward to do what the government wants, these business owners and investors pay the least amount in taxes, between 0% and 20%. If you compare that to W2 employees who pay 40%, and those who are self-employed and own small businesses that pay 60%, the educated investor knows that taxes are their biggest expense. Investors also know that what $$ you keep after tax is most important when it comes to wealth building. All by doing exactly what the tax code allows and is 100% legal and encouraged!
Tax Free Income
Thanks to the Tax Cuts and Jobs Act of 2017 (TCJA), residential landlords who operate as pass-through entities (a special business structure, such as sole proprietors, LLC’s, and S Corps, that eliminates the burden of double taxation). This essentially makes 20% of your profits tax free. There are some limitations and exemptions, so be sure to consult your income tax professional.
Cash Flow Sheltered by Depreciation
Also known as a phantom return, depreciation is an annual expense deduction that is taken on paper without actually incurring the expense. This deduction is typically a percentage of the value of the property that you can write off as an expense against revenues. The concept of depreciation holds there are two parts to an investment property, the land and the improvements (structures). Structures can be depreciated, as they will deteriorate over time. In most cases the land value is about 20%, and the value of the improvements are at 80%. It is the structure (80%) the IRS will let you write down (depreciate) over a certain number of years depending on the type of real estate. For residential real estate that timeline is 27.5 years. For example, a $300,000 property has $240,000 (80% of 300k) that can be depreciated over 27.5 years, which equals $8,888.88 per year. This amount is listed as an expense, even though no actual $$ is coming out of your pocket! The net income generated from the property is sheltered by the $8,888.88 (depreciated amount yearly), resulting in tax free income by the same amount to the owner.
Tax Free Harvesting
There are several ways to measure the performance of investment real estate. One of these ways is Return on Equity, or ROE. The less equity and more cash flow a real estate asset produces, the higher the return. Strategic real estate investors watch their Equity metric periodically. Due to market forces and inflation, quality real estate values will go up over time. This appreciation creates more equity for the owners. If there is a loan on the property, this is considered good debt. After all it is the tenants whom are paying for it! Each month when the payment is made, a portion of that payment goes to pay the loan balance down through amortization. This amortization of the loan balance downward also creates equity for the owners. These dual factors of a rising property value and loan paydown together widen the equity stake in the property for the owners simultaneously. This equity grows tax free, and strategic investors know that harvesting this equity can also be tax free. The forces of inflation will also cause rents to rise, pushing rent revenues upward. This allows the property to remain cash flow positive even when a new larger refinance loan is put in place of the previous one. The proceeds of this new greater loan permit the owners to re-position this newly monetized equity, harvesting the proceeds tax free and shielding it from any unforeseen drop in market value. Owners can then make necessary improvements to the subject property, and/or invest in additional cash flow producing real estate. Once the original cash equity investment is re-positioned, the returns to the owners become infinite!
Tax Free Trading
When an asset is sold for a greater amount than the cost basis, capital gains income is generated, and therefore taxed. Capital gains can be derived from the sale of various assets such as stocks, gold, cars, art etc. Capital gains can also be generated from real estate. Unlike gains from other assets, gains from real estate transactions can be tax free utilizing a 1031 tax free exchange. Instead of paying the tax on the gain like other assets, savvy investors know to utilize this tax-free option to put the proceeds into more “like kind” cash flowing real estate. This is a great way to “multiply thy gold” tax free and create even more cash flow. Strategic investors then harvest this equity through a refinance and re-position the newly monetized equity tax free to buy even more cash flow producing assets. This strategy blueprint execution is known as the “Velocity of $$.” It is no wonder why real estate is the favorite investment vehicle among wealthy investors.
Profit from Inflation
Inflation makes people poorer, and it is the primary reason why the gap between the rich and the poor in this country continues to widen. Educated investors thrive by carefully choosing investments that consistently perform at a rate that outpaces inflation. Smart investors use leverage and hedging, similar to the way banks make $$ through arbitrage. Savvy investors play the bank’s game and borrow $$ from a bank at a fixed rate to buy cash flowing assets.
This new asset covers the debt payment, and costs less as the dollar loses purchasing power due to the forces of inflation. This allows the investor to become their own bank and use less of their own $$, increasing the rate of return. Income from quality multi-family investments grows due to inflation, as rents generally rise 3-5% each year as the dollar loses purchasing power. This creates the hedge investors are looking for, as the bank is owed only the agreed upon payment. The rising costs for rent each year flow straight into the investor’s pocket.
IRA Cash Machine
If your IRA custodian is a big bank or brokerage house, your investments range to only what they offer in terms of stocks, bonds, or mutual funds. Your investment choices are limited, and you have little control over the performance of these precious retirement funds. Even worse, you are restricted to what is on the menu of investment choices offered. Mandatory with-drawls and market crashes have a big impact on how long investor’s $$ will last. Advancements in today’s medical care has retirees oftentimes outliving their IRA balance and run out of $$. Educated investors know this, proving why self-directed IRA’s are so important. It is not widely known that self-directed IRA’s can buy real estate. In fact, real estate is the most popular investment in self-directed IRA’s, and for good reason. Investment experts know that quality real estate:
- Offers focused capital backing & security, an important factor in any investment portfolio.
- Assets in your self-directed IRA grow tax free.
- The cash flow from an investment in real estate provide a steady income stream while the capital amount originally invested grows tax free, all while being secured and backed by real estate.
- Once a set of requirements are satisfied in a Roth IRA, the earnings are distributed tax free.
- Is a time tested hedge against inflation.
Blue Ocean Strategy
Real estate is an established asset class, and investment strategies that leverage the advantages of multifamily have a better chance of resilience and recovery. Smart investors utilize a strategic portfolio secured and backed by quality real estate as a safe harbor during the weather of a rough economy preserving asset value and income. During each of the last downturns, apartment owners found higher occupancy and higher rents as more people downsized and chose to rent vs. own a home. Knowing that “people have to live somewhere,” and can pay rent even when on unemployment make apartments an obvious choice over other real estate asset types. These factors provide increased stability of capital and net income to investors of multi-family assets through economic winds of change.
As an investor, partnering with Cornerstone gives you the opportunity to add real estate as another income source to your portfolio, one that can generate substantial passive income for years to come.