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Why Commercial Real Estate

Even with the overwhelming number of new investment options available today, commercial real estate remains a perennial favorite for many of the world’s highest net-worth individuals. Precisely why this is varies from investor to investor; however at their core income producing properties—whether multi-family apartments or retail spaces—offer investors several key advantages over other asset classes.

Stemming from a belief in the importance of property ownership and reinforced by substantial IRS tax incentives, it is perhaps not surprising many of the nation’s wealthiest individuals have considerable real estate holdings.  Commercial property ownership is unique because it combines several distinct benefits into one asset or portfolio. These include but are not necessarily limited to: attractive leverage and financing, appreciation, tax-based incentives, diversification, supply & demand, and consistent returns (cash-flow).  For those able to access the market these benefits can produce significant ongoing returns. Whether you are starting out or weighing your various investment options, the following are some general concepts and factors to consider when acquiring, financing, or exchanging commercial real estate holdings.

The Power of Leverage

Leverage, Verb. Definition: “To use borrowed capital for an investment, expecting the profits made will be greater than the interest payable” (Merriam Webster’s Dictionary). Because of this exponential earning potential offered through leverage, commercial real estate remains a long standing favorite for many private and institutional investors seeking to maximize returns. Using leverage, it is not uncommon for investors to enjoy the steady cash flow (plus appreciation) on a $3,000,000 asset while having to invest less than $1,000,000 of their own capital.

At its most fundamental level leverage is simply using a loan to increase one’s earning potential.  This makes sense financially because the cost of borrowing the funds typically is less than what the property generates in income. Investors across the commercial real estate spectrum from Real Estate Investment Trusts (REITs) to apartment building owners, use this financing concept of increasing revenue with borrowed money, subsequently paying back a portion of their total earnings in the form of a mortgage payment.

Depending on demand and how competitive a market is at a given time, some investors will elect to pay all cash up front in an effort to increase their chances of securing an asset, then once acquired will refinance the property to free-up much of their equity to pursue other opportunities. Even with anticipated increases in the Federal Funds Rate the cost of capital remains relatively cheap, while rental rates still continue to rise, thus making financial leverage an attractive choice for many investors.

Returns

One factor which makes commercial real estate desirable is the holdings are real tangible assets.  While there are still many reliable blue-chip companies listed on the NYSE or Dow Jones in which to invest, the earnings in the financial sector are increasingly based on complicated monetary wizardry which arguably few investors take time to fully understand. (If interested, we highly recommend Michael Lewis’ book The Big Short, which provides excellent insight into wealth creation on Wall Street). Given the opacity and volatility inherent to high finance, by comparison the generally predictable performance offered by commercial real estate assets makes them an attractive investment. And while there are many ways to increase your overall net worth when investing in real estate such as depreciation, deductions, and tax-deferred 1031 exchanges, fundamentally there are two major ways investors make money in real estate investments.  These are principally property appreciation and cash flow from operations.

Appreciation

Appreciation is simply an increase in a property’s value over time due to economic factors such as supply and demand, changing interest rates, inflation, or changing fiscal and regulatory policies.  However the rate of appreciation can also be increased deliberately through measures such as efficient and reliable management, renovations, and maximizing returns. 

Historically, appreciation has arguably been the greatest single passive wealth builder for real estate owners both regionally and nationally.  At a macro-level in the Greater Seattle area, the evidence for both shorter and longer term appreciation gains across commercial real estate remains strong.  Depending on condition and location, it is not uncommon for a property that was purchased for $500,000 20 years ago to be sold for $1,500,000 or more in today’s market. Or an apartment building purchased for $2,000,000 ten years ago to sell for over $3,500,000. While the overall market forecast for the Puget Sound region is promising, historically the real estate market has ebbed and flowed, making it important to study other economic indicators such as access to capital, other sector hiring, and inflation.

Cash flow

Cash flow is one of the most important metrics to consider when comparing different properties.  Fundamentally the question to answer is: how much cash is left over every month after all the expenses are paid?  The answer obviously depends on several different factors, however it’s important to remember that NOI (Net Operating Income) is different than Cash Flow. Typically when you see NOI figures for a property they do not account for any monthly debt service.  If you plan to pay all cash for an asset, the Debit Service Coverage Ratio (DSCR) is likely irrelevant. However if there is a mortgage payment (principal & interest) due every month, accounting for this real expense is critical in determining a property’s bottom-line yield and whether a property has positive cash flow.

