Benefits of Investing in Private Real Estate
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Institutional investors may be attracted to private real estate investing as a way to optimize and diversify their portfolio, seeking to benefit from tax efficiencies, historically attractive risk-adjusted returns, relatively low volatility, and the ability to hedge against inflation.
Institutional investors - including pension funds, endowments, foundations, insurance companies, and sovereign wealth funds - represent $140 trillion of investable capital[1] and on average target an 11% allocation to private real estate.[2] These investors typically have professional investment teams, significant resources, and unique access to information, seeking to optimize the risk-adjusted performance of their large portfolios of public equities, fixed income, and alternative investments such as real estate.
Individual investors may also consider allocating to private real estate, to avail themselves of similar benefits of investing in private real estate.
Potential Tax Benefits[3]
Private real estate equity investments may offer several tax benefits that can potentially help investors reduce their overall tax exposure and increase their after-tax returns relative to other investments such as public equities or fixed income[4].
One primary tax benefit of private real estate investments, which is not typically available in other investment types, is that property income can be shielded by depreciation, thereby potentially delaying and/or decreasing an investor’s tax payments. Because real estate assets experience wear and tear over time, investors can reduce their taxable income through a depreciation deduction, resulting in lower tax payments during an investor’s hold period. In some cases, depreciation deductions may be greater than the income generation from the investment, resulting in no tax liability in a particular year.
While the investor must pay a “depreciation recapture” tax upon sale, that tax rate (25%) is lower than many marginal ordinary income tax rates.[5]
Additionally, long-term capital gains tax rates may be lower than ordinary income tax rates for many investors. When an investor holds a property for more than one year and then sells it at a profit, the gains are considered long-term capital gains. These gains are typically taxed at lower rates than ordinary income (typically between 0% and 20%, plus net investment income rate of 3.8%, if applicable)[6], providing a further tax benefit for the investor.
Another tax benefit of private real estate is the 100% pass-through of income and losses. If an investor owns real estate through a pass-through entity, such as a limited liability company (LLC) or a partnership, which are not typically subject to income tax, the income or losses from the property pass through to their personal tax return. This means that the investor can avoid double taxation.
Real estate investors may also choose to invest through certain incentive programs such as Qualified Opportunity Zones (QOZs) or 1031 exchanges as a way to defer or eliminate taxes.
You can find more information about the tax advantages of real estate here.
Historically Attractive Risk-Adjusted Returns[7]
Real estate investments may be less volatile and less sensitive to market risk factors than other investment options.
- Over the past 20 years, private real estate delivered comparable pre-tax returns to public equities and REITs while exhibiting 69% and 76% lower volatility[8], respectively, prior to accounting for potential tax advantages
- Private real estate may improve overall portfolio efficiency by reducing volatility while generating returns and value creation from the implementation of an accretive business plan and appreciation
Annualized Pre-Tax Returns and Risk for Last 20 Years[9]
Diversification Away From Public Market Volatility
Private real estate has historically been an attractive diversification tool in portfolio construction, as real estate returns are typically lightly or negatively correlated with public markets.[10] Given the fact that privately held real estate is not listed on a public exchange, pricing may be more closely tied to real estate fundamentals, which tend to result in lower volatility relative to publicly listed securities.
Hypothetical Example of Portfolio Efficiency Improved with Allocation to Private Real Estate[11]
Income-generating private real estate may offer a combination of the traits of both stocks and bonds. Income derived from contractual leases in real estate function similarly to coupons from a bond while the appreciation of real estate over time resembles the value created in public equities. Real estate may offer investors a balanced return profile which improves the overall efficiency of their portfolio over a given time horizon.
“Real estate returns and risks fall between those of bonds and equities. With bond-like rental streams and equity-like residual values, investors expect real estate to produce results somewhere between the results of the bond market and the stock market. Ibbotson Associates data for the past eighty years indicate that stocks returned 10.4% annually and government bonds 5.4% annually. Splitting the difference suggests that real estate investors might realistically expect returns in the neighborhood of 2.5% per annum above bonds.”[12]
Potential for Higher, More Consistent Yield Versus Public Markets
Private real estate investors may earn potentially high, tax-advantaged yields driven by the long term, contractual nature of lease payments. For example, an industrial facility leased to a credit-rated single-tenant user for 10 years provides a recurring stream of income over a long time horizon with contractual rent step-ups.
Even in asset classes with relatively shorter lease terms, such as multifamily, tenants are often incentivized to renew leases due to the relatively high cost of moving. Furthermore, a diversified rent roll (i.e. numerous tenants with staggered lease maturities) helps smooth out any potential volatility that may arise from lease expirations. It is important to note that the figure below does not incorporate depreciation benefits, which could further elevate the tax effective yield of investing in real estate.
20 Year Average Annual Cash Yield[13]
Real Estate as an Inflation Hedge
As inflation remains above the Federal Reserve’s 2% target despite hawkish measures on the part of the Federal Reserve, some economists are projecting an extended period of above-target inflation. Investors in private real estate may benefit from its potential to hedge against inflation.
In contrast to bonds, commercial real estate produces dynamic income streams that can reset over time due to market rent growth and rent escalation clauses. For example, multifamily leases tend to be set on an annual basis, allowing for rents to potentially meet or beat inflation. While asset classes such as industrial or office offer longer-term leases where rents do not tend to be reset on an annual basis, contractual rent step ups allow for rents to increase over the long term. This acts as a hedge against inflationary pressures, while also stipulating that the tenant is responsible for paying their own expenses, which reduces investor potential downside from rapidly growing expenses. This helps the investor ensure income is keeping pace with rising costs while also shielding them from higher expenses. As shown in the graph below, net operating income growth across multifamily and industrial asset classes have often significantly outpaced inflation over the past 20 years.
