Despite what the real estate education circuit would have you believe, the road to real estate riches does not run through single-family assets. The road to wealth runs through commercial real estate (CRE). While single-family rentals and fix and flips get all the late-night ad time, it’s CRE that smart investors gravitate to for building and maintaining wealth.
Before getting into the advantages of CRE, first, what is commercial real estate (CRE)?
CRE is a class of income-producing real assets – property designed to make money. The primary purpose of single-family residences is to provide shelter and not necessarily to make money. CRE is designed primarily to make money.
The six primary CRE asset classes include:
There are multiple reasons why sophisticated investors like the ultra-wealthy, family offices and institutional investors like university endowments and private investment funds prefer CRE and ignore single-family.
The primary reason is the multi-faceted benefits of owning CRE vs. single-family assets.
Returns from single-family assets are derived principally from one source. Because cash flow from single-family is negligible, returns hinge on a single source: appreciation – the difference between the acquisition and eventual sale price.
Besides appreciation, CRE offers up an array of benefits that smart investors covet but that single-family does not offer. In addition to appreciation, these smart investors also seek reliable and consistent passive income, tax savings, insulation from volatility, and a hedge against inflation and recession.
Here’s a rundown of the top 9 reasons smart investors choose CRE over single-family:
(1) Value-Add Opportunities.
Because most single-family assets are acquired with debt, most single-family rentals produce little to no sustainable cash flow in most markets after payment of debt service. This makes the return on investment entirely dependent on the appreciation. Conversely, CRE generates reliable and consistent income that contributes to the underlying value of the property independent of the greater market. This is due to the intrinsic value of CRE.
Because CRE has intrinsic value correlated to cash flow, CRE offers opportunities to boost gains from the increase in value of the property separate from what’s happening in the greater market (i.e., what the investing public is willing to pay). This allows the owner/operator of the asset to directly impact the property’s value through management efficiencies that either increase revenue or reduce expenses to boost NOI. This boosts the asset’s value, separate from what the market says.
The asset value of a single-family does not correlate with its profitability and is solely dependent upon the overall market. Single-family returns are almost entirely dependent on the market.
(2) Leverage Risk.
If leveraged, owning a single-family rental puts the investor at risk of more than a 100% loss of equity risk because of the personal guarantees required in connection with investment debt. In a worst-case scenario, the investor could be on the hook for more than their original investment because of recourse. CRE debt is typically secured entirely by the property and requires no personal guarantees.
(3) Economies of Scale for Enhanced Returns.
Large capital items such as roofs, driveways, heating, and cooling systems are only dedicated to a single tenant. If a rental incurs unforeseen capital costs, it wipes out any cash flow for the foreseeable future and can tank future profitability. Forbes.com.
Compared to single-family, CRE properties lend themselves to economies of scale to reduce costs of large capital items and management expenses per-unit basis. On the management side, with single-family, investors must either manage the property themselves or spend significant amounts to pay a third-party property manager (typically 6-10% of gross income).
The economies of scale effect on expenses allow CRE investors to achieve higher returns from CRE than single-family assets.
(4) Occupancy Risk.
Instead of collecting rents from a single tenant from a single-family property, CRE properties offer the potential to collect income from multiple tenants. A delinquent single-family tenant imposes significant occupancy and income risk on single-family assets.
According to Freddie Mac, U.S. multifamily occupancy rates have averaged approximately 95% since 1990. Forbes.com. Therefore, large multifamily properties can reliably target 95% occupancy rates in most markets. In contrast, a single month of vacancy in a single-family rental equals a 91.75% occupancy rate (or 8.25% vacancy rate) for that year. If the house remains vacant for three months, you are now facing a 75% occupancy rate for the next year, equivalent to a seriously distressed multifamily property.
(5) Geographic and General Diversification.
Single-family investors typically invest in their backyards to maintain oversight of their assets. Passive CRE opportunities allow investors to leverage the expertise of others to invest in asset classes and locations not possible in just the investor’s backyard. In addition, CRE offers far more opportunities for the diversification of assets.
CRE offers diversification through various elements, including geographic market, asset segment, property type, investment strategy, compensation structure, and security type, an ideal hedge against downturns.
That’s because not every asset will be equally affected by a downturn. Income from certain performing investments can compensate for underperforming assets to help your portfolio ride out a storm.
In addition, there are six CRE asset classes to choose from, and investors also have investment options based on a property’s location, condition, and tenant profile (A-D) and by investment strategy (Core, Core-Plus, Value-Add, and Opportunistic). In other words, there are countless opportunities to make money in the CRE space.
(6) Tax Benefits.
CRE investments – mainly passive investments structured as partnerships – offer many tax benefits not available with single-family, including business deductions, regular depreciation, bonus depreciation, long-term capital gains treatment, avoidance of self-employment taxes like FICA, and tax deferral through 1031 exchanges.
(7) Financing Leverage and Scaling.
Commercial real estate loans allow investors to leverage their capital across multiple properties instead of a single property. Instead of sinking $1,000,000 into a single property, sophisticated investors will use the $1,000,000 as down payments on loans to acquire five properties.
Leverage allows for scaling unique to CRE, allowing for superior returns compared to single properties – even when accounting for debt servicing.
(8) Recession and Inflation Hedge.
Investments in the right CRE segments with the demand that doesn’t waiver offer ideal inflation hedges against recession and inflation. Historically, the essential segments have weathered downturns and inflation the best.
(9) Insulation from Volatility.
Investor sophistication requirements, relatively high barrier to entry, and illiquidity associated with a passive CRE investment insulate it from the risk of market volatility posed by herd mentality. Liquid markets with low investment entry minimums open the door to unsophisticated investors prone to wild market swings not seen in CRE.
Single-family gets all the attention on the real estate instruction circuit, but CRE receives all the attention from smart investors. It’s proven and reliable.