Private real estate has many advantages for investors of all kinds including higher returns, portfolio diversification along with tax efficiency. The institutional investors for years have recognized the benefits of this type of asset and have relied upon it to achieve stability and security that counteracts market volatility. Take Yale’s endowment — considered the gold standard for its exceptional performance; 10% of its investment portfolio is allocated to real estate. This is not surprising, as most retirement funds and endowments have an identical investment plan. However, individual investors have only begun to adopt this approach and began adding real estate from private investors to their portfolios over the past few years.
However, three aspects aren’t difficult to understand: the major advantages of investing in real estate that is privately owned. Each of these benefits is explained in detail to help investors make informed decisions regarding privately owned real estate.
Benefit #1: Private Real Estate Generates High Absolute Returns
Private real estate provides investors the chance to earn huge absolute returns. A true return takes into account appreciation and depreciation in order to calculate how much an investment makes over time. In analyzing data from Preqin which is a research company which tracks what happens to alternative investments, an investment of $100,000 in real estate for private use, beginning the 1st of January, 2001 could have been worth approximately $380,000 on March 1st 2017. The same $100,000 investment within the S&P 500 could be worth $255,000 on March 1st 2017, as depicted in the graph below.
Benefit #2: Private Real Estate has the lowest correlation to other Asset Classes
The aim of any portfolio is to achieve the greatest return for its investors with the lowest degree of uncertainty. The majority of investors are comfortable with the mix of bonds and stocks within their portfolios of investment — until markets’ fluctuations become a source of anxiety. Private real estate is a great way for investors to reduce the volatility of their portfolios due to its immunity to the daily turbulences of trading. The value of an individual property fund is determined on the value of the properties held in the funds. However, with an REIT that is public the value of the shares is determined by market conditions, which means the price of shares in the REIT’s public market could not accurately reflect the worth of the real property. In certain instances the share price could represent the REIT as 30 percent higher or lower than the actual worth of the real property.
Private property values don’t change much on a daily basis but do appreciate over time. This is the reason private investment is less volatile as compared to their public counterparts. Both have their pros and cons, and the ideal portfolio is an amalgamation of both. Public markets are a source of liquidity, but it is at the cost of high volatility, while private investments give investors low volatility, however there is a risk of illiquidity.
The graph below shows how the private sector of real estate is not linked with bonds, stocks or even REITs owned by public companies as determined by the National Council of Real Estate Investment Fiduciaries (NCREIF) property index (NPI) which examines the returns of commercial real estate.
● NCREIF Real Estate Correlation to:
● Russell 3000 Index: 0.23
● Barclays US Aggregate: -0.24
● NAREIT: 0.13
A correlation coefficient of zero signifies that the price changes do not have any correlation at all. A correlation score of one signifies that the assets move in tandem, while a negative correlation indicates that they are moving in opposite directions to each other. A portfolio of investments will benefit greatly by having different asset classes that aren’t dependent on one another.
Benefit #3: Private Real Estate is Tax Efficient
Investors who are focused on the investment’s returns and do not consider its after-tax returns aren’t aware of the significant benefits of investing in real estate. The income generated by property is generally protected through depreciation. This provides investors with the long-term benefit of a large cash flow, and a minimal tax burden. In general, people pay between 20% to 25% tax on investments in real estate as opposed to 37%, the tax bracket that is the highest for normal income, in hedge funds, as well as alternatives. Therefore, if a home generates the equivalent of $100,000 in cash flow and $50,000 of depreciation the taxable income to the individual is only $50,000. The tax burden in the event that an investor is in the top federal tax bracket can be calculated by .37 $50,000 x $18,500. That’s equivalent to an 18.5 percent tax rate on the total cash flow of $100,000.
In addition, since Private equity properties are usually located in an LLC which is regarded as an entity pass-through by the IRS the IRS, all earnings, losses, and expenses go onto the owner. In contrast to corporations, where the owners could be at risk of being taxed twice (the corporation is responsible for paying taxes on net profits of the corporation and the owner is responsible for dividends that they receive) The LLC itself is not taxed. In fact, the individual members are taxed based on their portion of the profits as well as losses, expenses and income that they report on their tax year-end document, known as the K-1. The tax is calculated at the tax rates they pay, and this is usually less than that of the corporation.
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