INVESTORS BENEFITING FROM THE RECORD-BREAKING RISE in the stock market, but concerned about possible increased risk going forward, may want to consider commercial real estate.
With financing rates low and reasonably priced inventory still available, “net lease, single tenant” properties are ideal investments now for predictable earnings.
Most popular are retail properties such as restaurants or discount stores, but investors might also consider offices, warehouses or specialty properties such as gas stations or data centers.
Most important for investors is cash flow: how much money the investor expects to earn from buying the property based on its location, tenants and lease terms.
“Every Realtor® learns that the three rules of property value are location, location and location. Since net leased properties require very little owner management, profitable properties can be found anywhere.”
Before suggesting specific properties, Realtors® need to understand their client’s earning expectations and tolerance for risk. Some investors are most attracted to stable, long-term returns. Like some baseball players, they are comfortable hitting singles and doubles. Others are more speculative – home run sluggers swinging for the fences with every pitch and willing to take higher risks to enjoy higher returns. Matching the right property for each investor can be like putting together a complicated puzzle: it may take multiple attempts until all the pieces fit together.
With a single-tenant lease the investor needs to know:
- Who the tenant is.
- What expenses the landlord will pay.
- How long the lease will last.
- What the rent increases will be over the life of the lease.
- Where the property is located.
Investors seeking to avoid risk may prefer “bond quality” tenants who issue bonds that are rated and publicly traded. Investing in a net leased property with an investment grade corporate tenant and a 20-year lease in a prominent location is considered a lower risk and will cost more than buying the local pastry shop with a five-year lease – regardless how good their donuts may be!
Every Realtor® learns that the three rules of property value are location, location and location. Since net leased properties require very little owner management, profitable properties can be found anywhere. Investors, even foreign investors, will not necessarily be looking for properties located in this market – or even anywhere in Virginia. This means their Realtor® will need to be able to find and evaluate the property with the best investment potential regardless of whether it is located in Alexandria, Seattle or Peoria.
There are numerous advantages to investing in real estate that are not available to investors in bonds, including:
1. Leverage. Unlike buying bonds, an investor can borrow money for a mortgage on commercial property. Financing is currently available from a variety of sources at very attractive rates. By using a mortgage to lower the amount of cash invested, the investor can achieve a higher rate of return on the actual cash investment, even after paying the mortgage interest. For instance, if the investor spent $1 million to purchase bonds, and earned $50,000 a year, the investment earned a 5% return on his or her cash. But if it is a $1 million net leased property, the investor may put up $200,000 in cash, with a mortgage of $800,000. Even recognizing the cost of the mortgage interest payments, the same earnings of $50,000 now amounts to a much higher return on the $200,000 cash that was actually invested.
2. Taxes. The $50,000 return from bonds would be taxed as ordinary income, while the $50,000 earned in real estate can be reduced by expenses, including the mortgage interest, incurred in purchasing and owning the property.
3. Depreciation. The tax code allows the investor to reduce or depreciate the “tax basis” of the property and use the depreciation as a tax loss to offset the earnings from the property. By using various accelerated depreciation techniques allowed by the tax code, the investor could even decide to increase the amount of tax loss in the earlier years and use the additional tax losses to offset earnings from other sources – reducing the investor’s overall taxes even further.
4. Capital Gains Taxes or Deferral. When the property is sold, regardless of how much the sales price exceeds the tax basis, investors can either pay taxes on the gain, including the tax recapture of the depreciation deductions, or the investor may choose to defer the tax altogether by buying a similar investment property using Section 1031 of the tax code. Section 1031 spells out the necessary process, which must be followed exactly, including using a qualified third-party intermediary to “facilitate” the transaction, or the benefit could be denied.
This ability to grow wealth by exchanging one property and then another, deferring taxes on each exchange until the investor dies and the property is passed on to the next generation is sometimes referred to as “Swap ‘til you drop!”
To provide clients with appropriate advice for these investments, Realtors® should surround themselves with an experienced team of commercial real estate experts – including a qualified intermediary, attorney, accountant, mortgage provider, building inspector and out-of-state representative, if needed.
Single-tenant net lease investments can be a complex puzzle for Realtors® to master, but the rewards for their clients can be substantial. 2020 may be the ideal year to help your clients make the investment.
Frank Dillow is a past chair of NVAR’s Realtor® Commercial Council, an NVAR instructor, and a senior commercial broker in Long & Foster‘s Commercial Division. He can be reached at francis.dillow@ longandfoster.com.
Arthur Nachman, CCIM, CPM is an associate broker with Long and Foster Commercial specializing in Single Tenant Net Lease properties.
Author: Arthur Nachman