Real estate investments may be safest bet
April 25, 2013
For many investors in Nevada County and across the country, the past 12 years have left you scratching your head. After enjoying a decade of unprecedented growth and prosperity in the 1990s, economic growth from 2000 through 2012 was essentially nonexistent.
If you invested in the Dow Jones Industrial or S&P 500 in the beginning of 2000 and pulled your cash out at the end of 2012, your portfolio would have grown at a compounding annual growth rate of 1.01 percent and -0.23 percent, respectively, a far cry from the double-digit annual growth seen in the 1990s.
Many in the baby boomer generation counted on annual growth rates of 7 to 10 percent for their retirements, a rate of return that used to seem conservative but now seems more difficult to reach than ever through traditional investment channels. These boomers are now left with account values that haven’t even kept up with inflation and are forced to consider more aggressive, risky investments to try and make up for the past decade.
While many see commercial real estate investments as speculative or extremely risky (both of which can be true), it is an interesting exercise to look at how commercial real estate investments have performed over the same time period.
Based on the National Council of Real Estate Investment Fiduciaries’ database of 7,270 properties across all regions of the United States, commercial real estate has vastly out-performed the major stock exchange indices. NCREIF’s database of properties is owned, at least in part, by tax-exempt institutional investors (namely pension funds), who have a relatively low tolerance for high-risk investments, making it a more fair comparison to look at against major stock indices. The comparison is astounding; the compounding annual growth rate for commercial real estate from 2000 to 2012 was 8.5 percent, compared to a unimpressive 1.01 percent for the Dow Jones Industrial and an even worse annual return of -0.23 percent for the S&P 500.
It is also worth noting that NCREIF’s property returns do not include investments made with leverage. In other words, the property returns consist of properties that are owned free and clear (with no loan). If the portfolio included leveraged returns (properties with loans), the CAGR for commercial real estate would be even higher.
A more concrete example of this is to look at the growth of a $100,000 investment made over the same time period based on the compounding annual returns above.
Upon exiting these investments, your $100,000 would have grown (or declined) to a cumulative ending balance of:
• S&P 500 – $97,057
• Dow Jones Industrial – $113,968
• Commercial real estate – $288,934
Even more convincing is to look at the long-term historical performance of the NCREIF property indices vs. the S&P 500 and Dow Jones Industrial. Since 1978 (when NCREIF began their indices) the S&P 500 and the Dow Jones Industrial grew at compounding annual rates of 8.04 percent and 8.18 percent, respectively. During that same time period, commercial real estate grew at 9.09 percent annually. Moreover, from 1978-2012, the S&P 500 had even years of negative returns, the Dow Jones industrial recorded nine years of negative returns while commercial real estate only recorded four.
Commercial real estate’s strong returns hold true from a long term perspective as well; since 1978, commercial real estate has outperformed both the Dow Jones and S&P 500 while showing less volatility.
You may say, “Hindsight is 20/20,” “If we had a crystal ball in to the future, we would all make the right investment decisions” or “So what … the last decade has been great for commercial real estate. Who knows what the future will hold?”
Think again … Commercial real estate is more attractive now than it has (arguably) ever been, and here is why:
During the “Great Recession” investors were wary of commercial real estate investments and loans were nearly nonexistent. In order to even consider commercial real estate investments, investors commanded historically high going-in yields (or “Cap Rates”). A good way to think of a Cap Rate is to think about it as income, in the form of an annual return percentage, from a given property. Cap Rates also dictate prices investors are willing to pay based on income (i.e., if you desired a 10 percent annual return on a property that had an income of $10,000, you would be willing to pay $100,000 for the asset ($10,000/10 percent); conversely, if you only required a 5 percent return, you would be willing to pay $200,000 ($10,000/5 percent). As you can see, Cap Rates have an inverse relationship with property values — as Cap Rates go up, property values go down. As we started to recover from the Great Recession, the Federal Reserve decided to artificially keep interest rates as low as possible to encourage investment activity. One result was historically low interest rates on commercial real estate loans.
Generally speaking, as interest rates decline, Cap Rates tend to follow because investors are willing to pay more for an investment when low interest rate debt is achievable as it is additive to their returns. While Cap Rates, in some markets, have compressed (reduced) over the past two years, they are still near historic highs due to macro-level economic uncertainty across the United States. What this means is very simple: you can buy commercial real estate at near historically high cap rates (historically low prices), while putting long-term debt on commercial properties at historically low interest rates. The result is outsized annual cash returns. A great visual of this is to compare income from real estate (in the form of Cap Rates) to the dividend yields of the Dow Jones Industrial, S&P 500, and 10 year U.S. Treasury Bonds.
Of course, cash returns are only one part of your potential gain from owning commercial real estate. As you increase rental rates (which are close to 10-year lows), reduce expenses or increase occupancy, the value of your property increases, leaving you not only with a healthy annual yield but significant capital appreciation upon selling your property.
While your Certificate of Deposit or Money Market Account is earning 1.75 percent, commercial real estate investors are taking advantage of low interest rates and high cap rates, achieving first year cash returns of 7-10 percent with no debt and 10-15 percent with appropriate leverage. Of course, cash returns are only one part of your potential gain from owning commercial real estate. As you increase rental rates (which are close to 10-year lows), reduce expenses, or increase occupancy, the value of your property increases, leaving you not only with a healthy annual yield, but significant capital appreciation upon selling your property.
Franklin D. Roosevelt once said, “Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full and managed with reasonable care, it is about the safest investment in the world.”
I would add that in this unique economic climate, it is also the most attractive.
Contact Tyson Tucker at Coldwell Banker Grass Roots Realty, Commercial Division, at 530-273-7293.