Why should you invest in real estate, especially since there are many other types of assets to choose from? There is one overpowering reason to do so, but before I tell you what it is, I want to explain the benefits of owning commercial real estate.
Four Well-Known Reasons
When comparing commercial real estate CRE to owning most other types of investments, there are four distinct advantages:
- The positive cash flow from real estate is a major advantage over owning most other types of investment. Stocks and bonds can also provide positive cash flow from their dividends. Bonds much more so than stocks, as an average dividend yield on the New York Stock Exchange is about 2 percent. But well managed CRE should generate significantly better cash flow, conservatively 6 to 8 percent and higher is not uncommon.
- 1031 exchanges on the sale of investment properties allow investors to defer capital gains taxes for decades. But if you sell another type of investment, you pay the capital gains that year.
- Depreciation on real estate shelters income, reducing the investor’s income tax burden. No such tax benefit exists for owning other asset classes.
- Using debt to buy property has two benefits: It significantly reduces the equity needed to purchase the property and leveraging a property with debt can significantly improve its return on investment. This is a huge advantage of owning CRE over other types of investments.
These four reasons for owning real estate are commonly known benefits. However, there are also three not so obvious reasons why investing in real estate is far superior to owning other types of investment assets. In my comments below, I will specifically focus on comparing real estate to owning stocks, because for many investors that is the logical alternative investment to owning real estate. But I believe this comparison is true of most other types of investments, not just owning equities.
Three Not So Obvious Reasons for Investing in Real Estate
- The Concept of Efficient vs Inefficient Markets
The first less obvious reason to invest in real estate rather than owning stock has to do with the concept of efficient vs. inefficient markets. In an efficient market, everyone has the same financial information.
And you buy at whatever the price is. The stock market is a good example of an efficient market. Investors know the value of each stock. They have no legal way to buy a stock below the established market price.
The real estate market, on the other hand, is a perfect example of an inefficient market. The price of a piece of property is determined by what the seller and buyer agree upon. It has very little to do with the market at large. You make me an offer, and if I agree to it, we have a deal. It’s as simple as that.
It is far more advantageous to invest in an inefficient market because you may have information that the seller doesn’t, and this can make your investment worth much more than what the seller thinks it is worth. This happens all the time. The buyer sees a for-sale listing through a different set of eyes than the seller. He sees the property, not as it is, but for what it has the potential to become. Now the seller has decided it’s time to sell, for whatever reason. He doesn’t see the property’s potential. Instead he sees the issues that plague his property. Who has the more accurate assessment of the property? No one knows with certainty, even when the sales price is agreed to between seller and buyer. But over time, the property’s true potential will become readily apparent.
So the first not so obvious advantage of owning real estate over owning common stock is that it’s possible to buy real estate at a bargain price. You can never buy stock at a bargain, only at what is considered the market price.
- Real Estate Owners Can Influence the Outcome of Their Investments
The second not so obvious reason to invest in real estate rather than owning other types of investments is that real estate owners have considerable influence on the outcome of their investments. They can:
- make capital improvements to tired properties,
- change management for those properties that are poorly managed, and
- re-tenant properties with better quality and higher paying tenants.
As an owner of stock, you’re a passive investor with no influence whatsoever on the value of your investment. You are at the whim of the emotions that control the stock market. Your particular stock might be doing well right now. But if the market takes a downward cycle, your stocks are going down in price with the rest of the market.
But the successful CRE investor is actively engaged with considerable influence on the value of his investment through a variety of ways. In commercial real estate, you actually have quite a bit of control over your investment and its potential for growth.
- The fastest, most reliable way to achieve financial freedom
But it’s the third not so obvious reason why investing in real estate truly makes it far superior to owning any other type of investment.
But before I explain what that is, I want to begin by defining financial freedom. This is my definition of financial freedom and it may differ from its textbook definition. Financial freedom is achieved when your monthly sources of passive income consistently and significantly exceed your monthly personal expenses. When that day happens you no longer need to work for a living. Congratulations! You can retire in style.
But notice I said passive income which is cash flow received that requires little or no effort to maintain it. Another name for passive income is mailbox money because it comes in the mail without lifting a finger. And real estate in my opinion is hands down the best source of passive income you can invest in.
Problem #1- Brainwashed & Incentivized
But there’s a problem. Actually, there are two problems. Some of you may agree intellectually that we should invest in assets that generate passive income, but most of us will fail miserably actually doing so. Why? Because we’ve all been brainwashed and incentivized to put our savings into an IRA or 401(k) plan. And what types of assets do you normally purchase for these types of accounts? Stocks and bonds which generate little or no passive income.
Problem #2 – Don’t understand the importance of passive income
The second problem is that many people don’t understand the importance of passive income. I’m confident that some of you are thinking, “Why is it so important to generate passive income? I’m very happy with the return I’m getting on my retirement accounts.” Here’s my answer to that response.
You’ve likely seen the television commercial where people are asked how much money they think they need to save over their lifetime in order to retire well. Their response is typically a shrug of the shoulders, a bewildered look, a financial guess, a “beats me,” or something equivalent. If your investments are in stocks, bonds, undeveloped land, precious metals, or other commodities, then a guess is about the best answer you can give. It’s anybody’s guess, including the investment banking firm that produced the TV commercial. They don’t know either.
But with commercial real estate you can make a reasonable estimate as to how much you’ll need to have accumulated in real estate in order to retire comfortably. All you need to know are the answers to these three basic questions:
- How much annual income before taxes do you need to retire comfortably?
- When you retire, how much are you expecting to receive annually from social security or other pensions you will receive?
- What is the current cash-on-cash return you’re receiving on your real estate investments?
Here’s an example of Investing in Real Estate
For example, let’s assume that you want $100,000 a year in income before taxes to live comfortably. As you get close to retirement age, the Social Security Administration sends you an annual letter stating what you will receive from them when you retire. Let’s assume you and your spouse will receive a total of $40,000 annually from social security.
Now, to determine your current cash-on-cash return on your real estate investments, add up all owner disbursements you received last year on your rental properties and then divide by the total initial cash investment in all of your properties. Depending on how good an investor you are, that could be anything, but I believe a 6- to 8-percent cash-on-cash return is a conservative estimate on well managed properties. So for discussion purposes, let’s assume your commercial real estate portfolio had a 6 percent cash-on-cash return last year. Now, let’s do the math:
Dividing $60,000 by 6 percent results in $1 million you will need to invest to make up the shortfall from your social security checks. In other words, over your lifetime, you will need to slowly grow your real estate investments until you have $1 million invested. If you are just starting out investing in real estate, this sounds like an enormous sum. But in reality, with prudent investing, this amount is attainable, in fact, quite likely to reach.
So, in this example, in order to live comfortably, you will need to have invested $1 million in real estate generating on average a 6 percent cash-on-cash return. If you do, you will never have to worry about running out of money as long as your properties are generating 6 percent annually.
Now fast forward to the day the person with a typical 401(k) or IRA retires. How is she going to live off her retirement assets? She will live off them by slowly liquidating them over time. What happens if she lives longer than his assets do? She’s toast. She ends up like the vast majority of Americans who eventually end up dependent on Social Security, family, friends or charity.
Not so with real estate. You do not live off liquidating your rental properties. You live off the passive income generated from your rental properties. When your passive income from your rental properties coupled with your future Social Security checks consistently and significantly exceeds your monthly personal expenses, you have attained financial freedom. In other words, you could live to be 120 years old and you’ll never run out of money. And that is why owning real estate is far superior to owning any other type of investment.