We’ve all heard that the goal is to buy low and sell high… Well, from its mid-peak values in 2007, U.S. commercial real estate has fallen 41 percent!^1. So is it worth considering? Let’s look at the pros and cons.

Opportunity?

To start off, think about what precisely in commercial real estate market is distressed. Is it the properties or the sellers? Or both? In some cases it is both, but for the most part it’s the sellers. Banks are so tight that if they could walk, they’d squeak. And think about most commercial loans over the latter part of the decade. They were typically short-term with a five-year maturity and required very little equity, which means many commercial real estate owners have found themselves in a squeeze and can’t get the lending they need to keep the property. It might be a great property, but it doesn’t matter if they can’t come up with the dough to keep it. Does this ring opportunity to you? But then again, it could simply be a distressed property, and possibly without hope. This is where knowing the business of real estate comes in handy.

Who Is it For?

Real estate is a hard asset. Take the story of Enron: Who, besides Ken Lay and a few others, had something left to take away? Stocks, bonds, everything was worthless, right? Wrong. The individuals making up the entity that owned the building of Enron were able to move on. A hard asset isn’t paper and can’t just disappear. On the flip side, a hard asset like real estate has an illiquidity burden and can’t be valued like a stock or bond on a daily basis. Think about your house. It’s the same. You don’t have overnight liquidity and you could have it valued daily, but it would cost you a mere fortune. In other words; individuals investing for the short-run have no business investing in real estate, while those investing for the long run and who can handle the burden of illiquidity could add more diversification to their portfolio with this hard asset. According to Michael Phelan and  Richard Zechauser, authors of Real Estate Done Right, “Most long-term investors are severely under-allocated to real estate.”^2.

Risk versus Reward

Now consider inflation. Do you think we are headed for inflation in the future? Historically, has real estate kept up with inflation? Sure it has. We all know past performance can’t indicate future performance, but it is important to bear it in mind in order to understand the asset class. Basically, there are 4 categories of commercial real estate: Income, Income and Growth, Value-Added and Opportunistic. Each of these has a different strategy and rates of return generally increase as the category gets riskier (Income having the least amount of risk and Opportunistic having the most.) Now, in a country where and when real estate values have fallen 41%, everything seems opportunistic, but just take a look at the lowest risk category in this asset class over the past 31 years. Since 1978 NCREIF has tracked the performance of commercial multi-family real estate on a nation-wide basis. This index has shown a compounded annual total return of 8.8% from 1978 to 2009. MIT/CRE data supplied by National Council of Real Estate Investments Fiduciaries (NCREIF).

Common Mistakes

There are a lot of mistakes made when it comes to this asset class simply because real estate is so idiosyncratic. There is so much of it, but so many investors aren’t choosy enough. And most of the time this is due to ignorance. If you aren’t in the real estate business every day, you probably shouldn’t be in the real estate business. Think about some the past mistakes you’ve seen others make like investing during bubble years, buying on emotions because they like how fancy or pretty something is, taking on too much leverage, buying something on a comparable transaction price, putting all your eggs in one basket, leaving an unprepared spouse to take care of things when you are gone…. Even as advisors, we leave the details up to the companies that do real estate all day every day. It doesn’t mean we don’t strive to learn more and stay informed about the real estate industry and do our own thorough due diligence on individual companies and the investments they hold. We do. Because as Socrates stated, “The only true wisdom is in knowing that you know nothing.”

For more information on real estate as an asset class, visit our on-line learning center at www.kennedy-financial.com and check out REITs under the Investments section.

1.      Phelan, M. & Zechauser, R. (2010). Real Estate Done Right from the December issue of Financial Planning.