Weighing the potential benefits of appreciation and cash flow is important when comparing different properties.  For example, there might be a property in Pierce or Snohomish County which has a cash flow of $6,000/month (an attractive return) however the anticipated market appreciation may only be 3% a year. Conversely, there might be an asset close to downtown Seattle which has a more modest cash flow of $3,500/month, but the historical and anticipated appreciation is closer to 6%.  Assuming you will only purchase one of these, which would you prefer?  Given the real opportunity cost involved with such a decision, it is important to know which type of investment best suits your goals.

Moreover perhaps not surprisingly, if leveraging financing is important, a Bank’s Loan-To-Value requirements (LTV) can vary depending on the specific asset class, location, condition, vacancy and assessed risk.  This can be important to keep in mind when comparing different (or similar) properties. In the same vein, when positioning a property to cash-in or execute an exchange, looking at an asset from a Buyer’s (or Lender’s) perspective and being able to effectively market a property so both investors and their potential creditors see all the value is equally important.

Regional Economy

It is no secret that the Puget Sound region is fast becoming a final destination for many people from around the nation and abroad. Strong economic growth across a variety of sectors—technology, health care, professional services—have contributed to a rapid growth in and around Seattle.  Industry leaders such as Microsoft and Amazon require talented professionals, and these professionals in turn often prefer to live and work in a vibrant metropolitan area with a higher ‘quality of life’ metric. Holding other variables constant, this employer-employee relationship and the corresponding economic demands often create a self-reinforcing system. For destination cities such as Seattle and San Francisco, this translates into a healthy long-term growth outlook as the demands of both employers and employees continue to grow. Workers in both the core economic sectors as well as support industries need a place to live, work, and play and commercial real estate spaces are increasingly playing an important role in citizen’s everyday lives.

Changing Life Styles

For many the American Dream still consists of home-ownership.  However that traditional model is increasingly giving way to new more flexible living arrangements. Many in the Millennial Generation—who now outnumber their parent’s baby-boom generation (76 million to 75 million) are living in multi-family housing or some type of rental housing configuration. In the City of Seattle, over 40% of city residents are now tenants living in a rented space. 

The reasons behind these shifts and circumstances are undoubtedly complex: cost of living, student loan debt, life style-preferences, etc.  Nonetheless, with the cost of homeownership on the rise, and many young people looking at home-ownership differently, the demand for new multi-family buildings as increased dramatically. For investors interested in multi-family housing, this asset type can be an excellent short and long term investment.

Scarce Resource

Anyone who has visited a major city recently (Seattle, San Francisco) can attest that as population and overall commerce are increasing, the corresponding Land Use Intensity (LUI) is increasing throughout these regions as well.  As the available space is reduced and demand continues, it is not uncommon for development sites in core areas to surpass $500/square foot for land.  This type of development coupled with legislation such the Growth Management Act (GMA) intended to protect green-spaces, sensitive habitats, and wetlands only serves to increase the scarcity of available space.  As a result developers and investors are looking further out, in areas to the North in Snohomish County and South in Pierce County, where land is relatively inexpensive and the municipalities are viewed as more development-friendly.

1031 Exchange

If looking to modify an investment portfolio, 1031 Exchanges are an excellent way to shield the gains realized from possible tax liability.  This section of the IRS tax code (1031) allows investors to ‘exchange’ one like-kind investment property for another.  The phrase ‘like-kind’ is actually somewhat misleading because as the IRS sees it, the definition of like-kind is quite broad.  While is it important to engage a tax professional for specific requirements, what is considered acceptable for an exchange is generous. You can exchange an industrial building for an apartment complex, or an office building for a strip mall—all while allowing your equity to grow tax-deferred. 

It is important to use a facilitator such as a Qualified Intermediary because if you take actual possession of any funds they could be subject to capital gains tax.  Equally important is paying close attention to the required timelines.  For most exchanges an investor has 45 days from the closing date of the first property to identify up to three (3) possible exchange properties.  The timeline for closing on the second property also starts immediately once the first property is sold.  According to the IRS 1031 code, an investor has 180 days from the sale for the first property to close on the second (exchange) property.  These 45 day and 180 day timelines run congruently, meaning that if you were to wait until day 45 to identify your three potential exchange properties, you would only have 135 days remaining to close on one of them.  As there can be many factors involved, it is important to engage a knowledgeable Qualified Intermediary (QI).  If you are in need of an experienced QI who serves the Greater Seattle area please let us know!

About the Author

Kirk Thorson is a fully-licensed Commercial Broker with Keller Williams Commercial Real Estate.  His specialties includes Multi-Family Acquisitions and Dispositions, Office Buildings, Land Development, and Mobile Home Park transactions. He holds a B.A. from Whitman College in Walla Walla, and a Master’s from Gonzaga University in Spokane. He has lived in the Seattle area for over 30 years.