Why Buy Real Estate?

Why Buy Commercial Real Estate

by Michael Bull, CCIM

Sometimes as company leaders or investors we may ask ourselves, why buy real estate. We innately know it’s a good part of an overall investment strategy, but why? If we look at an example cap rate of maybe 8% on a net lease property or apartments, we might get those returns in the stock market. Why deal with real estate?

The cap rate alone can be misleading when comparing investments like stocks, bonds or savings to real estate. Just looking at the cap rate or even the cash on cash return we may overlook many of the benefits of real estate investments like the power of leverage and inflation.

A few years ago an agent’s son was considering acquisition of a multi-family property through our firm. She was incensed at the price. She demanded explanation of the value and why her son should settle for an 8% cap rate and deal with real estate.

We told her we considered and compared the income, expenses and returns by the following methods: G.R.M., C.A.P., I.R.R., as well as the F.M.R.R. approach. We told her we also considered the replacement cost and the sales comparables approach, which all seemed to support the sometimes utilized W.A.G. method of valuation.

We defined and explained these methods further, but she only wanted to consider the cap rate and she found no humor in the W.A.G. method, (Wild A?! Guess). She advised her son against buying the property.

The property sold the next day and the buyer of that particular property ended up with a 50% return during a 3 year ownership period!  She should have looked further than the cap rate and the W.A.G. method. They can lead you to the wrong ideas, like my attempt at humor sometimes does.

Let’s look at a small example of just how leverage and inflation alone might affect a real estate investment. Let’s assume a $100,000 stock investment has a very good return of 10% or $10,000. You are comparing it to a $100,000 real estate investment that has a low cap rate of only 5%. If you can get a 10% return on the stocks and only 5% on the real estate, why would you consider the real estate?

On the real estate investment consider an example where a lender will invest (loan) $400,000 with you. This enables you to leverage that $100,000 into a $500,000 property. Look at how inflation and leverage alone affect your real estate return. Using a low 2.5% inflation rate, the real estate value increases by $12,500, ($500,000 x 2.5%= $12,500). Add the $5,000 cash flow and you gain $17,500!

Your return on the stock investment is 10% or $10,000, compared to 17.5% or $17,500 on the real estate investment, even though the real estate cap rate was 5% less than the return on the stock investment!

Another benefit of real estate investments is positive leverage. In some cases real estate investments offer higher returns than the cost of mortgage debt. This will increase your returns depending on the size of the investment, the amount of leverage and holding period. For instance an 8% cap rate property providing an 8% unleveraged return, when financed at 6%, will increase the cash on cash return to10% or more.

My favorite aspect of real estate investments is principal reduction on the debt. While positive leverage increases your return, principal reduction increases your net worth or balance sheet each month.  For example many companies can buy space amortized over 15 years at the same cost of leasing. Time flies when you run a company. Many companies have found the principal reduction on their real estate to be an almost windfall profit. In 15 years you have a paid off asset rather than an increased rental payment.

Be sure to add the principal reduction on the debt when considering the return on real estate investments. There are online calculators available to easily calculate principal reduction and print out amortization schedules.

Real estate investments provide additional benefits like possible increasing rents, repositioning and added value through better management.

The real estate investment has another large comparison blue ribbon, the 1031 exchange process. When you make these stock or real estate profits, good old Uncle Sam has his hands out. With the real estate investment when you sell the property instead of donating the capital gains tax to Uncle Sam to invest, handled properly you can use and invest this capital gains tax portion to build wealth for you or your company.

Another factor is the timing of real estate cycles. If you can muster the fortitude to be a contrarian investor and buy in the recession or recovery period of a real estate cycle, your returns can increase dramatically.  Sometimes you can acquire properties below replacement costs. To further increase returns, if again you have the fortitude, sell in the expansion period of the cycle.

Michael Bull, CCIM is the host of the Commercial Real Estate Show (www.CREshow.com) and Founder and President of Bull Realty, (www.BullRealty.com) a company that helps investors and companies chose the right real estate alternatives.