In the past, direct participation in commercial real estate (CRE) investments has mostly been reserved for institutional investors or the ultra-wealthy. After all, commercial real estate often costs tens of millions, if not hundreds of millions of dollars to purchase.
But since the JOBS Act of 2012 passed, millions of investors can now participate in CRE. In addition, the minimums to invest are as little as $5,000 through real estate crowdfunding.
Below are the four ways that investors can participate in the CRE market. In all cases, your dollars are funding investments in commercial real estate properties. For example, office buildings, retail centers, hotels and multi-family housing. However, how that investment occurs varies depending on the investment vehicle.
Common Ways To Invest In Commercial Real Estate (CRE)
1) Outright Property Ownership
In this case, investors purchase a CRE property, after which they own and operate it. If you can afford to buy a property on your own, these investments present a considerable opportunity to obtain both steady income and appreciation.
But given the high cost, buying a CRE property outright is often not realistic. It also requires a significant amount of effort. Ask yourself: Do I have a workable business model? Am I prepared to be a landlord?
2) Traditional Direct Investing
In this case, investors purchase a debt or equity stake in a CRE property. This is usually done by pooling their funds in a limited liability company (LLC).
By combining resources, direct investing offers a way for multiple investors to access CRE. In addition, the minimum investment amount is often significantly less than outright property ownership.
That said, it is still considerable, often around $100,000, and finding these opportunities tends to require a lot of legwork.
3) Publicly Traded REITs
In this case, investors buy shares in real estate investment trust (REIT) that owns a range of income-producing CRE properties. They then receive a portion of the properties’ earnings on an ongoing basis.
REITs offer a simple, liquid way for investors to add CRE to their portfolios. However, public REITs can be bought and sold at will. Thus, their performance tends to track more closely with the performance of stocks and bonds. Also, investors don’t have control over what properties the REIT invests in.
4) Real Estate Crowdfunding
This method of investing allows you to hand-pick individual real estate projects. Select ones that align with your financial goals, alongside a pool of other investors.
The fact that these projects are listed in online marketplaces generally makes it easier to find opportunities. This is especially true for opportunities outside your home city.
With both traditional investing and real estate crowdfunding, the LLC structure may provide important tax advantages. Ultimately this depends on the investment type and an investor’s personal tax situation.
As investment vehicles, the LLCs allow for the “pass-through” of depreciation, interest expense, and other deductions. In addition, the payout structures with direct investments are usually designed to align the interests of the investors with the sponsoring real estate company.
Main Reasons To Invest In Commercial Real Estate
There are many reasons to explore commercial real estate. For example, looking to save more for retirement or give your kid’s college savings a boost. Or you may simply want to diversify your investment portfolio,
As an asset class, CRE behaves very differently from stocks or bonds. CRE has a historically low correlation with the stock market. This means a drop in the global equity markets doesn’t necessarily impact your investment.
While the asset class is different from the traditional equities market, investors can also differentiate within CRE as well. There are different demand drivers for different types of commercial property. For example, a diversified portfolio can potentially mitigate risk with investments in various CRE projects.
For instance, job growth usually correlates to a need for office space; meanwhile, an increase in household formations may lead to a need for more apartment complexes. With a strong labor market, you might see the Fed raise rates. This can put a damper on the stock market, but not so much on the CRE market.
Improved Cash Flow
CRE investments can offer income in the present. In addition, it has the potential for a return based on the asset’s future appreciation. A key feature of direct CRE is that a significant portion of the total investment return comes via current cash flows from rental income.
Regular cash flow has the potential to provide a “stabilizer” to the volatility of equity prices otherwise sometimes seen with stocks valued solely on the basis of their long-term appreciation prospects.
The long-term rental arrangements common to commercial real estate helps reduce cash flow volatility. Tenants often sign lease agreements for 3 to 5 years, with some leases extending for several more years. During the 2008-2009 recession, my rental property cash flow stayed the same because I kept my tenants.
In addition, direct investments in commercial real estate have shown less volatility than stocks or even publicly traded REITs. The fact that direct real estate investments aren’t publicly traded means they are less impacted by short-term news and events, and that helps smooth valuations.
