Real estate investment strategies

Owning a home is the most important component to build net worth over time. It is far more significant a contributor to financial well-being than any stock market or other investment vehicle. In addition to the emotional and psychic benefits of homeownership, the equity you are creating is tax sheltered with mortgage interest deductibility, homeowner exemption property tax policies, and capital gains shelter. This is why it is often referred to as the “American Dream.” There is a lot of media attention these days on the difficulty of realizing this Dream however, given the high cost of homes, mortgage rates, insurance coverage, and property taxes. But if you are lucky enough to own your home, and have funds you could invest in other real estate, what might you consider? 

Any investment should yield two returns: cash flow and appreciation. Start with the U.S. Treasury as the basis for comparison. It is the government-backed risk free return. You can buy or sell these same-day without any transaction fees or holding costs. The mixed maturities basket (two to ten year terms) is paying 5% right now. Any other investment you could make must generate a return superior to this to account for the additional risk and expenses to hold. The next issue to consider is your investment time horizon: if you have a shorter term objective and want liquidity, then Real Estate Investment Trusts (REITs) should be evaluated. REITs own and manage commercial properties, and trade like stocks. They can be diversified across property types, or specialize in one kind of asset. Popular plays right now are REITs that focus on warehousing, cell towers, and data centers. Less popular are REITs that have significant exposure to office buildings or shopping centers. REITs must pay 90% of taxable income as dividends; any capital appreciation in the share price comes upon periodic sales of the portfolio’s properties. REITs take all the work out of owning real estate assets: the management team acquires, finances, and operates the properties, hopefully skillfully enough to generate cash to pay dividends. Returns vary widely among the hundreds of REITs, from a low of 2% to high teens. A certain amount of investment equity dictates the type of investment: with $250,000 possibly a single family rental house, with $2.5 million a small strip retail center, with $25 million, a large cold storage warehouse facility. If it’s $25,000, the REIT play allows participation in assets normally out of reach to the small investor. There are also crowdfunding sites for investment amounts that pool investor money, that are structured like limited partnerships, promoting cash flow returns plus capital appreciation.  

For the more adventurous, there is direct ownership. Returns from direct ownership should be greater given the investor is responsible for the smart acquisition and continued operating challenges. The degree of investor involvement varies widely:  some properties rely on special skills/technology, like advanced AI data centers, or properties that have high labor components like hotels and assisted living centers. Management fees vary too: residential property management is about 8 to 10% of gross rent, but resort rentals can go to 40% of the rent. More conventional commercial property management runs from 6 to 12%. In acquiring a property, the investor calculates the expected return, usually with a capitalization rate, or occasionally, an Internal Rate of Return. The cap rate assumes an all-cash purchase, and is the result of net operating income divided by the purchase price. The net operating income is one year’s rent. For example, an asset with $100,000 NOI that cost $1million has a cap rate of 10. Cap rates are a quick analysis to compare properties, and generally are similar for various asset classes. Over the past few years, quality multi-family projects traded at a 4 cap rate, strong covenant retail buildings at a 5, and offices at 8 or above — these shorthand rates reflecting the risk/reward and demand side for each asset class. The higher the cap rate, the less expensive the acquisition.   

A more detailed and sophisticated analysis is the Internal Rate of Return. The IRR is based on a certain hold period, for example a 10-year lease or a plan to sell after ten years. It takes into consideration changes in income, property value, and debt service. The IRR expresses total returns on a project on an annualized basis. It is the sum of all future cash flows according to when they occur in time. The earlier the earnings from an investment are received, the higher the IRR. The IRR is an important metric in that it can be used to supplement cap rates. Unlike cap rates, which only use the first-year NOI and purchase price, the IRR calculation factors in NOI for multiple years as well as the sales proceeds, so it’s a more comprehensive look at a project’s overall returns. 

The IRR is an excellent analytic tool in that it considers the term of the investment, which is useful when looking at investments that have a fixed holding period and projected exit strategy. An investor who wants to compare investment opportunities including the cost of capital (debt and equity) will want to use IRR, as IRR can be calculated both with and without leverage. Cap rates do not factor in debt. Using debt in the acquisition leverages the return on equity, but debt causes heightened sensitivity to interest rate fluctuations. 

The most important distinction between cap rates and the IRR is that cap rates provide a snapshot of the value of a property at a given moment in the investment lifecycle, whereas the IRR provides for an overall view of the total returns on the investment on an annualized basis. 

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Raphael Barta is an Associate Broker with an active practice in residential, vacant land, and commercial/investment properties (Raphaelb@sandpoint.com).