April 2011

APRIL 2011: What You Need To Know About - Tired of Volatility? Need Income? Try Commercial Real Estate

Author: Robert Star | Photographer: Photography by Anne

Most individual investors have access to a limited number of solutions to meet their financial goals. It is unfortunate, but high net worth and institutional clients have many more options from which to choose. In fact, the largest endowments and financial institutions benefit from diversification through alternative asset classes. By broadly diversifying, an investor can create a portfolio that is not based solely on the performance of the stock and bond markets, but on the overall performance of many non-correlated asset classes.

A traditional portfolio contains stocks, bonds, cash or CDs. Most people access these investments through advisors who provide mutual funds, Exchange Traded Funds (ETFs), third party money managers, annuities, or stocks and bonds. For the most part, these portfolios are “long” only, and a large percentage of these investments underperform the major indexes: S&P 500/DOW/NASDAQ. So why do investors continue with this long-only strategy? It’s simple because that is what the majority of financial firms offer their retail clients.

If you are unfamiliar with the term “long,” this means you are buying a security and will make money if it appreciates in value. This includes both stocks and bonds. So if you have a brokerage or retirement account with a mix of different funds, you will only make money if the market goes up. You may make more money in a rising market if you have a good manager, but when the market gets hit like it did in 2001 and 2008, mutual fund managers cannot go to cash. It is up to you to decide to sell, and by then, it could be too late. This is why many advisors look to dividend-producing stocks so you can at least receive some income while you wait for any capital appreciation.

As we know, the markets do not always go up. In fact, investors are usually misled by long-term charts that “prove” the value of the buy-and-hold, long-only investment strategy. In reality, charts containing 100 years of data are simply irrelevant since the typical investor has only 15-20 years to build a retirement nest egg and hopefully longer than that to live from those funds. History has shown that there have been many periods in which long-only portfolios have been disappointing.

Let’s look at the last decade. The S&P 500 has returned a little over 1 percent. Of course this depends on when you invested, as many investors got in at higher prices and are still down. One of the statistics I like to look at is the maximum drawdown (MDD), which measures the largest percentage decline from peak to a trough. In the last 15 years, the S&P 500 had a maximum drawdown of 45 percent and the NASDAQ has a whopping drawdown of 74 percent. It can take years to get back to even; if you go down 50 percent, then you need to go up 100 percent to get back to even. So from how many more severe drawdown periods can a retired person recover?

What does an individual investor do? Buy CDs or leave cash in the bank earning less than 1 percent, buy gold, buy silver, or look to alternative investments that may broaden his or her portfolio into asset classes that are not correlated to the volatile markets.

One such investment alternative is Direct Participation Program (DPP) in commercial real estate. Direct investment in real estate provides the opportunity to have institutional caliber professionals managing a portfolio on your behalf, much like a mutual fund. The only difference is that they are not buying stocks and bonds, but actual real estate. Through DPPs, you may choose to invest in a non-traded real estate investment trust (REIT). This REIT is usually targeted to specific asset classes like medical buildings, office buildings, big box retail, self storage, apartment, and even timber property. One of the benefits to diversifying through REITs is they provide an investor with sector and geographical diversification with properties located around the country.

When investing in the DPP, you will purchase shares, like stock, that actually have partial ownership of the real estate portfolio. Your investment is pooled together with many other individual investors into a large fund. Some of these funds have assets in the billions. By pooling your money and having sophisticated portfolio managers invest and manage the funds, the average investor has similar opportunities previously available only to the wealthy or institutional investor.

DPPs provide a regular stream of dividend payments, usually paid monthly. The yield on these portfolios can range from six to nine percent annually, depending on the asset class. In some cases, investors realize capital gains at the end of the term from the sale of their assets. The term is usually seven to ten years. Many of these investments pass through the depreciation of the underlying assets, which may increase the investor’s after tax yield. DPPs can be excellent investments for IRAs as there would be no tax on the dividends or capital appreciation.

If commercial real estate is something you think is worth buying for the long haul, you may want to better understand how commercial property is valued and priced for sale. When purchasing income-producing commercial real estate, an investor must understand how the property is valued in relation to the income the property generates. This is referred to as capitalization rate or “cap rate.” This is the ratio between the net operating income produced by the unit and its original price paid to purchase the unit. For example, if a unit cost $1,000,000 to purchase and is generating $80,000 of net income, the cap rate is eight, or commercial investors would refer to it as an “eight cap.”

The cap rate is a very important component to determine if you are getting a good value when making an investment in commercial real estate. The higher the cap rate, the lower the purchase price, and vice versa. By looking to historical cap rates, an investor can benchmark the price paid and potential for appreciation. If a property is being purchased at an eight cap and that class of property historically sells for a six cap, then you can try to quantify your potential long-term gain on a sale of that property in a higher market.

In our previous example, if the market improves and property now sells for its historical value of a six cap, you will expect to sell that unit for $1,333,000. Remember, if you are generating $80,000 in income (not including annual increases built into the lease) and you sell for $1,333,000, you get the six cap by dividing the $80,000 by $1,333,000. This is a long-term gain of over 30 percent while receiving 8 percent on your invested capital.

Due to the credit crunch of 2008-09, cap rates on commercial property are at historical highs around the country. Many opportunities exist in different types of real estate for an investor to diversify his or her portfolio. If you can take a long-term perspective on investing, you may want to consider adding DPPs to your portfolio, and you can start with as little as $1,000!

DPPs are long-term investments, and there is no formal secondary market. Remember, you are actually buying real estate. If you do not have a long-term outlook on a portion of your portfolio, these investments may not be appropriate. However, the illiquidity of a DPP can help insulate you against the volatility of the market, because it is not subject to the daily fluctuations on price. As a result, a DPP may have a stabilizing effect on your portfolio. Please consult your financial advisor and/or your tax professional before investing.

Robert Star is managing director of EDI Financial, located at 29 Plantation Park Dr., Suite 803, Bluffton. For more information, call (843) 815-6636.

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