Let’s get the obvious out of the way first. There are four well known reasons for favoring commercial real estate investments over owning stocks. They are:
1. The positive cash flow from commercial real estate (CRE) is a major advantage over owning stocks. Some may say stock dividends also provide cash flow. True, but an average dividend yield on the New York Stock Exchange is about 2% which is nothing to get excited about.
2. 1031 exchanges allow the investor to defer capital gains taxes for decades. If you sell a stock you pay the capital gains that year.
3. Depreciation on commercial real estate shelters income, reducing the investor’s income tax burden. No such tax benefit exists for owning stocks.
4. Using debt to buy property substantially increases an investor’s cash-on-cash return. Some may say that stock options also allow you to leverage. In my opinion, options are a great way to lose a lot of money very quickly!
I could have titled this blog post “Seven Good Reasons For Owning Commercial Real Estate” but we all know those reasons mentioned above. I would like to focus my attention on three not so obvious reasons why investing in commercial real estate is far superior to owning stocks. So here goes:
The first not so obvious reason to invest in commercial 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 information. The stock market is an example of what an efficient market is. In an efficient market you buy at whatever the price is. There is no legal way to buy the stock at a below market price.
On the other hand, the real estate market is a perfect example of an inefficient market. Price setting is 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 we have a deal. It’s as simple as that. It is much more advantageous to invest in an inefficient market because you may have information that the seller doesn’t have that can make your investment worth a whole lot more than what the seller thinks it is worth. So the first not so obvious advantage of owning commercial real estate vs. common stock is that it’s possible to buy CRE at a bargain price. You can never buy stock at a bargain, only at what is considered the market price.
The second not so obvious reason to invest in commercial real estate rather than owning stock is that CRE 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,
- Re-tenant properties with better quality and higher paying tenants.
As an owner of stock you’re a passive investor having no influence whatsoever on the value of your investment. You are at the whims of the emotions that control the stock market. Your particular stock might be doing well but if the market is on a downward cycle your stocks are going down in price with the rest of the market.
And finally the third not so obvious reason to invest in commercial real estate vs. stocks is no more need for retirement calculators. We’ve all seen the TV commercial where people are asked how much money they think they need to save in order to retire comfortably. Their response: With a shrug of the shoulders and a bewildered look on their face they reply, “Beats me” or something equivalent. And if your investments are in stocks, bonds, land, precious metals or other commodities that is an honest answer. Who knows? It’s anybody’s guess including the investment banking company that sponsored the TV commercial.
But with commercial real estate you can make a reasonable guess 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 questions:
How much annual income before tax do you need to retire comfortably?
How much annual income are you expecting to receive from Social Security?
What is the current cash-on-cash return you’re receiving on your commercial real estate investments?
For example let’s assume that you need $100,000 a year in before tax income to live comfortably. Every year the Social Security Administration sends you a letter stating what you will receive from them when you retire. Let’s assume you will receive $30,000 annually from Social Security. To determine your current cash-on-cash return on your commercial real estate investments add up all disbursements you received last year on your CRE 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 CRE portfolio had a 7% cash-on-cash return last year. Now let’s do the math:
$100,000 Annual income requirement
$-30,000 Minus what’s received from Social Security
$ 70,000 Net income needed from CRE investments
$70,000 / .07 = $1,000,000
In this example, in order to live comfortably this person would need to have $1 million in commercial real estate generating on average a 7% cash-on-cash return. They will never have to worry about running out of money as long as their properties are generating 7% annually. What happens if there is high inflation? If rents over time increase with the rate of inflation they’ll be fine. Living off the cash flow of their CRE portfolio means they never need to use the equity in their properties to mainatain their lifestyle. Let me say it another way: they could live to be 120 and they will not have to worry about running out of money. Can you say that about owning stocks? Nope!
Sources: Stocks vs. Real Estate: Which is Better?, The BiggerPockets Blog, by Peter Giardini, March 11, 2010;Real Estate is Better than Stocks – Fact, Not Opinion, The BiggerPockets Blog, by Ben Levbovich, November 19, 2013;9 Reasons Why Investing in Real Estate is Awesome (And Better Than Stocks!), The BiggerPockets Blog, by Mark Ferguson, November 10, 2013; Dividend Yield for Stocks in the S&P 500, IndexArb, http://www.indexarb.com/dividendYieldAlphasp.html, February 26, 2014.