Further diversifying a portfolio beyond public equities and fixed income can help mitigate the impact of inflation. Private real estate historically has performed well in rising rate environments and is generally regarded as an effective hedge against rising inflation within investor portfolios.
NOI Growth by Property Type vs Inflation[14]
Real estate also has the potential to appreciate in value over time, especially in periods of inflation. As inflation occurs, the general price level of goods and services tends to rise, including the net operating income of real estate assets. As a result, the value of real estate assets can potentially increase, providing an effective hedge against inflation.
Conclusion
Private real estate investments typically represent 11% of a typical institutional investor’s portfolio since the sector offers a variety of advantages that may serve to optimize a portfolio’s risk-adjusted returns.[15] These include potential tax advantages, historically low levels of volatility, the ability to act as an inflation hedge, and strong risk-adjusted returns. Individuals may consider allocating to private real estate themselves to enjoy similar asset class advantages.
1. Bain & Company: Why Private Equity Is Targeting Individual Investors, February 2023
2. Preqin Investor Outlook: Alternative Assets, H2 2023
3. This section is generally intended for U.S. taxable investors. This article does not constitute tax advice to, and should not be relied upon by, potential private real estate investors, who should consult their own tax advisors regarding the matters summarized herein and the tax consequences of private real estate investing. No representation or warranty is made as to the reasonableness of the assumptions made, that all assumptions have been stated or that all relevant factors impacting flow of funds have been taken into account. No model can completely account for all factors that could impact the flow of funds and there are frequently sharp differences between modeled results and actual results subsequently achieved. This summary describes only some of many U.S. federal income tax considerations that may be applicable to an investor. It does not address state and local or non-U.S. tax considerations. All rates disclosed are based on the latest rates published by the IRS, as of September 30, 2023.
4. This statement is hypothetical and there can be no assurance that the investment will achieve the benefits described or avoid losses.
5. All rates disclosed are based on the latest rates published by the IRS, as of September 30, 2023.
6. All rates disclosed are based on the latest rates published by the IRS, as of September 30, 2023.
7. There can be no assurance that the trends described herein will continue.
8. NCREIF and NAREIT, as of December 31, 2022, volatility calculated as the annualized standard deviation of returns between 2003 and 2022. Private real estate returns are represented by the NCREIF Property Index (NPI) total return data, public equities returns represented by the S&P 500 total return data, and REITs returns represented by the FTSE Nareit U.S. Real Estate Index total return data.
9. Return calculated as the average annualized return between the 20 year period from 2003 to 2023 and risk calculated as the annualized standard deviation of returns over that time. Private RE returns are represented by the NPI total return data, Public REITs returns represented by the FTSE Nareit U.S. Real Estate Index total return data, Public Equities returns represented by the S&P 500 total return data, and IG Bonds returns represented by the Bloomberg US Aggregate Bond Index total return data, sourced from NCREIF, NAREIT, and YCharts, as of December 19, 2023.
10. NCREIF and YCharts, as of December 19, 2023. Low and negative correlation as calculated by the correlation coefficients between private real estate returns and both equities returns and fixed income returns between 2003 and 2023. Private real estate returns are represented by the NPI total return data, equities returns represented by the S&P 500 total return data, and fixed income represented by the Bloomberg US Aggregate Bond Index total return data.
11. NCREIF, NAREIT, and YCharts, as of December 31, 2023. Return calculated as the average annualized return of stocks, bonds, and private RE weighted by the indicated percentage of each in the two hypothetical scenarios in a 20 year period between 2003 and 2023. Stock returns are represented by the S&P 500 total return data, bond returns are represented by the Bloomberg US Aggregate Bond Index total return data, and private RE returns are represented by the NPI total return data. Risk is calculated as the annualized standard deviation of the weighted average returns.
12. "Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, Fully Revised and Updated" by David F. Swensen. Published by The Free Press, 2009.
13. NCREIF, NAREIT, FRED, and YCharts as of December 31, 2022. Average annual yield between 2003 and 2022. Private RE yield is represented by the NPI income return data, Public REITs yield is represented by the FTSE Nareit U.S. Real Estate Index dividend yield data, IG Bonds yield is represented by the ICE BofA AAA US Corporate Index effective yield data, 10-Yr Treasury yield is represented by the US Treasury Securities at 10-Year Constant Maturity market yield data, and Public Equities yield is represented by the S&P 500 dividend yield data.
14. Multifamily NOI Index, Industrial NOI Index, and Avg. CPI Index calculated relative to 2003 base year. Avg. CPI Index uses the average monthly CPI data for each year. Source: CoStar and Bureau of Labor Statistics as of December 19, 2023
15. Preqin Investor Outlook: Alternative Assets, H2 2023
Disclaimer
Educational Communication
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Opportunity Zones Disclosure
Any discussion regarding “Opportunity Zones” — including the viability of recycling proceeds from a sale or buyout — is based on advice received regarding the interpretation of provisions of the Tax Cut and Jobs Act of 2017 (the “Jobs Act”) and relevant guidances, including, among other things, two sets of proposed regulations and the final regulations issued by the IRS and Treasury Department in December of 2019. A number of unanswered questions still exist and various uncertainties remain as to the interpretation of the Jobs Act and the rules related to Opportunity Zones investments. We cannot predict what impact, if any, additional guidance, including future legislation, administrative rulings, or court decisions will have and there is risk that any investment marketed as an Opportunity Zone investment will not qualify for, and investors will not realize the benefits they expect from, an Opportunity Zone investment. We also cannot guarantee any specific benefit or outcome of any investment made in reliance upon the above.
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