Historical Data, and Tax Changes, Point to Attractiveness of Commercial Real Estate

Direct participations in commercial real estate (CRE) – private investments via pass-through vehicles – have long provided meaningful diversification to an investment portfolio.  The Yale Endowment, for example, in its 2016 report notes that real estate’s “steady flow of income with equity upside creates a natural hedge against unanticipated inflation without sacrificing expected return.”  Online marketplaces such as RealtyShares have now made CRE available to accredited investors generally.

Observers have recently remarked on how additional real estate investment deal flow may be increasingly important to many institutional investors, who in many cases have experienced disappointing results with other alternative investments.  (Many pension funds, for example, have begun to divest themselves of hedge fund investments — Rhode Island recently decided to cut its hedge fund holdings in half). And other recent news reports — showing the historical success of commercial residential real estate and recent favorable tax changes – indicate why many such funds may continue to shift their assets toward additional real estate holdings.

Extensive Data Now Supports the Attractiveness of Commercial Real Estate

Data has recently been gathered that reviews investments over more than 150 years and across multiple advanced economies and asset classes in an effort to try to demonstrate where the investment chips have really fallen among asset classes.  As Oliver Wendell Homes, Jr. once said about another field, “The life of the law has not been logic; it has been experience.”  The same can be said about economics and financial investments, where elaborate theories are sometimes exposed as having been built on false assumptions — once the relevant data has been gathered.

The recent news involves an important research paper produced in December 2017 – aptly titled “The Rate of Return on Everything, 1870-2015.” The report, which was published under the auspices of the National Bureau of Economic Research, an epic example of data retrieval.  It is a research product that spells out the rates of return on important asset classes, for 16 advanced economies, from the amazi

For each of the 16 economies, the researchers crafted long-term series showing annual real rates of return—taking into account both investment income (such as dividends) and capital gains, all net of inflation—for government bonds and short-term bills, equities and housing. Theirs is the first such data set to gather all of that information for so many countries over so long a period.

Commercial Residential Real Estate Comes Out Ahead

Among other things, the study attempted to answer an important question: among equity, housing, bonds, and bills, which particular assets have the highest long-run returns? The authors conclude that over the very long run it is housing, rather than equities, that provides the best return (see chart below): both asset types have yielded about 7% a year on average over the 145 years, but equity returns are much more volatile.

.                                    

The authors were discussing commercial housing, not owner-occupied properties. Their findings were reported to have concluded that rental yields account for about half of the long-run return on housing.  Owning a diversified portfolio of rent-yielding property, then, is a much different (and generally better) bet than borrowing to house the family.

Tax Changes Favor Real Estate Over Art for 1031 Treatment

Real estate investors received several gifts in the recent tax code overhaul, but a change that particularly favors real estate over other asset classes is its continued ability to utilize “1031 exchanges,” where property can be sold tax-free as long as the proceeds are used to buy more property.  This ability had earlier been available to certain other “hard asset” classes as well, including art collectors, classic car aficianados, and franchisees – but no longer.

As recently described in the New York Times, investors (and their heirs) whose real estate holdings are comparatively modest were given an added bonus: the estate tax exemption for couples doubled to $22.4 million, allowing those investors to conceivably pay no tax on their properties, ever. They can use 1031exchanges to buy ever more valuable property, and when they die, all of the capital gains are erased, so their heirs inherit the real estate at whatever it’s worth at the time.

Investors who see their stock market investments in hot technology appreciate significantly can be expected to feel proud.  But real estate investors in say, San Francisco, who have also seen sizable appreciation, can sell their property and use the proceeds to buy another property – all without incurring the 20% capital gains tax that the technology stock owner would be charged with if he tried a similar maneuver.

The art market, for example, had previously been another asset class favored with 1031 exchange capabilities.  But that stopped with the new law.  American art collectors may, in this respect, lose their advantage over collectors in the Middle East and elsewhere in Asia.  “This is really bad for U.S. collectors,” said Michael Kosnitzky, a partner at the law firm Pillsbury Winthrop Shaw Pittman.

If real estate investors combine their tax-free gains with the higher real estate tax exemption, it’s possible that they would never have to pay capital gains or estate tax on tens of millions of dollars in real estate.  If, at the investor’s death, the assets total less than the $22.4 million exemption (for a couple), then decades of embedded gains would be erased for tax purposes.

Risk Factors for Private Direct Participation Vehicles

Past performance is not indicative of future results.  The direct participation vehicles generally utilized by Realtyshares are not, themselves, amenable to 1031 exchanges.  RealtyShares and North Capital Private Securities Corporation do, however, effect transactions in property interests that can likely take advantage of such 1031 exchanges; qualified registrants on the RealtyShares website should inquire at contact@realtyshares.com if they are interested in such exchanges.  All of the investments offered by RealtyShares are private offerings, exempt from registration with the SEC, and the disclosures are less detailed than would be expected from a registered public offering.  Ongoing disclosure requirements are negligible.  The investments are also illiquid, with undetermined holding periods and no real preset liquidity terms. These offerings are also only available to accredited investors, so the illiquid nature of any investment is heightened – further emphasizing the differences of these securities compared to registered, publicly-traded securities.

Neither RealtyShares, Inc. nor North Capital Private Securities Corporation, as institutions, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied.  Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.

 

 

Lawrence Fassler
Corporate Counsel
Lawrence has over 15 years' experience as a corporate attorney and has also run a real estate construction business. He previously worked with Realty Mogul, AVE (acquired for over $4 billion), Shearman & Sterling in NYC, and Cooley in their Sand Hill Road office.
No Comments

Sorry, the comment form is closed at this time.