Why Real Estate?
At Revolution Realty Shares, we believe that commercial real estate is the ideal asset in which to invest. The positive aspects of investing in real estate make it a clear choice as compared to more traditional asset classes, such as equities (stocks) or fixed incomes (bonds). A diverse and successful track record of success has reinforced our belief in the viability of this asset class.
Low Volatility
- Real estate is an asset class that historically possesses low volatility, especially in comparison to the stock market. While the real estate market does experience both high and low points, fluctuations in the stock market tend to be far more frequent and unpredictable. Additionally, real estate often shows no correlation to the equities market, and the real estate market tends to maintain its value even when the stock market is plummeting. Nobel Prize winning economist Robert Shiller notes that real estate prices rose during 14 of the 15 bear markets that the stock market sustained, prior to the Great Recession. Real estate investment has proved more stable than many other options, making it an excellent first option, or a rewarding diversification option.
Diversification
- In finance, diversification is the mitigation of risk, accomplished through spreading capital out among different asset classes. Portfolio diversification is common because sometimes, different asset classes possess no correlation, or are only minimally correlated. As previously mentioned, the real estate market historically shows no correlation, and at times even features a negative correlation to the stock market. Therefore, when the stock market crashes, the real estate market rarely endures a related downturn. The overall lack of connection between the two markets strengthens the rationale behind diversification. If an investor has all their capital invested in the stock market, they may experience gains higher than other assets during a bull market; however, they can in turn suffer greatly, and even lose their sense of financial stability in a downturn. Simply put, placing all of your capital into one asset, especially a volatile asset such as equities, is risky, and deemed unwise by the majority of financial advisors. When spreading capital out, risk is reduced, and over the long run the return becomes greater because investors are not as negatively affected by market downturns.
- Diversifying a portfolio by adding real estate creates a tangible asset. Equities, for example, can be provisional, and impermanent. As noted in our explanation of low volatility, this does not tend to be the case with real estate. Real estate is a tangible physical object, one that can supply a basic human need: shelter. Beyond housing, the specific purposes may change; but in the business world, there will always exist a need for commercial space in which to operate. Even in the digital era, huge commercial real estate demands remain. For example, E-commerce giant Amazon owned 14mm square feet of office space, and subsequently leased another 240mm square feet of commercial real estate, according to its 2017 annual report. These staggering numbers make it apparent that commercial real estate needs are constant, even in our dynamic economic market. Owning a highly sought-after hard asset can provide comfort and security to investors, whether it is their first investment, or as they continue to diversify.
Cash Flow
- Investment in commercial real estate can yield a consistent high return, due to tenant lease payments. Depending on the type of deal in place, the income may be immediate or delayed, and predictable or more speculative. Specifically, investment in a turn-key property or a property that requires minor cosmetic change will yield a relatively predictable income immediately. This is because such properties have pre-existing tenants in place and the vacancy rate is already established. In Revolution Realty Shares’ case, a delayed cash flow is due to either a re-adapted use development of a run-down existing building that shows strong indications of financial success after a renovation, or an urban infill development. The latter development type is characterized by new construction in a densely populated urban settling. The derived income from these projects is predicted conservatively, using the best market data and metrics available, and is communicated to investors through the detailed RRS Investor Portal. In either investment case; turn-key or development, the future income is rationally speculated so a predictable return can be established.
Inflation Hedging
- Inflation is the loss of the purchasing power of currency. Over the last decade, inflation has stayed around 2%, which is a healthy level and is the goal of the Federal Reserve. Historically, inflation rates have varied greatly, topping 12% in 1980, and reaching 6% in 1990. The idea of spending 12% more money on the same goods and services in one year’s time is a difficult concept for consumers to digest; however, this historic possibility is largely ignored by novice investors. Fortunately for real estate investors, this specific asset class inherently offers protection against inflation. Evidence of real estate inflation protection has been highlighted by the commercial real estate and investment firm CBRE. They sought to answer the question of whether real estate has been a good hedge against inflation by examining property values and incomes versus the U.S. CPI (consumer price index), from the first quarter of 1978 to the fourth quarter of 2016. According to CBRE, property income typically stays on pace with inflation at a rate of 62%. Property value, on the other hand, stays on pace at a rate of 92%. It is important to note that these are averages, with some types of commercial real estate providing complete protection against inflation, and others lagging slightly behind. These interesting results can be explained by the presence of inflationary pressures being passed onto tenants, to protect the income, and, by passing these inflationary pressures on during future sales in the form of appreciation to protect the property value. In both cases, it is apparent that real estate reacts proportionately to inflation.
Power of Leverage
- In real estate terms, leverage is the act of using borrowed capital, or debt, to take possession of a real estate property. The leveraging of a property is common in all sales of real estate, including residential and commercial use. For the inexperienced and ambitious, leverage can be risky. In the worst cases, the borrower overextends their financial means and a market crash occurs. This results in the borrower not being able to afford their loan payments or owing more than the property is worth, which is commonly referred to as being “underwater” or “upside down.” However, when properly utilized, leverage can be extremely beneficial to the borrower or investor. Leveraging a property allows one to purchase valuable real estate for a small percentage of the cost. Typically, a buyer must contribute 20-25% of the purchase price in the form of a down payment, but this down payment can cost as little as 5% if circumstances allow it. The down payment then constitutes equity in the property. No other asset class allows an investor to take ownership of an investment that is 75%, 80%, or 95% owed to another party, and the value of this is evident in the following simplified scenarios.
