A brief review of the Forbes 400 list for 2021 quickly demonstrates real estate’s ability to create wealth. Twenty-four of the billionaires that made the list focused their careers in real estate, and that doesn’t consider the number of other Forbes 400 members who generated their wealth elsewhere but currently hold real estate as part of their investment portfolios.
One of the 24 billionaires gracing the Forbes 400 list is Sam Zell. Sam’s parents were Jewish immigrants from Poland. In Sam’s book titled Am I Being Too Subtle: Straight Talk From a Business Rebel he recounts how his family escaped from Poland in 1939 barely escaping the Holocaust (Zell, 2017, p12). Sam was later born on September 28, 1941 in Chicago shortly after his parents arrived in America.
As immigrants with almost nothing to their family name, Sam’s parents taught him how to work hard and appreciate the opportunity that America presents. Sam’s interest in real estate began while pursuing a law degree at the University of Michigan.
Sam started by managing properties for another investor, and eventually he was managing thousands of apartment units. After graduating from law school, he founded Equity Group Investments from which he created Equity Residential, Equity Office Properties Trust, and Equity Lifestyle Properties.
Over the course of his career, Sam and his companies have been the largest owners of apartments, office buildings, and mobile home parks in the United States, and as of the 2021 Forbes 400 list, his net worth is estimated at $6.0 billion dollars.
Sam Zell’s story represents the rags to riches American dream, and he achieved it primarily through investing in real estate.
While real estate has created fortunes for the most successful real estate investors, there is no guarantee of success. Mortgage foreclosure and bankruptcy are common when real estate investments underperform or fail to live up to their potential.
For every billionaire real estate investor, there are many more who have lost everything. Real estate investing, like all other investing, is not a sure thing, and those who choose to pursue it need to consider all the facts before taking the leap.
Key Takeaway:
Real estate investing has created substantial wealth for many investors, but it can also result in ruin for those who make bad investments.
Unique Advantages to Real Estate
Individuals interested in real estate investing are typically drawn to real estate because of a few unique advantages.
Passive Cash Flow: The first immediate attraction of real estate for most investors is the passive cash flow that it provides through rental payments and the ability to utilize the passive cash flow to supplement other sources of income. Passive cash flow from real estate can be an important component to creating financial independence.
Leverage: Many investors are also attracted to real estate because debt financing allows them to leverage their investment. Leverage will magnify the results of the investment. Often investors see this as a benefit, but it is important to realize it can also work against the investor if the real estate investment falls short of expectations.
Tax Benefits: In addition to passive cash flow and leverage, real estate provides substantial tax benefits. The internal revenue code considers most real estate (not land) as a depreciable asset. Depreciation reduces the investor’s tax basis in the property; so when the property is sold, taxes will be due. However, in the meantime, the investor is able to defer taxes on a large portion of the real estate income through annual depreciation deductions.
Long-term Appreciation Potential: While depreciation deductions are allowed, the fact is that most real estate has appreciated over time. Since most investment real estate is valued based on the cash flow it produces, typical inflationary pressures allow real estate owners to increase the rents they charge. Rising rents result in rising property values over time which are tax deferred until the eventual sale of the property (see the discussion about 1031 exchanges later for more information on deferring taxes when property is sold).
Behavioral Investing Commitment: An additional and often overlooked benefit of real estate investing is the behavioral commitment it promotes. In last month’s blog post, we discussed the importance of investor behavior in the article Why Do Market Bubbles and Crashes Happen. Real estate naturally encourages investors to exhibit behavior that leads to long-term success.
For example, real estate is typically an illiquid investment which makes it more difficult for an investor to make an emotional decision to bail on their investment strategy if they become concerned about current market conditions. The illiquid nature of real estate can increase the likelihood that investors stick with their plan.
Also, real estate investments are typically privately held versus publicly traded which protects the investor from being barraged by constant price changes. While real estate prices do fluctuate, the saying “out of sight, out of mind” appropriately captures how the nature of private investments reduce the temptation to react emotionally to volatile markets.
Finally, since most real estate is frequently purchased partially with debt, there is a forced savings mechanism that requires the investor to continue investing over time through debt repayment irrespective of market conditions. Consistent investment is one of the greatest keys to long-term success.
Key Takeaway:
Real estate provides unique benefits that can help build, diversify, and protect portfolios while helping investors reach their long-term goals.
