The advantages of investing in commercial real estate—such as medical buildings, apartment complexes, retail centers, warehouses, industrial parks and office buildings—are numerous. The asset class is considered stable, resilient and one that can provide reliable returns in both bull and bear markets. In addition to providing stability, resiliency and reliability of returns, commercial real estate is attractive because it can generate strong income potential, benefit from market and forced appreciation, offer tax benefits, create outsized returns through leverage and potentially offset inflation.
Income
Perhaps one of the most attractive reasons to invest in commercial real estate is its ability to generate income, particularly passive income. Compared to income from a job – which typically requires the performance of a service and is limited by wage, salary or commission – income from commercial real estate usually requires minimal active effort to generate or sustain and is not capped by wages, salaries or commissions. As such, relative to a typical job, revenues from commercial real estate are “passive” and can supplement or replace an investor’s active income, thus helping him or her build wealth and create financial freedom.
Commercial real estate investors collect regular rent payments from the tenants leasing their property. The tenants could be businesses, such as a dentist or coffee shop, or individuals, such as residents who lease an apartment. These rental payments create a stable stream of income for the investor over the life of the lease. If the property is purchased at the right price, the investor can enjoy an attractive return on his or her investment. Many commercial leases also contain escalation clauses that guarantee the income produced by the property will continue to increase over time.
Appreciation
In addition to rental income, commercial real estate investors profit when their asset appreciates, which can occur naturally or which the investor can force.
Natural Appreciation. Natural appreciation occurs when rising market conditions result in rising rents or a valuation of the property that is higher than when the investor purchased it. Land can neither be created nor destroyed and although economic conditions may cause real estate prices to dip occasionally, over time, real estate tends to increase in price. The law of supply and demand controls natural appreciation. Because there is a fixed amount of land, population growth over the long term results in an increase in demand for real estate thus contributing to rising valuation and rents.
Forced Appreciation. In addition to natural market appreciation, investors can force appreciation through intentional and proactive efforts to increase a property’s net operating income. Net operating income is the income remaining after operating expenses are paid (and before the mortgage is paid). An increase in net operating income increases the value of the asset.
An investor can force appreciation—increase the value of the asset— by increasing income or decreasing operating expenses. Actions that could result in an increase in income might include leasing vacant space, adding parking fees, installing vending machines or laundry facilities or converting unused space into rentable storage units. Strategic capital improvements may also lead to higher rent rates and thus increase the income of the property. There are numerous ways an investor can attempt to increase income. The specific property, local market conditions and asset class will dictate what approaches are best.
The same is true for identifying ways to reduce expenses. A thorough audit of a property’s expenses over several years will reveal areas in which an investor can reduce expenses. These reductions could include, for example, creating efficiencies in maintenance and management operations, negotiating prices with service providers, reducing or regulating energy or water use, sourcing cheaper labor or billing back utility costs to tenants.
Tax
In addition to benefiting from appreciation, the commercial real estate investor can take advantage of several tax benefits, which include deductions for: depreciation expense, interest and non-mortgage expenses as well as capital gains taxation and tax deferment.
Depreciation expense. Commercial real estate investors can use depreciation to offset their taxes. “Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property.” IRS Publication 946 (2021).
In the eyes of the IRS, the property begins to depreciate when it is placed in service for use in a business activity or the production of income. In some cases, a commercial property starts depreciating from the moment it is acquired. The IRS allows depreciation of a commercial property over a period of 39 years (27.5 years for residential properties), allowing a commercial real estate investor to take an annual depreciation deduction each of those 39 years, thus substantially reducing his or her taxable income.
Suppose, for example, the value of a retail building is $300,000. The IRS allows the retail building’s owner to depreciate the building over 39 year and therefore deduct from his or her income $7692 ($300,000/39) in depreciation expenses each year. It is important to note, however, the investor may, through what is known as “depreciation recapture,” a commercial real estate investor may owe taxes at his or her ordinary tax rate upon the sale of the asset if he or she used depreciation to offset taxable income.
