Benefits of Owning Commercial Real Estate
Posted by Alan Donenfeld
While the stock market continues to exhibit significant volatility and less risky asset classes such as treasuries offer little to no return, commercial real estate continues to provide an excellent risk/reward profile to investors. The three main advantages of real estate investing are as follows: consistent income stream, lower volatility/lower risk, and portfolio diversification.
Consistent Stream of Income
Investments usually generate two kinds of returns: income returns (cash yields) and value changes (capital gains or losses). Regarding commercial real estate, income streams from rental payments have accounted for approximately 90 percent of the total return. Alternatively, income returns from equities amount to 23 percent of the total return. As such, real estate is attractive to investors seeking stable cash flow.
The following chart demonstrates that commercial real estate’s cash yield exceeds that of other main asset classes.
Figure 1. Commercial Real Estate (CRE) Income Returns Relative to Other Asset Classes
Commercial real estate’s notable income constituent helps reduce its volatility in comparison to equities, whose valuations are more sensitive to market risk factors. Further, longer rental lease terms help reduce the risk of economic fluctuations on rental income. As such, the overall stability offered by commercial real estate is especially attractive in today’s uncertain economic climate.
Figure 2. Volatility Comparison Over 20 year Period 1983-2013
High Income of CRE Reduces Volatility
Real Estate has distinct characteristics, including extended lease terms, sensitivity to development activity, and other factors. Consequently, its ability to reduce volatility is enhanced upon its inclusion in a balanced portfolio. Moreover, the return correlations of CRE with other asset classes have historically been low.
The fact that CRE has a low correlation with equities implies that a crisis in the stock market would not adversely affect real estate to the same extent. As such, this would curb the overall damage to a portfolio containing both investments.
Diversification may also be increased within commercial real estate through exposure to a broad range of geographies, tenants, and property types.
- Geographies: Real Estate is inherently local and what happens to real estate in one part of the country may bear very little on what is happening locally.
- Tenants: Government, healthcare, and even student-housing tenants may prove more resilient in recessions versus finance and technology companies.
- Property types:There are unique economic drivers that can impact the performance of the major property types such as job growth for office, demographics for multi-family, and sales for retail properties.
In sum, commercial real estate provides a regular stream of income that is higher than typical stock dividend yields. Moreover, since real estate produces a steady income stream, it is less dependent on price variation to generate a total return. This steam income reduces volatility. In addition, when an investor adds commercial real estate to their portfolio, diversification is achieved and the portfolio is protected against adverse shocks in the equity markets.