To understand how a real estate investment will perform over time, we must first examine where the return on that investment is derived. Private, direct real estate investments tend to produce value from four distinct categories.
First, after a period of time, equity investors expect to receive normal distributions from their investment as a result of the cash flow from operations from the property or properties in which they have invested.
The cash flow from operations available for distribution can be thought of as the effective gross income, less all operating expenses for the property, less capital expense or reserves, partnership expenses and all debt service. What is left over is the cash available for distribution. This amount, as a percent of your investment, is known as your cash-on-cash return, or the return on equity. In multifamily investing, this category is often both stable and predictable because of the diversification of the tenant base and the length of the lease terms (typically one year). The loss of a single tenant or even a handful of tenants in a 250-unit property would correspond to around a 1 percent decrease in income, and moreover, a single unit has the ability to be filled by another renter quite quickly. Compare that to a single-tenant office building, or multi (2-3) tenant industrial building. Here, a loss of a tenant may represent up to a 100 percent loss of income, it may take months to fill, and will cost significant capital in the form of leasing commissions and tenant improvement allowances to re-tenant the space. Multifamily properties, in this sense, are significantly more stable.
Second, equity investors typically capture value through principal reduction or amortization.
Once the debt on a property begins amortizing, meaning that the monthly debt obligation pays down the principal balance in addition to the interest payments on the debt, the equity in the investment grows. This can add a 2-4 percent in yield on top of the cash flow from operations discussed above. Of course, this value isn’t captured or realized by the investor until an equity event such as a sale or refinance. At these events, the bank or a prospective buyer states the new value of the asset in the market, and once the now-lowered principal balance is paid off, that increase in equity value is captured by the investor.
The third form of return is the tax benefits of owning real estate.
Each investment partner will receive an IRS Form Schedule K-1 each year, which reflects their proportionate share of the taxable income (loss) of the partnership. Oftentimes, however, the income on which they are taxed is significantly lower than the cash they received from their investment. This is because the tax laws incentivize real estate ownership and allow owners to deduct the interest expense and scheduled depreciation from their taxable income. In new investments, the owner may show a tax loss despite receiving cash for the year and may be able to use this paper-loss to offset other passive income. Otherwise, they may carry the loss forward, indefinitely, to offset future tax obligations. Additionally, one of the more powerful tax benefits afforded to real estate investors is the ability to defer capital gains taxes upon the sale of an asset when those proceeds are invested into a like-kind investment, within a specified period. Collectively, this makes real estate a very tax-efficient investment.
The fourth, and final category of return is appreciation.
This category is frequently correlated to the sentiment in the market, but it’s important to distinguish what may be called “cycle” appreciation from that of normal appreciation. Real estate investments tend to be a hedge against inflation. “Normal” appreciation should be considered separate and distinct from “cycle” appreciation, which is less important to sponsors like Timberland Partners who invest as long-term owners. To understand how an investment may act as a hedge against inflation, it is easiest to use an example.
Consider a property that produces $1 million in gross income during the year.
The property also has $400,000 in normal operating expenses. The net operating income (NOI) is thus, $600,000 (income less expenses). Assuming that the property could be sold in the market with a capitalization rate (cap rate) of 5.5 percent, the resulting value or sales price would be $10.9 million (NOI/cap rate).
Base Scenario: Year 1
|Sales Price (NOI/Cap Rate)||$10,909,091|
Now, assume in the subsequent year inflation allows the rents to rise and associated gross income increases by 2 percent.
However, operating expenses such as taxes, insurance and wages also increase and the overall operating expenses are also up 2 percent for the year. The new gross income is $1.02 million, the new operating expenses total $408,000, and the resulting NOI is $612,000. Now, assuming an equivalent cap rate (5.5 %), the value of the property is $11.1 million.
Inflation Scenario: Year 2
|Income (2% growth)||$1,020,000|
|Less Expenses (2% growth)||($408,000)|
|Sales Price (NOI/Cap Rate)||$11,127,273|
In this case, the margin, or operating efficiency of the property has not been improved at all year-to-year and buyers are willing to accept an equivalent rate of return (5.5 %) for the stream of income, yet the equity for the owners of the property has increased by 2 percent due to nothing more than inflation.
Now, assume instead that in year 2 we’re “later” in the cycle, and buyers are willing to accept a lower rate of return for assuming an equivalent level of risk.
Many factors could drive that change in attitude, from perception of local market trends to changing attitudes toward other asset classes such as fixed-income or public equities investments. Now, in year 2, buyers are willing to pay a 5 percent cap rate instead of a 5.5 percent rate and the resulting price is $12.2 million, a 12.2 percent increase over the previous year. This would be a significant one-year gain in equity value for the investor, but counting on that change in valuation is a risky game.
Late Cycle Scenario: Year 2
|Income (2% growth)||$1,020,000|
|Less Expenses (2% growth)||($408,000)|
|Sales Price (NOI/Cap Rate)||$12,240,000|
Predicting the future cap rates that the market will apply to a particular investment is a difficult task – and the margin of error increases over time.
Like stock investors who don’t try to time the markets and instead invest based on the intrinsic value of the underlying security, Timberland Partners employs a similar strategy. We look to add value through strategic capital improvements at the property, increase the operating efficiency over time, and drive continual growth in the net operating income of the property. When that happens, the intrinsic value of the property increases. We remain focused on growing this intrinsic value over the long-term and are less concerned over the relative market fluctuations.
So, does your investment make money in a down economy?
As a long-term owner, most likely. No investment is without risk, but even with relative declines in valuation (meaning an implied higher cap rate if the property were to sell) you may still receive normal cash distributions from the operations of the property, you will still build equity through principal paydown, you will still enjoy the benefit of interest and depreciation deductions from your tax bill, and inflation and value creation can still positively affect the normal appreciation of the property. When you maintain a long-term perspective, you may even enjoy opportunity, but not obligation, of selling or refinancing in a period of higher relative valuations.