Interest and Non-Mortgage Expenses. Commercial real estate investors can deduct their mortgage interest and other operations-related expenses, which may include property taxes and insurance, repairs and ongoing maintenance expenses and management fees.
Qualified deductible expenses may also include advertising, office space, equipment, legal and accounting fees and even travel. Deducting these expenses can significantly reduce the investor’s taxable income. If, for example, the investor’s rental income from an apartment complex is $100,000 and his qualified expenses are $25,000, his taxable income from the real estate asset is $75,000.
Capital Gains Tax Treatment and Deferral. If an investor profits from the sale of an asset he or she has held for more than one year, the profit is considered a long-term capital gain, and in many cases, may be taxed at a lower tax rate than the rate applied to the investor’s ordinary income. Currently, the long-term capital gains rates are 0%, 15% or 20% depending on the investor’s taxable income and filing status.
A commercial real estate investor may defer capital gains taxes through what is known as a 1031 exchange. With a 1031 exchange, the IRS allows deferral of capital gains taxes if the investor purchases a like-kind property. In other words, an investor can sell his or her commercial real estate asset in exchange for another investment without cashing out or recognizing a capital gain, allowing the investment to grow tax deferred. Keep in mind that there are very specific rules and timelines that an investor must follow to complete a 1031 exchange.
Debt Leverage
With leverage, a commercial real estate investor can use a small amount of his or her money to gain an oversized return in relation to his initial investment. Although risky if not used properly, leverage generally increases the investor’s purchasing power. Through leverage, for example, an investor can own 100% of a property by investing only 30% in the form of a down payment on a mortgage. In that example, let’s say an investor has $300,000 to invest. That investor could use all $300,000 to buy one small property for cash or use the $300,000 to buy one large property worth $1,000,000. In the latter example, the investor finances – i.e., “leverages” – the remaining $700,000 with a mortgage, which allows him to purchase a more valuable property with the same amount of cash.
Continuing with that example, let’s say the value of the properties increases 10% by the time the investor decides to sell. The small property is now worth $330,000 and the large property is worth $1,100,000. Without considering taxes and expenses associated with the sale of the properties, the investor would profit $100,000 on the larger building and $30,000 on the smaller building. Leverage therefore allowed the investor to increase substantially the return of his initial investment of $300,000.
Leverage carries risks, of course, and there are pitfalls to overleveraging a property. If the property unexpectedly loses a tenant, for example, the investor will still need to cover his or her mortgage payments. If the property is overleveraged, the investor may have difficulty continuing to make payments upon an unexpected vacancy. When used judiciously though, leverage can provide an investor the opportunity to own a larger asset than he or she would otherwise be able to afford.
Potential Hedge Against Inflation
Inflation is the rise in the price of goods and services. High inflation can erode the value of an investment, and during times of rising or high inflation, investors seek opportunities for returns that are higher than the rate of inflation. Investors have traditionally considered commercial real estate an asset that helps offset inflation over time. This is because real estate rental rates tend to rise with inflation as do real estate values. Leases contain set expiration dates that allow the real estate owner to renegotiate the lease terms, including price. The owners can thus increase the rental rate to keep pace with inflation or, upon the lease expiration, find a new tenant willing to pay the increased rate.
Commercial leases also often include escalation clauses that increase rents over the life of the lease. Some leases specifically link a rent increase to the consumer price index, which is a measure of inflation. Assuming the rent increases outpace the inflation rate, the investor’s return remains positive. Keep in mind that if there is a gross oversupply of real estate in the market, rents and values may not rise in step with inflation.
Commercial real estate offers a potential hedge against inflation and provides the opportunity for income generation, appreciation, tax benefits and maximized returns. Although this list of benefits is not exhaustive, it describes some of the most attractive reasons to add this asset to your investment portfolio.