Oct 17, 2022
We'd all like to make more money with less time and effort. While there is no magic answer, investing in private real estate opportunities that have little correlation to the stock market is one way to create a balanced portfolio to reduce risk and boost returns.
1. Stream of Cash Flows
2. Tax Benefits
3. Value-Add Appreciation
4. Financial Leverage
5. Hedge Against Inflation
6. Portfolio Diversification
Distributions from real estate operations are akin to dividends from stock investments. One should expect recurring distributions when a property is stabilized, meaning its occupancy rate is roughly in line with the market's average occupancy rate for similar properties and there are no major unit renovations taking place to significantly disrupt occupancy levels.
Depreciation expense is an annual reduction of taxable income that allows for the wear and tear, deterioration, or obsolescence of property used in a trade or business. Most apartment buildings are depreciable over 27.5 years at a rate of 3.636% each year.
A cost segregation study identifies the cost of each interior and exterior component of a building to identify those that can be depreciated over 5, 7, or 15 years instead of 27.5 years. Some examples are roofs, windows, and HVAC units. A shorter depreciable life means a higher income tax deduction.
Bonus depreciation allows businesses to deduct the full cost of certain assets that have a useful life of 20 years or less. So, assets with useful lives of 5, 7, or 15 years identified in a cost segregation study are eligible to be fully deducted in the year of acquisition rather than depreciated over a number of years. Congress is reducing bonus depreciation rates to 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and 0% in 2027 and beyond.
Depreciation expense defers tax rather than eliminates it. If a property is later sold at a gain, a portion of that gain equal to the accumulated depreciation on the property is recaptured as ordinary income.
The 20% qualified business income deduction will be effective through 2025. Qualified taxpayers get up to a 20% deduction of their income from pass-through entities such as limited liability companies and partnerships, which are commonly used to hold private real estate investments. The deduction applies to married taxpayers filing jointly if their income does not exceed $321,400, beyond which it is gradually phased out until their income reaches $421,400. For everyone else, those lower and upper income limitations are $160,700 and $210,700, respectively.
This section is merely a summary of the tax benefits of real estate investments available to investors. Each investor's situation is different. Consult your tax advisor to understand what tax benefits apply to your unique circumstances.
Value-add real estate investing means injecting expertise into the process of buying and upgrading a property with the intention of increasing its value by more than the cost of the upgrades. The following definitions will help explain the application of this concept.
The Cap Rate is the expected annual rate of return on a real estate investment property. It is equal to the property's Net Operating Income (NOI) divided by its market value or purchase price. So, mathematically:
Cap Rate = NOI ÷ Valuation (or Purchase Price)
NOI is a property’s annual revenue reduced by its annual operating expenses (essentially all expenses except for loan payments and income taxes).
If we rearrange the cap rate formula above, we get:
NOI ÷ Cap Rate = Valuation
and that means...
Δ NOI ÷ Cap Rate = Δ Valuation
where Δ means "change in."
Let's illustrate the concept with an example. Suppose we have a 100-unit apartment building and we believe we can raise rents by $50 per month if we upgrade each unit at a cost of $7,000. The cap rate for our type of property in this market is 5.00%. As shown below, our $700,000 investment in unit upgrades adds $1,200,000 to the property's value.
Although Buyer A made more money than Buyer B in absolute terms ($22,000 v. $14,300), Buyer B made a higher return (23.83% v. 11.00%) and had $140,000 of additional capital to invest in other opportunities.
Inflation's impact on investment performance and on the economy as a whole is extraordinarily complex; however, apartment rents and property values tend to rise with inflation. Rising home prices make buying a home less affordable and therefore push more people into renting. As demand for apartments increases, so do rents. Further, as property owners' expenses such as taxes, insurance, and maintenance rise with inflation, they often pass those rising costs on to tenants in the form of higher rent.
On the other hand, during some of the worst periods of inflation in the United States stock market returns net of inflation were devastated, as shown in the following graph.
Portfolio diversification aims to minimize losses by investing across various financial instruments, industries, and asset classes that would each react differently to the same event, meaning they have little correlation to each other. It is probably the most important component of investment management to reach long-term financial goals while reducing risk. The low, long-term correlation between real estate and the stock market, depicted by the graph below, helps investors smooth out returns and reduce risk.
If you'd like to learn more about how Volhawk can help you create passive streams of income from commercial real estate, connect with us here and one of our team members will be in touch to schedule a call.
All examples presented above are fictional and the results presented are used only to demonstrate the ideas conveyed in this article and are not guaranteed.
"Tax Cuts and Jobs Act, Provision 11011 Section 199A - Qualified Business Income Deduction FAQs" from https://www.irs.gov/newsroom/tax-cuts-and-jobs-act-provision-11011-section-199a-qualified-business-income-deduction-faqs
"What Is Bonus Depreciation? Definition and How It Works" by Julia Kagan, from https://www.investopedia.com/terms/b/bonusdepreciation.asp#:~:text=Bonus%20depreciation%20is%20a%20tax,additional%20first%2Dyear%20depreciation%20deduction, updated 9/21/2022
"What Is the Pass-Through Tax Deduction?" by The Ascent Staff, from https://www.fool.com/the-ascent/taxes/what-is-the-pass-through-tax-deduction/, updated 3/17/2022
"“The Role of Commercial Real Estate in a Multi-Asset Portfolio” by Jeffrey D. Fisher, Ph. D. and C. F. Sirmans. Jeffrey D. Fisher is a Professor Emeritus of Real Estate at the Indiana University Kelley School of Business.
“Real Estate: Surprising King of Noncorrelated Assets” from investmentnews.com, 1/6/2012
June 2021 – May 2022: S&P 500 return from Yahoo! Finance and inflation from Trading Economics; other periods from http://www.moneychimp.com/features/market_cagr.htm
Annual Performance of REITS v. The S&P 500 data from Yahoo! Finance