Summary/TL;DR
Commercial multifamily real estate has been described by some as “the perfect investment”, and for compelling reasons. The potential tax advantages and returns, when combined with America’s demographic and housing market trends, make investing in multifamily real estate an essential slam-dunk. Partnering with a competent property sponsor who is conservatively natured, has a strong track record, and participates in their investments alongside their investors is key to success.
Introduction
There’s a lot of hype surrounding real estate investing, as the potential returns and tax benefits can make even long-term stock investors raise their eyebrows. Many potential investors, however, are discouraged from exploring real estate as an investment due to the additional work and risks of looking for properties, obtaining financing, screening tenets, and dealing with renovations and ongoing maintenance.
In today’s post, I discuss my personally preferred approach to investing in real estate that is not only completely passive, but has tremendous benefits of its own – investing in commercial multifamily apartment complexes as a limited partner.
The Demographics
It’s no secret that the American housing market has changed (perhaps forever) after the COVID-19 pandemic. Trends towards renting and away from ownership that appeared before the pandemic were accelerated and are unlikely to reverse course for a very long time. Reinforcing this conclusion is the fact that home ownership has become more expensive than renting by the widest margin since the 2008 Financial Crisis, a fact not expected to change for the foreseeable future.
Keep in mind that the dark line above (representing mortgage payments) is exclusive of the cost of taxes, insurance, and maintenance. These costs, as all homeowners know, can easily meet or exceed the principal and interest payments of a mortgage. In other words, the cost of owning is severely underestimated in this visual. When the above is taken into consideration, in addition to other economic and cultural trends not discussed here, it’s no surprise that there has been an enormous surge in the demand for multifamily housing.
Adding fuel to the demographic fire above is the fact that there is a massive shortage of multifamily housing. Due to the rapid pace of interest rate hikes over the past year, forecasted multifamily construction starts have declined 70% from their peak obtained two years ago, and currently sit at the lowest levels of the past ten years.
True Diversification
“Diversification” is often achieved through the inclusion of bonds or other fixed income assets into one’s portfolio. Historically, bonds have served as a “safe haven” asset that investors flee to during times of economic distress and uncertainty. The strong influx of purchases bids bond prices up in periods when the stock market is often crashing, insulating one’s portfolio from hefty losses while still allowing it to participate in moderate long-term growth. The monthly income that they produce in the meantime is simply icing on the cake.
Bonds and other fixed income investments, however, come with a serious cost. They inherently limit your long term returns and all but guarantee that your investment will lose value after accounting for inflation. In other words, what’s gained in short-term “safety” is lost in value preservation. Furthermore, as has become all-too-clear over the past few years, fixed income investments continue to be subject to high levels of interest rate risk which will be further exacerbated as pressure on the Federal Reserve to lower interest rates manifests into actual policy, threatening their reputation as non-correlative “safe-haven” assets.
Multifamily real estate, however, can consistently provide (tax-free) monthly income, non-correlative returns (relative to stocks), and serve as an effective inflation hedge with long-term returns that rival those of equities. Properties considered “Class B” are particularly well-equipped to endure recessionary and inflationary times. For these reasons, I consider multifamily real estate to be a far superior portfolio diversifier than bonds.
Tax Advantages
The tax advantages of real estate (in general) are unparalleled in the world of passive investing. First, accelerated depreciation strategies such as cost segregation studies in conjunction with bonus depreciation allow large sums of passive losses to be passed through to investors in the first year of ownership. This can be used to offset the passive income produced from the property or any other investment producing passive income, making it tax-free.
Furthermore, the tax-code allows capital gains deferral upon the sale of a property via a transaction known as a 1031 exchange. This is significant, as real estate is the only major asset class with a tax-favored “like-kind” exchanged allowed in the law. Ordinarily, when property is sold for a profit, the amount of the sale proceeds that exceed the investor’s cost basis is subject to capital gains taxes, which may be as high as 23.8% (20% long term capital gains tax plus 3.8% net investment income tax). Through a 1031 exchange, however, all of the gain may be deferred into another real estate investment as long as some strict (but relatively simple) rules are followed. This will allow the profits to continuously be reinvested into future projects, potentially in perpetuity.
Some real estate investments might be classified as Qualified Opportunity Zones (QOZs), arguably the greatest tax incentive currently in the tax-code. You can read more about QOZs in the blog post I’ve dedicated to them here. The QOZ classification is yet another tax-advantageous characteristic unique to real estate.
Finally, upon the eventual passing of your real estate portfolio to posterity, all of the capital gains and depreciation recapture that you’ve deferred via 1031 exchange will be erased entirely. This is because the tax-code currently allows your heirs to experience a “step-up” in cost basis equal to the fair market value of any property they inherit outside of qualified retirement accounts. In short, you can potentially defer and reinvest capital gains perpetually during your lifetime, and completely eliminate the tax liability upon your passing.
How To Invest
Investing in private equity is not something that should be done flippantly. The space if full of grifters and snake-oil salesman, and many have lost money in “bad deals” that have gone south. It’s extremely important that you choose to work with someone who has a consistent track record of high performance in this space. A good property sponsor will be extremely conservative with their deployment of capital and will have a clear and foolproof path to adding value to the property, allowing them to raise rents, cut costs, and improve net operating income (NOI) before either refinancing or selling.
They will have purchased the property at a conservative valuation, providing their investors with a margin of safety. They should have every realistic hypothetical “what could go wrong” scenario considered when projecting returns. Finally, and perhaps most importantly, they will have significant “skin in the game” by investing considerable sums of their own wealth into their investments.
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