- Suppose you have $100,000 to invest with. You can use that money to purchase $100,000 worth of stocks, or you can use that money to buy $500,000 worth of investment real estate, for example, a small multifamily property. The real estate investment comes replete with $400,000 in debt; but, if the multifamily property is occupied, the income from the tenants should cover the monthly debt payment and still supply plenty of regular income. In this scenario both investments appreciate 5% during the first year. With the stock’s appreciation, you make 5% of $100,000, which is $5,000. With the real estate, the appreciation affects the total value of the asset, not simply the investor’s equity portion; therefore, the investor makes 5% of $500,000, not the $100,000, and their investment appreciates $25,000. Therefore: the investor has made 25% on their initial capital investment.
- In a similar scenario, let’s say someone wants to purchase $100,000 worth of stocks or $100,000 worth of real estate. For the purchase of the stocks, many investors would need $100,000. However, for the real estate the investor would only need $20,000. As in the previous scenario, the assets appreciate 5% over the first year. The stock investor would make $5,000 from the 5% appreciation on their initial investment. The real estate investor would make 5% of the total value of the asset; $5,000, but this appreciation equals a 25% return on their initial investment, since they only spent $20,000 on their asset.
- Both scenarios ignore income, inflation, taxes, volatility, and many other key components that are critical to these investments. These simplified scenarios are solely meant to showcase the true power that leveraging real estate offers investors.
Amortization
- There is one more inherent positive attribute to leveraging commercial real estate: amortization. Amortization is the gradual repayment of an outstanding debt through monthly payments. With each monthly mortgage payment, the owner of real estate gains equity through principal recovery. If properly executed, mortgage payments are made with funds gathered from tenants through their monthly rent payments. Therefore, over the course of ownership the equity investor will be gaining increased equity with someone else’s capital.
Tax Benefits
- There are also inherent tax benefits to owning real estate that are difficult to duplicate or surpass in other investments. As in other businesses, operating expenses can be deducted from revenue to lower taxable income, either at the entity or individual level, dependent on the entity structure. Some common expenses associated with real estate are loan interest, management fees, insurance, property taxes, professional services, and repairs. This lowered taxable liability from expenses is beneficial, but not unique to real estate and the deduction only comes after payment. The bigger real estate tax benefit, that is not fundamental to most asset classes, is depreciation. Real estate depreciation is a tax deduction that results from reallocating the real estate’s cost over a specific time frame, set by the IRS. The IRS acknowledges that the physical improvements made to land have a finite period of life and will break down eventually. Due to this acknowledgement, the IRS reallocates the building and its materials’ cost over time through annual tax deductions. For this form of tax deduction, the cost of the building is deducted over a specific time frame that is determined by the tangible asset type. A depreciation deduction allows investors to legally generate a net loss in the eye of the IRS, while maintaining positive cash flow. This scenario, which is most often realized in the beginning of a real estate investment, is not seen in other investment options such as stocks and bonds. Depreciation does not require ongoing payments to cover the deductions, as with expenses, and is not limited to the structure of the building. Interior components; such as flooring or appliances, and exterior components; such as lighting fixtures or fencing, can depreciate, and have their own deduction schedules.
- It is important for investors to realize that depreciation deductions successfully defer taxes; the deductions do not eliminate those taxes entirely. Depreciation deductions will be accounted for at the time of sale with the adjusted tax basis, which will lead to an additional tax (depreciation recapture). For some investors, the depreciation recapture tax rate (capped at 25%) is lower than their normal income tax rate, so the deferred tax is still lower than the tax they would have paid earlier in the investment. Since the implications of depreciation’s deduction and recapture are dependent on the investor’s personal circumstances and income, Revolution Realty Shares advises all investors to consult a tax professional for advice and careful planning.
Similar to all other asset classes, commercial real estate investment does include drawbacks. In the world of traditional real estate equity, the drawbacks most financial professionals will point out are:
- Labor intensive, as compared to other asset classes
- High initial investment, relative to other asset classes
- Illiquid
Fortunately, these drawbacks are reduced or eliminated if real estate ownership is obtained through a crowdfunding platform like Revolution Realty Shares.
Crowdfunding works to lower existing financial hurdles by collecting smaller contributions from a group of individuals or investors. When applied to commercial real estate, crowdfunding effectively lowers the high point of entry, making ownership substantially more attainable. Our investors enjoy the benefits of commercial real estate ownership with an initial investment totaling several thousand dollars, as opposed to the millions traditionally required for institutional quality commercial real estate.
Similar to the drawback of high costs, the labor-intensive requirement that is seen as innate within traditional real estate ownership is eliminated through real estate crowdfunding. Real estate crowdfunding allows investors to own real estate from a passive position, while the sponsor assumes the active position. This passive position allows investors to enjoy the benefits of commercial real estate ownership with no ongoing responsibilities. Instead, all responsibilities and decisions are handled by the sponsor.
Illiquidity is defined as the inability to quickly or easily convert an asset into cash. Traditional, direct real estate ownership is notoriously illiquid. Selling real estate can take months or even years and usually requires a high degree of marketing and effort, as compared to other asset types. With crowdfunding, the investor generally must find someone to buy their equity on their own, meaning the platform or sponsor will not assist you in the sale. This gives most real estate crowdfunding platforms an illiquid characteristic, similar to traditional real estate ownership. Revolution Realty Shares reduces the illiquid characteristic by bringing the investment opportunity to the attention of the other passive investors involved in the particular property or development. This can be used in conjunction with the seller’s own efforts to find an accredited investor to purchase their equity. This reduces, but does not eliminate, the illiquid nature of the investment. It is important to note that SEC regulations prohibit the transfer of an investment within the first year. Due to these factors, we strongly encourage investors to invest if they are comfortable and capable of holding the investment until the end of the specified holding period. We absolutely understand that unexpected circumstances can arise, and based on that, we also supply an avenue to assist investors to sell their equity.
