A great question we’ve received this year from our investors is if it makes sense to invest in private real estate during a market downturn. No one wants to buy the top of the market but holding your investment capital in cash is also not the most lucrative choice. What history has taught us is that time in the market is far more important than timing the market.
However, to definitively answer this question, we turned to data to quantify the returns investors would have achieved in other periods of uncertainty. We analyzed historical return data using the NFI-ODCE, a capitalization- and time-weighted private real estate index, and calculated the returns of a $100,000 investment made during four of the most recent recessions. The chart below shows how four separate $100,000 investments in private real estate would have grown if made during each recession and held for five, seven or 10 years.
For example, if you invested $100,000 in private real estate in 2009 and held your investment for 10 years, it would have grown to $275,000 by the end of 2017. There was no example where you would have lost money if the investment were held for more than five years. Even in the worst-case scenario during 1991, you would have broken even after year five and doubled your money in 10 years. Private real estate returns endure over time because a significant amount of returns come in the form of cash flow and the properties are hard assets that tend to appreciate over time for a variety of reasons.
There are other investments that would likely pass the same 10-year return test as outlined above. So why are you better off investing in private real estate during a downturn? There are three additional benefits of investing in private real estate that other assets generally don’t offer.
Private Real Estate Offers Stability In a Market Downturn
During turbulent markets, private real estate can provide downside protection and reliability. Private real estate’s low correlation to stocks and bonds creates a balanced portfolio that helps counteract the daily shocks of trading. Private real estate also acts as a hedge to inflation. Rents and property values can keep pace with inflation as annual lease terms allow landlords to adjust rents accordingly. Real estate owners are able to replace tenants or perform renovations to increase rents upon renewal. This is especially important in recessionary periods when the government prints money to keep the economy afloat. Each real estate property also typically holds multiple units or spaces, which provides a diversified and steady income stream. This lowers the risk proposition even further and allows for predictability during times of uncertainty.
Multifamily itself is an essential asset class, generating relatively stable demand as people will always need a place to live. We have witnessed this firsthand as our Origin IncomePlus Fund targets this asset class and has consistently averaged 94% occupancy in the period from March to August 2020. The IncomePlus Fund offers a consistent yield of 6% per year, with a total target net annual return of 9% to 11% and has delivered on this stability during 2020’s market downturn. This resilience can be attributed to many factors including the IncomePlus Fund’s diversification and balance between investing in preferred equity and direct equity. This structure allows us to provide a consistent distribution to our investors in a tax-efficient manner during a time of market uncertainty.
Private Real Estate Delivers Powerful Tax Benefits
In all market cycles, investors who ignore after-tax yields fail to recognize a large benefit of investing in real estate which can be impactful to returns. The stable and diversified income generated by properties is largely shielded through depreciation, providing investors with the long-term benefits of cash flow with a very little tax burden. Typically, a big expense for accredited investors is the ordinary income tax rate. With an investment in real estate, individuals will generally pay 20% and 25% in taxes versus the highest tax bracket of 37% for hedge funds or other alternative vehicles. The savings due to the tax rate differential can be dramatic.
Another tax benefit of private real estate investing is the ability to save through deductions. Real estate is typically held in an LLC, which is considered a pass-through entity and allows its members to get taxed on their share of income, expenses, and losses, rather than being subject to the double-taxation affiliated with corporations. There are also tax savings present upon selling an asset. The profit on the real estate sale will be taxed as a long-term capital gain, assuming the property has been held for more than one year. The long-term rate ranges from 0% to 20%, which is typically lower than the ordinary income-tax rate. This can be advantageous when eliminating most, if not all, ordinary income through real estate deductions and depreciation, so that a majority of the taxable income is taxed at the lower capital gains tax rate.
Using Origin as an example, our IncomePlus Fund aims to be extremely tax efficient by utilizing these tax benefits. The Fund’s buy-and-hold strategy allows investors’ net worth to grow with minimal tax exposure, optimally building wealth by avoiding an extra tax burden as real estate appreciation doesn’t get taxed if you don’t sell. Similarly, you can roll sale proceeds into a 1031 exchange or Opportunity Zone Fund to avoid, and even eliminate, the capital gains tax. In addition to using depreciation deductions, expenses can significantly offset taxable income for investors with any taxable portion being classified as rental or dividend income. The sheltered portion of distributions will be classified as return of capital until all investor capital has effectively been returned from distributions, at which point distributions may be taxed as capital gains. Investors could also be eligible to take a 20% deduction on any taxable portion of their distributions each year, providing investors with an additional opportunity to create a greater return in times of market volatility.
Private Real Estate Provides High Absolute Returns
Private real estate offers investors an opportunity to generate high absolute returns, regardless of the market cycle. Looking at data from Bloomberg, an investment in private real estate beginning on December 31, 2000, would have been worth around $420,000 on December 31, 2019. This is a time period that covers two market downturns – in 2001 and 2008. This investment would have earned $64,000 more than the same investment in the S&P 500.
Further illustrating private real estate’s outperformance can be done by looking at Origin’s own portfolio. As of June 2, 2020, our IncomePlus Fund distribution yield is 170% more than the yield on investment-grade bonds and 855% more than the 10-year U.S. Treasury Yield. It’s no wonder that 35 of the wealthiest 400 Americans on Forbes’ list accumulated their wealth in real estate.
As the federal reserve attempts to keep the economy afloat during recessionary periods, interest rates are reduced, and debt is subsequently cheaper. Lower borrowing costs increases the money going to investors as less money goes to the bank. The opportunity to purchase properties at discounted prices is greater during market downturns due to loan defaults and high supply coupled with low demand. This creates an attractive real estate buying opportunity that otherwise might have not existed.
With banks now being more conservative with their lending, highly regarded sponsors are reaching out to us to fill the lending void. This is giving us unprecedented opportunity to invest in high-quality preferred equity deals, which provide a protected position in the capital stack. Preferred equity investments offer routine payments and provide compelling returns where asset values would have to fall 20% to 40% before our first dollar is at risk. We have also seen construction pricing and interest rates come down substantially, which gives us an additional opportunity to decrease the amount of risk on the table. This all contributes to private real estate’s ability to outperform the public markets and offer stability to an investor’s portfolio.
How Underwriting and Risk Management Drive Returns
Origin was built out of the last recession where our principals applied similar thinking to their own investing strategies. Since our founding in 2007, we’ve built strong relationships in our 11 target markets and can acquire institutional properties off market and avoid bidding wars. In fact, 50% of our deals in the IncomePlus Fund have been sourced off market, allowing us to buy right. Then, we put smart managers in place to realize our business plans and the full value of our assets, earning outsized returns for our investors.
We place an emphasis on risk management, which includes a stringent underwriting and pricing process, responsible leverage and no cross-collateralized debt. We’ve had zero losses across our private real estate portfolio and because of our strong balance sheet and quality assets in our Funds, we can be opportunistic with new acquisitions during periods of disruption. Origin works to protect and grow our investor’s capital in all market cycles, and our principals invest significant capital alongside of you to ensure that we are aligned in all that we do.