Investment In A Hard Asset
Unlike stocks that can poof in a day, real estate is a hard asset with intrinsic value both in the building and the land. Hard assets can often be used to produce other goods or services, which accounts for the increased price of the property. Hard assets can be remodeled to increase value. The landlord can also maximize occupancy to increase value.
Hedge Against Inflation
As the prices of goods and services increase in the broader economy, real estate often benefits.
That’s because increasing wages and profits also generally increase the amount that property owners can charge for space, as well as what tenants can afford to pay.
The property appreciation that has occurred since the last recession offers a prime example, with CRE prices increasing at a significantly higher rate than inflation. Data from the Federal Reserve Bank of St. Louis, for example, shows CRE prices increasing by at least 5% every quarter between 2012 and 2016.
The Consumer Price Index—the measure of inflation or growth in consumer prices—stayed at or below 2% during the same time period. Rent escalation clauses in many leases provides another inflation hedge, in addition to organic rent growth.
Potential Tax Benefits
If properly structured, you may be in a position to claim deductions related to depreciation, interest expense, and other items help to defer the taxes on cash distributions.
For instance, the IRS allows CRE investors to deduct some of a property’s depreciated value to account for the cost of maintenance and upkeep. The overall result is that CRE-related tax advantages may help investors to defer some taxes in a way that is not available with most other investments.
For 2018 and beyond, the new tax law now allows for a 20% deduction of income received through pass-through entities such as LLCs.
CRE Or Residential Real Estate?
There are certainly some similarities between CRE and residential: both are hard assets can provide income from rents and leases in addition to appreciation. But CRE, as noted above does offer some unique benefits that can play an important role in a diversified portfolio.
Besides the larger valuations usually seen with commercial properties, the biggest differentiator between residential and commercial is the diversification of income streams inherent in most commercial properties.
With residential properties, investors are often dependent on a single tenant, which presents them with increased risk.
Commercial properties generally have multiple tenants—sometimes hundreds—that help mitigate the risk of defaulting or otherwise non-paying single tenants.
With residential properties, though, investors are often dependent on a single tenant, which presents investors with increased risk.
With online real estate platforms, investors can often enjoy relatively small minimum investment amounts even while participating in larger CRE investments.
My main philosophy is to own a house you’ll enjoy living in and invest in commercial real estate for profits. Your primary residence shouldn’t be considered a profit center, unless you plan to rent out rooms. Instead, focus on living life to the maximum and optimizing your investment dollars in CRE instead.
Real Estate Crowdfunding Solution
The ability to pool investments into an LLC, as we described, allows you to scale your investment power to participate in projects that you wouldn’t be able to access on your own.
That said, it’s important to note that real estate investments carry risk and are not guaranteed. You run the risk of losing invested capital, up to all of your original investment. Never invest money you cannot afford to lose and always assess your risk profile.
With real estate crowdfunding, you don’t need to risk $100,000 or more to invest in CRE. Instead, you can invest for much lower amounts such as $5,000.
The best real estate crowdfunding platforms today are:
1) CrowdStreet is based in Portland and connects accredited investors with a broad range of debt and equity commercial real estate investments. CrowdStreet is great because they focus primarily on 18-hour cities (secondary cities) with lower valuations, higher net rental yields, and potentially higher growth.
2) Fundrise, founded in 2012 and available for accredited investors and non-accredited investors. I’ve worked with Fundrise since 2016, and they’ve consistently impressed me with their innovation. They are pioneers of the eREIT product. Most recently, they were the first ones to launch an Opportunity Fund in the real estate crowdfunding space to take advantage of new tax laws.
Both of these platforms are the oldest and largest real estate crowdfunding platforms today. They have the best marketplaces and the strongest underwriting of deals.
So far, I’ve invested $810,000 in commercial real estate since 2016 and am earning a ~15% IRR. Below is my dashboard.
About the Author: Sam worked in finance for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. He spends time playing tennis, taking care of his family, and writing online to help others achieve financial freedom too.
Sam started Financial Samurai in 2009 and has grown it to be one of the largest independently owned personal finance sites in the world.