While the group of doctors that goes in on a local apartment building or strip mall has become almost an investment cliché, commercial real estate isn't always the first investment that comes to mind when investors are building portfolios. Yet as yield is increasingly in short supply and investors are looking beyond bonds for new ways to diversify increased exposure to equities, commercial real estate (CRE) is emerging on more people's radar. This paper looks at where the opportunities are and at the full range of vehicles for accessing them.
An evolving market. For the most part, CRE never faced the enormous overhang of foreclosed properties that weighed on the residential real estate market. As such, most CRE markets began stabilizing in early 2011 (or a year before the residential markets) and have been slowly climbing ever since. Multi-family residential buildings benefitted early on in the aftermath of the financial crisis and may already be expensive in some markets. Still, we believe ample opportunities remain in retail, warehousing, and other CRE segments.
Putting CRE to work in your portfolio. The strengthening CRE market may present opportunities for wealthy investors looking to balance out equity and bond holdings as they put more cash to work post-the financial crisis. Merrill Lynch Private Banking and Investment Group Chief Investment Officer Christopher J. Wolfe suggests investors looking to diversify consider placing as much as 5% of their assets in a variety of real estate holdings; those with a higher appetite for growth and risk might go as high as 10% to 20%.
REITs and private equity. The first stop for many new CRE investors is a real estate investment trust (REIT). Unlike directly purchasing real estate, which can tie up large chunks of assets for extended periods, most REITs have the advantage of being more liquid. The payments generated by individual properties inside a REIT have historically translated into regular dividends.
While REITs have been less correlated with the broader markets than traditional equities, as listed securities they're still somewhat correlated. For that reason, some investors have begun gravitating to non-listed REITs, which provide similar securitized exposure to a broad range of properties but are traded over the counter.
Private equity funds are another option. They offer less liquidity than either REITs or non-listed REITs, but provide managers more flexibility to pursue and hold onto attractive properties, and also give investors more ability to home in on specific aspects of the CRE market — both here and overseas.
Exploring a direct investment. The purest form of exposure to commercial real estate is to purchase a commercial property (or properties), collect income from tenants, and reap the reward if it appreciates in value.
Andrew Tanner is a managing director of Private Business Group and Real Estate Services in the Specialty Asset Management group at U.S. Trust, a part of Bank of America. He recommends buyers begin by focusing on finding a quality income-producing building that is expected to hold its value over time and gradually appreciate with inflation. "Maybe if you invest in real estate for a living you can think about buying very low and flipping it," he says. "Anyone else should leave the short-term appreciation strategies for the pros, and think long-term."
Since in CRE local knowledge is everything, buyers are generally advised to focus on areas where they at least have some familiarity with market dynamics. That's where the advice of a professional steeped in the market becomes particularly essential. Most major markets have a handful of national and regional players handling the majority of the most desirable properties in town. Tanner's group can work with you and your advisor to identify the ones are likely to be better positioned to help you find an investment that meets your needs.
Financing the deal. And if you do decide to invest directly in a property, financing will usually take one of two forms, both available through Merrill Lynch. In commercial mortgage-backed securities (CMBS), the property itself serves as collateral and the debt is paid off through regular rent from tenants. This avoids the complexities of having each investor (if there is more than one) issue a guarantee. Since the loan ends up being pooled with other mortgages and sold to outside investors, though, it tends to be best for a well-established building with reliable cash flow. In a customized loan, which may be better for a more unique property, a credit specialist can structure a loan enhancing the real estate collateral with a personal guarantee.
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Past Performance is no guarantee of future results.
Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties, such as rental defaults.
Nonfinancial assets, such as closely-held businesses and real estate, are complex in nature and involve risks including total loss of value. Special risk considerations include natural events (for example, earthquakes or fires), complex tax considerations, and lack of liquidity. Nonfinancial assets are not suitable for all investors. Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy.
Alternative investments such as private equity funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk.