How private real estate provides return and stability in volatile markets

buildingsThe coronavirus pandemic has dramatically changed the investment landscape. For investors who’ve experienced the recent stock market volatility, private real estate ownership can provide a welcome port in the storm. In particular, multifamily real estate property values remained relatively stable throughout the dip and subsequent rebound of public markets in early 2020.

Public REITS (real estate investment trusts), however, were not excluded from the wider public market turmoil. The two largest residential REITs, Equity Residential (EQR) and AvalonBay Communities (AVB) experienced in the first quarter of 2020 peak-to-trough price reductions of 40.9% and 46.9% respectively before making subsequent recoveries. [1]

During the same period, values in the private multifamily markets were only marginally diminished, if at all. “After a period of price discovery, we’ve preliminarily begun to discover that in the 27 geographic markets where we’re active, we have not experienced any erosion in values for our largely stabilized, suburban, garden-style apartment homes,” said CIO Matt Fransen of Timberland Partners.

“Net operating incomes continue to trend upward and the debt markets for stabilized apartments are liquid with interest rates at historic lows. I would argue that it’s possible that values for this type of product have actually increased marginally, post-Covid-19,” he said.

In addition to greater stability, private real estate frequently affords owners higher cash yields than public markets – a boon to investors seeking passive income. This is because real estate, as a capital-intensive asset class, is usually purchased with a portion of debt financing. As the operating income from a property increases (using fixed-rate debt leverage), the cash-on-cash return to investors tends to increase over time. In public REITs, management fees and costs associated with regulatory filings eat into yields.

Beyond greater stability in pricing and higher cash yields, one of the unique benefits of private real estate ownership are the tax benefits which are unavailable in the public markets. Owners in private real estate can capture value from depreciation, refinancing, and through 1031 exchanges. Collectively, these benefits can make private real estate ownership an attractive option compared to the public market alternative.

One of the largest tax benefits is the ability to shelter income earned on investment properties by using the depreciation deduction. Depreciation accounts for the wear and tear on the buildings and personal property over time and the IRS allows apartment building owners to take this deduction over a 27.5-year period (39 years for commercial property). The tax code allows real estate owners to use this deduction to smooth out the costs of future capital expenditures. This benefit is not passed through to investors in public REITs.

Refinancing

When a property is refinanced, the owner is able to borrow against the appreciated value of the asset and access the increased equity on a tax-deferred basis. This strategy can allow investors to build additional wealth by harvesting equity earned in a long-term real estate investment and reinvesting those proceeds in other assets without paying capital gains taxes in the current year.

1031 Exchange

Section 1031 of the tax code allows owners of direct investments in real estate to defer the recognition of capital gains generated from the sale of property if the proceeds on the sale are reinvested into a “like-kind” replacement property within 180 days following the sale. Similar to refinancing, this strategy allows investors to capitalize on equity appreciation while deferring capital gains taxation.

The relative stability, high-cash yield, and favorable tax treatment are a few reasons why private real estate has attracted savvy investors over the years, and in particular during times of market volatility. Private real estate is a unique wealth-building vehicle and deserves consideration as a part of any diversified portfolio.

Source: bizjournals.com