While real estate is often a great long-term investment, many investors are enthralled with the success stories they hear and forget the challenges that are also present. Those who have been extremely successful in real estate have typically devoted their entire careers to it.
Investors who choose to allocate a portion of their investment portfolio to real estate need to understand the challenges so they can determine the strategy that is most appropriate for them.
Challenging Aspects of Real Estate
While real estate has many unique benefits, there are drawbacks that investors should consider before choosing to purchase real estate.
Time Investment: First, individuals must choose between directly owning real estate themselves or investing passively – typically through private partnerships or Real Estate Investment Trusts (REITs).
Direct ownership of real estate requires a significant commitment from the investor in two ways. First the investor must spend a considerable amount of time studying real estate to understand how to evaluate potential investments to ensure they make wise decisions. Second the investor will be required to either manage the property personally or provide oversight to a management company who can handle the day-to-day aspects.
Individuals interested in pursuing direct real estate need to consider whether it represents the highest return on their time. For individuals who have lucrative careers or small businesses, focusing their attention on their primary income source often adds more to their future net worth than using their time to identify and manage direct real estate investments.
Key Takeaway:
Individuals who have lucrative careers or small businesses are often better off avoiding direct real estate investments so they can direct their time into the careers they already excel in.
Passive ownership of real estate is an alternative approach for those who decide against direct real estate investment. Passive real estate investment typically occurs through a private partnership arrangement or REITs. In many cases, the investment is privately held and does not trade publicly, but there are also large publicly traded REITs that are available to investors.
Identification of Attractive Deals: When passively investing in real estate, one of the primary challenges is finding attractive deals offered by a quality sponsor. A sponsor is someone who finds and coordinates an investment deal and uses investor money to purchase the property.
When evaluating sponsors, a few of the most important considerations are the track record of the sponsor in past investments, the experience of the sponsor’s management, the fees charged by the sponsor, and whether the sponsor has invested their own money alongside their investors into the same deal (i.e. do they have their own skin in the game).
Most of the real estate deals that are available to individuals are not from the best sponsors. The best sponsors who have great long-term track records generally don’t have difficulty raising capital and accordingly don’t need to convince new investors to participate. As a result, investors should be very careful when evaluating a sponsor who is trying to convince them to invest.
Key Takeaway:
Great sponsors often don’t need to market their deals to attract investors. Any type of high-pressure marketing should be considered a red flag to investors.
Accredited Investor Requirement: An additional challenge of most private partnership real estate deals is that investors must qualify as an accredited investor. While there are a few exceptions, an accredited investor is defined by the Securities and Exchange Commission as someone with:
- Net worth over $1 million, excluding primary residence (individually or with spouse or partner), or
- Income over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years, and a reasonable expectation for the same in the current year
Accordingly, many individuals who would like to invest in private real estate partnerships are excluded if they don’t meet one of the accredited investor thresholds.
Potential Lack of Diversification: Individuals who do qualify as accredited investors still face the challenge that many of the private partnerships have investment minimums of $100,000 or more. While many accredited investors can make a $100,000 investment, they quickly may find that they have a large portion of their net worth tied up in one or two investments without adequate diversification.
Diversification within real estate is important because a single property can easily encounter challenges if something unexpected occurs either to the property itself or to the local market.
For individuals attempting to obtain appropriate diversification with private investments, it is important to understand the level of diversification within the partnership itself and consider whether their real estate allocation should be spread across multiple investments.
When the goal is to purchase an interest in multiple partnerships, an individual likely will need to have substantial wealth to meet the investment minimums in each partnership while still avoiding an over allocation to real estate across their entire portfolio.
REIT Alternative: For individuals who would like to passively invest in real estate without the challenges of meeting the accredited investor thresholds or investment minimums, investing in publicly traded REITs can be a good option.
The downsides to publicly traded REITs are that they trade publicly on stock exchanges and are subject to market volatility. It is also common for publicly traded REITs to trade at a premium to private real estate because of their increased liquidity which can act as a headwind to long-term returns.
While real estate comes with many challenges, the investor who identifies the approach that is best suited to their needs and appropriately mitigates the challenges has the opportunity of long-term appreciation, passive cash flow, and significant tax benefits.
Key Takeaway:
Investing in real estate does not result in guaranteed success. Investors must be prepared to navigate the challenges associated with real estate.
