Private real estate offers many benefits to individual investors, such as high returns, leverage capability, portfolio diversification and tax efficiency. Institutional investors have long understood the merits of this asset class and relied on it to gain stability that balances market uncertainty. Not surprisingly, most pension funds follow a similar investment plan. Private investors have also been investing in this asset class for long. However, people are looking for simplicity and have been thinking if they should continue investing in this sector. This article will encourage investors why this is one of the most attractive asset class for investment.
What is Private Real Estate Investment?
It is direct ownership in a piece of physical real estate, such as land, an office building, apartments, or industrial facilities, with the intent of making a profit. Individuals can invest in private real estate by acquiring assets actively as a direct buyer, or passively with a private real estate investment firm, an online crowdfunding website or a non-traded private Real Estate Investment Trust.
Benefits of investing in Private Real Estate Investment
There are 4 benefits of investing in private real estate and they reinforce why it is the most compelling asset class for an investor.
1. Generates High Returns
Private real estate offers investors the ability to generate high absolute returns. An absolute return takes into account appreciation, depreciation and cash flows to measure the amount of money an investment earns over time, and is expressed as a percentage gain or loss on the initial investment.
Typically, private investments generate absolute annual IRR from 18% to 30% based on asset type. Yes, the holding period for higher IRR options is between 5 years and 10+ years.
2. Provides opportunity for portfolio diversification The goal of every portfolio is to create the highest total return with the optimal risk. Most investors are comfortable with a mix of stocks and bonds in their investment portfolios—until the markets’ ups and downs start making them nervous. Private real estate helps investors temper the volatility in their portfolios because it’s immune to the daily shocks of trading.
The value of a private real estate fund is based on the actual value of property held by the fund. Conversely, in a public REIT, the share price value is determined by daily market forces, which means the share price of a public REIT may not reflect the actual value of the underlying real estate. In some cases, the share price can value the REIT 30% higher or lower than the actual value of the underlying real estate.
Private real estate values don’t move much daily but rather appreciate steadily over time, which is why private investments are less volatile than their public counterparts. Both vehicles have pros and cons, and the optimal portfolio has a combination of both. Public markets offer liquidity, but that comes at the expense of volatility and private investments offer investors low volatility, but with that comes illiquidity.
It has been found after analyzing data over a period that private real estate and financial markets are not corelated. An investment portfolio benefits greatly when it includes asset classes that are not correlated to each other.
3. Tax Efficient
Investors who focus solely on an investment’s underlying returns and ignore its after-tax yields don’t recognize a big benefit of real estate investing. Income generated by properties is generally shielded through depreciation, providing investors with the long-term benefits of substantial cash flow and very little tax burden.
In general, individuals will pay between 20% and 25% in taxes on real estate investments versus 35% (approximately), the highest tax bracket on ordinary income, for other alternative vehicles.
Additionally, any investment appreciation above the original purchase price, assuming the property has been held for more than one year, will be subject to the long-term capital gains rate of only 20%. Moreover, capital gain tax is applied on difference between sale price and indexed purchase price. The indexation considers the annual inflation for the land portion. Therefore, effectively long-term capital tax is around 15% of the total gain.
Another tax benefit of real estate is the ability to defer taxes indefinitely. The tax provision allows real estate owners to sell a property and buy another property without incurring capital gains taxes. In theory, an investor could buy and sell properties without ever paying taxes on the gains. The ability to defer taxes into the future is one of the greatest attributes of owning real estate directly.
Finally, because private equity real estate is typically held in an LLP, which is considered a pass-through entity, 100% of income, losses and expenses pass through to the owners. Unlike corporations, where owners may be subject to double taxation (the corporation pays taxes on corporate net income and the owner pays on any dividend income they receive), the LLP itself does not get taxed. Instead, individual members are taxed on their share of the income, expenses and losses reported on their year-end tax document. They are taxed at their tax rate, which is often lower than the corporation’s.
4. Provides leverage advantage
One of the greatest advantages of investing in real estate is your ability to use leverage. In real estate, leverage allows you to achieve a much higher return on investment than you could without it. Real estate investing allows you to use leverage when you buy. Using leverage in your real estate investments can have a big effect on your financial statement.
Real estate is one of the few places that if one buys something, he/she needs to infuse own equity only a small fraction of the purchase price. Banks will lend you a significant percentage of the purchase price (60% to 80%; varies based on property and credit rating of the borrower). Banks/ financial institutions will finance it and allow you to pay them back over time.
Therefore, private real estate is one of the best asset class to invest for an investor. It creates wealth multifold for an investor over the period. In our experience we have witnessed investor generating over 18% to 16% (annual ROI) from rent yielding assets and over 30% in land investments. Yes, most of the investors stayed invested over 10 years to make such handsome investments. It is important to choose your investments correctly and conduct all required due diligence before committing to such investments.