Editor’s note: Salvatore “Sam” DiFranco is chief executive officer of Triangle Commercial Real Estate in Cary, NC.
Commercial- and investment-grade real estate has become a “must-have” investment for both institutional and individual investors’ portfolios. Money managers and financial advisors suggest that 15-25 percent of financial portfolios be compromised of investment real estate holdings — that is, property held other than for a primary residence.
Multiple factors such as the aging demographics in the U.S. have contributed to the popularity of commercial real estate as a sound investment. Much of that popularity is driven from five primary options:
1. REITs (Real Estate Investment Trusts)
2. TICs (Tenant’s in Common)
3. CMBS (Commercial Mortgage Backed Securities)
5. Individual Properties
Although commercial real estate is delivering historically low returns, the downward pressure on most investments offers real estate an attractive buy in today’s economy. Undoubtedly, real estate is competing with with stocks and bonds on an absolute and risk adjusted return basis.
Demand has far exceeded the supply in all sectors, including second/vacation homes, multi-tenanted and triple net (NNN) properties where the buyer receives a “mailbox check” every month with limited management. In triple net situations, the tenant is responsible for all expenses associated with the property including TICAM (taxes, insurance, and common area maintenance), while the landlord is responsible for debt service (mortgage) only.
On average, returns have followed the supply and demand curve. Capitalization rates (Cap Rates) is a measurement of return based on the property’s first year Net Operating Income (NOI). The NOI is the amount of income the property has taken in less after all TICAM expenses have been paid. NOI does NOT include any mortgage or debt service on the property.
Cap rate is the percentage of return divided by the purchase price. An example of a ten percent cap rate: $1,000,000 property purchased with first year NOI of $100,000. Twenty-four to 36 months ago the cap rates traded at 8-10% for income-producing properties. In 2005, that number has decreased approximately 200 basis points or 2 percent. Current deals are trading in the six to eight percent range, and as low as 4 percent in geographic areas like California and New York. Typically the higher the cap rate the higher the return and risk involved. Conversely the lower the cap rate the lower the risk and return.
1031 and 1033
On top of all this feeding frenzy comes the IRS 1031 and 1033 tax deferred exchanges. The 1031 and 1033 exchange allows for a seller of “non principle residence” real estate held for investment in the U.S. to sell that property and repurchase “like kind”, “Non personal residence” real estate in the U.S. while deferring capital gain taxes that would normally be due upon a traditional sale and reinvesting them in a replacement property.
An owner can sell farm land and purchase more land or income producing office buildings, apartments, beach house rental, or TICs (Tenants in Common) property. They can also use this opportunity to sell a management intensive property and replace it with a lesser or no management (NNN) type property. The IRS term “Like — Kind” is very liberal, but strict procedures must be followed to facilitate a proper exchange.
With interest rates ticking up from a 40-year-low, returns are expected in the six to eight percent range for stocks and bonds. Investing in commercial real estate is still and will remain a viable part of a savvy financial portfolio.
Bricks and mortar are here to stay and every quarter you will be able to physically see the performance (or lack of) within your property. Not just another loss on a statement.
Sam DiFranco is the CEO of Triangle Commercial, a full service commercial real estate company. He specializes in representing tenants and buyers to help locate sites and negotiate terms and conditions for their new facilities for both occupancy or as investments. With more than 27 years of real estate, construction, sales and leasing experience, including office, flex, industrial and retail space, he has assisted companies with growth and expansion strategies, exit strategies, creative financing, buy vs. lease options, vendor recommendations and facilities management. He can be reached at (919) 604-2140.