WHY INVEST IN COMMERCIAL REAL ESTATE?
Commercial real estate has a long history of being an attractive investment play during both up and down market cycles. An article from CrowdStreet perfectly describes the top six reasons to invest in commercial real estate. Read the full article.
1. Attractive returns: One of the main reasons that institutional and private investors alike are pursuing real estate investments right now is that they are chasing yields. Real estate returns are attractive compared to alternatives in stocks, bonds or even other commodities such as gold. One benchmark for measuring investment performance for a large pool of individual commercial real estate properties in the private market is the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index, which measures the performance of an immense pool of individual commercial real estate properties on an unleveraged basis. The NCREIF Index reported an annual return of 12.7% in 2015, which bested other key indexes such as the S&P 500, Dow 30 and Russell 2000. On a longer term view, the NCREIF Index has reported an average annual return of 8.8% over the past 15 years, which is 200 basis points above the average performance of the S&P 500 for the same period.
2. Cash flow: Real estate investments are often structured to deliver steady cash flow with dividends that are distributed to investors monthly, quarterly or annually. An equity investment is a popular way to achieve steady, reliable cash flows.
Equity investments involve buying a passive, minority ownership stake in a hard asset, such as a net-leased, retail, industrial or office building. High occupancies and rising rents generally deliver what most owners/investors strive for – steady or rising cash flow over time.
3. Equity upside: Specific to equity investments, investors have the opportunity to boost their overall return by cashing in on property appreciation or a capital gain on an asset once it is sold. Property values certainly rise and fall during market cycles, which makes timing the exit strategy a critical aspect of maximizing investor value. Some investors can reap the rewards of opportunistic buys that allow them to buy, fix and flip an asset in a relatively short period, such as one to three years. Other investment strategies, more predicated on the prospect of stable cash flows, might target a hold period of five to seven years or longer.
4. Depreciation: While realizing appreciation and capital gains is a definite incentive to real estate ownership, there also is depreciation on the other end of the spectrum. Depreciation decreases the accounting value of the physical structure of a real estate asset, as most assets decline in value over time, but does not affect the market value of a property. In its most basic form, the physical improvements of a property may be depreciated over a 27.5 year period in an accounting method referred to as “straight line depreciation”. However, certain improvements (e.g. appliances and flooring) may be depreciated over a period as short as five years. Depreciation is utilized by real estate operators as a tax benefit tool, which allows an investor to utilize a passive “loss” from depreciating improvements to offset other passive income. The net result is a higher after-tax yield. As the tax benefits of depreciation are dependent upon an individual’s or entity’s taxable income, investors are strongly encouraged to consult a tax advisor.
5. Principal Paydown: For assets that are mortgaged with a fully amortizing loan (in most cases over a 30-year period), the property’s revenues service an outstanding debt that reduces with each month’s payment. Think of it as a monthly savings program - the rents paid by a property’s tenants reduce the asset’s leverage, which in turn, increases equity and, hence, investor returns at the point of exit (which at 75% leverage can amount to 25% of total returns) while also reducing risk. In a world of investment uncertainty, principal paydown infuses an element of month-over-month certainty of returns.
6. Tangible assets: Another key advantage of real estate investing is that it is a good way to diversify portfolios that are backed by hard assets. Real estate is not the same as buying shares in a company that may be here today and gone tomorrow. Certainly, cases such as Enron and Lehman Brothers have proved that even stalwart corporations are not infallible. Real estate is an asset class that investors can literally touch and feel. Yes, some building occupants may come and go, and there may be ups and downs in building valuations over the course of its life, but the property itself is not going to disappear.
1031 Exchange
Another key reason Investors find commercial real estate such an attractive investment option is the ability to defer capital gains taxes upon sale by completing a 1031 Exchange.
WHAT IS A 1031 EXCHANGE?
IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
More simply put: a 1031 exchange allows an investor to defer paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained by the sale of the first property. In order to completely defer the capital gain tax, the exchanger must (1) acquire like kind replacement property, (2) purchase replacement property of equal or greater value, (3) reinvest all of the equity into the replacement property, and (4) obtain the same or greater debt on the replacement property. Debt may be replaced with additional cash, but cash equity may not be replaced with more debt. IMPORTANT – taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction and make all gain immediately taxable. It is highly recommended to use a qualified intermediary to create the exchange of assets and ensure funds are handled and transferred according to IRS regulations.
FREQUENTLY ASKED QUESTIONS
IS THERE A REQUIRED TIMEFRAME TO COMPLETE AN EXCHANGE?
The exchanger has 45 calendar days (the identification period) from the date the property is sold to identify up to three potential replacement properties. Identification must be specific and in writing, signed by the exchanger, and delivered to the qualified intermediary prior to the end of the 45-day identification period. The list of potential replacement properties cannot be changed after the 45th day; only a property from the list of identified properties may be acquired. If no property is identified, the exchange funds will be returned to the exchanger after the 45th day.
Purchase of replacement property must be completed within 180 calendar days (the exchange period) after sale of the first property or the tax filing date, whichever is earlier.
WHAT IS CONSIDERED LIKE-KIND PROPERTY?
IRC Section 1031 does not limit “like-kind” property to certain types of real estate. Real property must be exchanged for like-kind real property. Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. Both properties must be similar enough to qualify as "like-kind." Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land and real property is not considered like-kind to personal property.
WHAT ARE THE BENEFITS OF 1031 EXCHANGE?
1031 tax deferred exchanges allow real estate investors to defer capital gain taxes on the sale of a property held for productive use in trade or business or for investment. This tax savings provides many benefits including 100% preservation of equity. Investors can take advantage of exchanges to meet other objectives including – 1) Leverage: exchanging from a high equity position or “free and clear” property into a much larger property with some financing in order to increase their return on investment. 2) Diversification: Such as exchanging into other geographical regions or diversifying by property type such as exchanging from several smaller single tenant properties into a multi-tenant retail strip center or office building. 3) Management Relief: for example, exchanging out of multiple management-intensive properties into a replacement property like an apartment complex with an on-site manager or a single-tenant net-leased investment with no landlord responsibilities.
CAN TAXES BE PAID ON A PORTION OF THE CAPITAL GAIN?
Yes, an exchanger can do a partial exchange and not reinvest all of the net equity or take on debt in the replacement property that is less than the debt in the relinquished property. The exchange proceeds received and/or the reduction of debt to the extent there is a capital gain must be recognized as income.
HOW IS THE BASIS COMPUTED IN THE NEW PROPERTY?
It is critical to adjust and track basis correctly to comply with Section 1031 regulations, refer to a professional tax representative for assistance. The basis of property acquired in a Section 1031 exchange is the basis of the property given up with some adjustments. This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition. A collateral affect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.