Maximizing the Tax Benefits of Real Estate
Two of the greatest benefits of investment real estate are the tax benefits of depreciation that offset current cash flow and the ability of the property to appreciate over time as rents increase with inflation.
Both of these benefits result in tax deferred investment returns but also increase the amount of taxable gain that will be due when the property is sold. This occurs because the depreciation that offsets current cash flow also reduces the investor’s tax basis in the property.
Over the course of 27.5 years for residential property or 39 years for non-residential property, the property will become fully depreciated (except for the land component which is not depreciable). The sale price in the future will be compared to the depreciation-adjusted basis with the difference treated as a taxable gain.
Consider the following example of a property that was originally purchased for $500,000. The example assumes that the owner took depreciation deductions of $400,000 while he/she owned the property. Now the owner plans to sell the property for its current fair market value of $750,000 which will result in the $400,000 of prior depreciation being recaptured at a maximum 25% tax rate and any gain over the original purchase price of $500,000 taxed as a capital gain.
Accordingly, while real estate results in tax deferred treatment for most of the income and appreciation while the property is held, tax will eventually be paid when the property is sold.
Paying tax on the sale of tax depreciated real estate can be a painful bite for many real estate investors especially since the portion of the gain that results from prior depreciation is taxed at a higher rate (taxed at a rate as high as 25%) than typical capital gains. Taxable gains can also be subject to the additional 3.8% net investment income tax depending on how the property was used.
Key Takeaway:
Taxes on the sale of real estate are typically substantial making tax deferral strategies valuable for investors.
Because the taxes associated with selling real estate are typically high and offset many of the tax benefits of holding real estate long-term, employing tax strategies to maintain the tax deferral are important.
1031 Exchange: The primary strategy for maintaining the tax deferral is a 1031 exchange. The 1031 exchange allows investors to sell investment or business (not personal) real estate and purchase other investment or business real estate without recognizing any taxable gain as long as necessary requirements are met.
Investors who never cash out of their real estate holdings and simply complete 1031 exchanges when they choose to sell a property can maintain the tax deferral for life (under current tax law).
721 Exchange: Another strategy that is often useful for investors who hold real estate directly but would like to switch to a passive approach without recognizing taxable gains is a 721 exchange.
In a 721 exchange, the investor contributes their property to a partnership in exchange for ownership in the partnership. Many REITs have an operating partnership where they will offer units of the partnership in exchange for property.
When this occurs, the investor receives ownership of the partnership which holds a diversified portfolio of real estate in partnership with the REIT. This allows for fully passive and diversified real estate ownership for the investor while maintaining the deferral of taxable gain.
Stepped Up Basis at Death: The final strategy of a stepped-up basis is often paired with the 1031 and 721 exchange. A fact of current tax law is that an individual who passes away with certain assets will transfer those assets to their heirs with a stepped-up basis.
A stepped-up basis means that the tax basis of heirs will equal the fair market value of the property when the original owner passes away. For real estate that has appreciated in value or has a very low tax basis through years of depreciation deductions, a stepped-up basis effectively allows the heirs to reset the basis and sell the property with no taxable gain.
Accordingly, the original investor and their family receive the benefit of depreciation deductions to offset cash flow during life, long-term appreciation of the property, and a tax-free sale after the death of the investor. That is an amazing benefit for those who maintain the tax-deferral for their entire lifetime.
Conclusion
Investing in real estate has been a pathway to wealth for many Americans, and it often represents a great addition to most individual’s investment portfolio. However, individuals can make poor investments in real estate just like they can in any other asset class. Accordingly, the decision to invest in real estate should be part of an overall investment plan designed around your family’s goals and values.
Those that choose to invest in real estate need to honestly assess whether they have the capability, time, and desire to invest in real estate on their own or whether they are better off pursuing a passive approach.
Once the challenges of real estate investing are identified and the appropriate approach is determined, real estate investors can benefit from the many advantages of real estate. Some of the most unique benefits of real estate are the tax benefits that allow savvy real estate investors to significantly reduce the amount of taxes they pay over their lifetime.
As with most investments, there is no one size fits all approach that will work for everyone. If you are interested in having a Family CFO assist you in determining whether real estate would be a good addition to your portfolio or whether you are maximizing the value of your current real estate holdings, we would love to connect to see if what we do is right for you.
References:
- Sam Zell (2017). Am I Being Too Subtle? Straight Talk From A Business Rebel. Penguin Random House LLC.
