A week like this, where the S&P 500 (Growth and Growth & Income) will most likely fall 3% and the Russell 2000 (Aggressive Growth) will probably fall close to 6%, gives us an excellent chance to remind ourselves that there are other structures of investments available to the consumer, beyond just the stock market and at times there may be reasons, why someone should consider an investment that provides non-correlation benefits, or said another way, adding an investment that does different things, at different times, to stocks. To be clear, the principal investment most of us will have will be stocks, which is more than likely ideal - but as this week helps us to see - as your wealth grows - perhaps your investment universe should grow as well. And of course, as we've written many times, the retiree has a significant risk of the sequence of return risk with stocks, which can be learned more about in my article: Bear Markets, Normal Not Fun.
Commercial real estate has long been a cornerstone of wealth creation for investors. Unlike residential real estate, which is driven largely by individual homeownership and rental demand, commercial real estate encompasses office buildings, retail spaces, industrial properties, and multifamily housing complexes. Over the decades, this sector has consistently offered robust returns, diversified income streams, and tangible asset value appreciation. Many of the private real estate strategies we pursue for our clients combine the best of both worlds: commercial real estate and residential real estate. For the purposes of this article I’m going to focus on commercial real estate to help you try and understand it just a little better.
Of course, your mind, when thinking about commercial real estate, is instantly thinking: office buildings! What a terrible investment idea, right now! Yes, we would agree, but commercial real estate is so much more than that – it’s industrial buildings that have high demand right now because of online retailing. Its data centers also have high demand currently because, in the last three years, we have created more data than the entire history of the country before that. It’s student housing – because does anyone see college demand decreasing? Can you say, captive audience, when you own housing on or near a campus?
We agree that the office commercial building market in 2024 faces significant challenges and transitions. The most prominent trend is the persistent high vacancy rates across many major markets, driven by the continued effects of hybrid and remote work arrangements. The overall vacancy rate in U.S. office spaces is nearing record highs, with some markets experiencing particularly acute vacancies, like San Francisco and Philadelphia. See the picture below from Kastle Data Systems, which tracks office vacancies in more than 2,600 buildings across 138 cities.
The commercial office market is expected to remain challenging for the foreseeable future, with high vacancies and subdued rent growth likely persisting. However, there are areas of optimism, particularly in regions with strong tech sector demand and ongoing urban development projects. Investors and stakeholders are closely watching these trends, adapting strategies to navigate the evolving landscape of the office commercial real estate market.
However, let’s explore some reasons why you might want to pursue some of those other areas in the commercial real estate market that we discussed above.
Steady Cash Flow and Income Stability
One of the primary attractions of commercial real estate is the potential for steady cash flow. Commercial properties, such as office buildings and shopping centers, typically have long-term lease agreements with businesses and retail tenants. These leases can range from several years to over a decade, providing investors with a reliable income stream. This stability is further enhanced by commercial tenants often being responsible for many property-related expenses, including maintenance and taxes, through triple-net leases. Additionally, many leases have inflation riders built into them, so you won’t be stuck with a lease paying a below-market rate because inflation raised its ugly head (2022, anyone?).
Appreciation and Value Addition
Commercial real estate has historically shown significant appreciation in value over time. Several factors, including economic growth, urbanization, and inflation drive this appreciation. As cities expand and economies grow, the demand for commercial spaces increases, driving up property values. Investors can also add value to their properties through strategic renovations, improved management practices, and adaptive reuse projects, all of which can lead to substantial increases in property value.
Inflation Hedge
Commercial real estate has proven to be an effective hedge against inflation. As inflation rises, the cost of goods and services increases, leading to higher rents for commercial properties. Many commercial leases include provisions for rent escalations tied to inflation, ensuring that rental income keeps pace with rising costs. This ability to adjust rents makes commercial real estate a valuable asset during inflationary periods, protecting investors' purchasing power.
Diversification Benefits
Investing in commercial real estate provides diversification benefits to an investment portfolio. Real estate often exhibits a low correlation with other asset classes, such as stocks and bonds. This means that commercial real estate can help reduce overall portfolio volatility and enhance returns, particularly during periods of market turbulence. Additionally, the diversity within the commercial real estate sector itself—from office buildings to industrial warehouses—allows investors to spread risk across different types of properties and tenant bases. According to one of our real estate partners, INREIT (Invesco Real Estate), for the period ending September 30, 2021, the correlation to the stock market, of private real estate (using the NCREIF Property Index) has been 0.12 and the correlation of private real estate to US Fixed Income (bonds) has been -0.15.
Historical Performance and Tax Benefits
The historical performance of commercial real estate has been strong, often outperforming other asset classes. According to the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index, commercial real estate has delivered annualized returns of around 9% over the past 30 years. This performance is comparable to, and in some cases better than, the returns of the stock market over the same period. Furthermore, commercial real estate has shown resilience during economic downturns, recovering value more quickly than other investment types after recessions. Additionally, while not available to investors of public REITS (see something VNQ: Vanguard Real Estate Fund as an example of a public REIT), private real estate investors are able to reap some tax benefits at times when investing in in real estate. This is because of depreciation and other expenses that can be written off against the income your real estate is providing. This makes real estate a more attractive option for investors who have higher incomes and/or invest non-retirement dollars. Please consult your tax professional for actual tax advice and to learn if these benefits may be of interest to you.
Institutional and International Interest
The attractiveness of commercial real estate has not gone unnoticed by institutional investors and international buyers. Pension funds, insurance companies, and sovereign wealth funds have increasingly allocated significant portions of their portfolios to commercial real estate. This institutional interest has provided additional liquidity and stability to the market. Additionally, international investors view commercial real estate in stable economies as a safe haven, further driving demand and supporting property values.
Conclusion
Investing in commercial real estate has historically been profitable for many investors. The sector offers stable income streams, significant appreciation potential, and effective inflation hedging. Its diversification benefits and historical solid performance make it an attractive addition to any investment portfolio. As urbanization continues and economies grow, the demand for commercial properties will likely remain robust, ensuring that commercial real estate remains a cornerstone of wealth creation for investors. You can contact your Whitaker-Myers Wealth Managers Financial Advisor today to learn about our real estate investment strategies available to our clients.
The Historical Value of Commercial Real Estate
August 2, 2024
John-Mark Young
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