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“… Nothing is certain except death and taxes.” — Benjamin Franklin
It’s understood that investment returns involve risk. Yet perhaps never have we been more acutely aware of that. That risk was on full display in 2022 with the S&P 500 declining double digits and Treasurys close behind. The last time it happened was over 50 years ago. The weakness of stocks and bonds together highlights the need for including other asset classes to achieve a truly diversified portfolio. For that, real estate can be a valuable tool.
Publicly traded real estate investment trusts offer a simple way for investors to add to their real estate holdings. Traded on major stock exchanges, REITs are as convenient to buy and sell as shares of big companies. Additionally, REITs are afforded a special tax status by the IRS, allowing investors to benefit from some of the tax advantages of investment real estate. By law, REITs are required to pay most of their earnings out to owners in dividends each year, making them an attractive income-producing alternative to bonds.
But REITs also had a difficult 2022, with rising interest rates and softening investor demand suppressing market values across the board. These headwinds are reflected in the NAREIT index of publicly traded REITs, which lost more than 25% in 2022. With such a strong correlation in a down market, investors may question whether real estate really offers the diversification they seek.
But there’s another way to approach real estate investing that carries a different risk profile. The NPI, an index of top private real estate investments, outperforms the REIT index over time with less volatility.
These direct investments carry more challenges than REIT investments, but they have much to offer in return. In fact, in some of these challenges, private real estate finds its largest advantages:
1) It’s virtually impossible to make enough direct investments to match the diversity of REITs, but what is lost in diversification can be replaced with portfolio construction.
A direct real investor is solely focused on meeting their goals rather than a comparison to an index. This difference in focus means the direct investor only needs to take as much risk as necessary to meet their goals. For example, in 2022, our firm invested $140 million in properties with long-term commitments from strong brands like Lane Bryant, Uber Freight and Shutterfly paired with fixed-rate debt for a moderate to long-term hold. A public REIT would have been panned for these investments because they were designed in a way that gave up some of the near-term opportunities in the market. But because this was an investment with a moderate to long-term horizon, we were able to trade some of that near-term opportunity for the additional probability that we would meet our longer-term goals.
2) The significant cost and effort to buy and sell helps direct investors avoid the classic investment pitfall of buying high and selling low. Volatile markets often entice investors to abandon discipline, while the lower volatility and higher transaction costs for direct investments help direct investors stay the course, thus avoiding sales at market lows.
3) The more complex tax, legal and compliance features of private real estate enable them to particularly shine when it comes to one of Franklin’s great certainties, taxes.
Private real estate allows the opportunity to offset taxes generated by the property with depreciation and, potentially, offset other income as well. And while these tax savings are only temporary, Franklin’s other great certainty transforms these temporary savings into permanent ones. Under current tax law, when real estate passes to heirs through an estate, the depreciation resets without any tax due.
In investments, it’s true that nothing is certain except death and taxes, but in those at least, private real estate wins the race.
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