Why commercial real estate is probably the most basic question investors must ask themselves when considering whether to invest hard-earned dollars in the sector, and specifically, invest in private or direct commercial real estate (“CRE”). It’s a good question, and there a number of reasons that real estate is a sound choice for investors that include competitive total returns and dividends, diversification and hedging against inflation. Let’s look at these attributes:
- Competitive total returns: commercial real estate has consistently produced returns that are as good as, or better than, returns produced by other products, such as stocks and bonds. This is true for both public and private strategies. Private real estate funds that comprise the National Association of Commercial Real Estate Investment Fiduciaries’ ODCE index have produced an annual average total return of 8.7% since 1978.
- Regular dividends: commercial real estate is a cash flow-producing investment that provides investors with two types of returns, appreciation and regular dividend income. Appreciation involves the increasing value of properties, which can be realized when an asset is sold, while dividends stem from the cash flow produced by properties on a regular basis. This is particularly true of mezzanine debt and preferred equity investments, which are structured to produce returns of 4-8% in excess of prevailing Treasury rates. Equity investors also get dividend income that has historically outperformed other sectors.
The NCREIF Property Index, for example, has produced an average dividend income of 5.5% over the past 10 years and 7.4% since inception in 1978. The NAREIT Equity REIT index has produced an average 4.9% dividend return over 20 years, and as of July paid a 4.3% dividend compared to 2.0% for the S&P 500. The Levy CRE Mortgage Index has produced an average total return (annualized) of 6.77% including credit losses over the last 20 years for the period ending 06/30/2015.
- Diversity: commercial real estate encompasses a wide variety of assets and investment types that can be blended together to create a diverse portfolio. For example, there are multiple property types, major (apartments, offices, retail, industrial and hotel) and minor (self-storage, medical office, senior apartments, etc.), each with their own set of economic drivers. Diversity can come in the form of geography, investing in properties in different regions with diverse economic drivers or different levels of liquidity.
Another form of diversity is in the types of investments. Individuals can invest in senior loans, mezzanine loans, preferred equity or equity. Investors can blend risk levels, such as new construction, value-add properties that need improvement, stable assets in core markets or triple-net leased properties that have a tenant signed to a long-term lease.
Investors can mix stakes in fixed-income assets that pay dividends with equity investments that pay a small or no dividend but carry the potential for a larger payoff at the end. All in all, commercial real estate investors have access to an enormous number of strategies and asset types that enables them to build diverse portfolios.
- Hedge against inflation: over time commercial real estate can act as an effective hedge in inflationary environments. Inflation tends to rise in times of strong economic growth, which often produces higher rents and rising property values. This can increase the cash flow and value of commercial properties.
In sum, commercial real estate has long produced returns competitive with riskier investments such as the stock market while also providing regular cash flow that is in line with or better than fixed-income investments that have no appreciation upside. What’s more, CRE investors have the ability to diversify and hedge against inflation by constructing a portfolio with a wide range of attributes and risk levels.