Why Are People Investing in Rental Properties? Here's What You Need to Know
The commercial real estate market is as hot as ever, in all parts of the country and across all different property types. This was true even amid the uncertainty brought on by the COVID-19 pandemic. With the stock market swinging every which way, more investors turned to commercial real estate as a way of providing diversity and stability for their investment portfolios.
One of the benefits to investing in commercial real estate is that it is an illiquid asset; it cannot be purchased or sold as quickly as stocks, bonds or other securities. This makes it subject to less market volatility, securing your wealth in hard assets that appreciate over time. This is especially true when investing in Triple Net (NNN) lease properties in which tenants generally sign long-term leases and are responsible for all property taxes, insurance, and maintenance.
That said, commercial real estate also has high barriers to entry. Unlike stocks and bonds, which can be easily purchased with $100 or less, commercial real estate requires a substantially higher up-front capital commitment. Even well-educated, experienced investors often find it challenging to identify, underwrite, finance, and then manage commercial properties on their own. Instead, many turn to investing in a fund, which pools their and other investors’ capital and deploys it through an adept sponsor who oversees the investment on their behalf.
Either approach, direct ownership or passive investment, can prove very worthwhile. In today’s article, we look at why all kinds of investors are increasingly drawn to rental properties.
Why are people investing in rental properties?
Commercial real estate comes in all shapes and sizes, offering a variety of investment opportunities. At one end of the spectrum, someone can invest in single-family rental homes and either decide to own the property directly, self-manage, or hire a property manager on their behalf. At the other end of the spectrum, there are multimillion-dollar deals, including 500+ unit apartment complexes, large shopping centers, office towers and more. The larger the scale, the more likely the deal will be overseen by a highly qualified sponsor managing the daily operations on behalf of multiple investors (debt and equity alike).
There are also many product types for an investor to consider, including residential, office, retail, hospitality, industrial, self-storage, and more.
Commercial real estate also offers different opportunities depending on someone’s risk tolerance and investment time outlook. A low-risk investor may prefer investing in stabilized assets, whereas an investor with higher-risk tolerance may be drawn to ground-up, value-add, or otherwise opportunistic investments. Similarly, someone who wants to preserve their wealth might opt to invest in a real estate investment trust (REIT) or short-term debt. Those with more patient capital might invest in a fund that specializes in development deals.
As you can see, rental properties control the CRE market; the variety of investment types means that there is something for everyone. This variety can also cause some people to feel overwhelmed, which is why investors should map out their investment priorities before deciding how, when, where, and with whom to invest.
Nearly all of those who purchase rental property finance it with a mortgage—at least in part—which is a term known as “leverage.” For example, someone can buy a property worth $1,000,000 and collect the cash flow on a property worth that amount while only having to put down 20–25% in equity; the rest can be financed with leverage. Lower-risk investors will try to minimize leverage to hedge against a possible downturn. By keeping mortgage payments low, an investor can still typically collect enough cash flow to stay above water, even if the market drops.
Compare this to buying stocks, bonds, or other equities: in order to purchase $1 million worth of stock, you need to have $1 million to invest. Very few people do.
Now, let’s say you actually have $1 million to invest: rather than putting it into $1 million worth of stocks, you could invest $250,000 apiece into four separate rental properties each worth $1 million. Instead of owning $1 million in stocks, you could own $4 million in rental property. Over time, rents collected from the tenants allow you to pay those mortgages down and, eventually, you will own the property outright without needing to provide significant capital upfront—the beauty of using leverage.
Consistent Cash Flow
Rental properties, if managed properly, can be a great source of consistent cash flow, especially when leasing a property to long-term, creditworthy tenants. For example, a commercial property owner signs a 10-year, NNN lease with a reputable franchise; this lease might include two 5-year options to extend the lease. Barring any unforeseen obstacles, the owner will have a relatively hands-off, passive investment for the next 10 to 20 years (perhaps longer), during which time they will collect regular monthly cash flow.
What’s more, most long-term Triple Net leases will contain a rent escalator clause, which provides an incremental rent increase each year of the lease term—sometimes 1–3%. As a result, the owner will collect additional passive cash flow every leased year.
Commercial real estate is generally considered an illiquid asset class. Properties cannot be easily purchased or sold, with most transactions taking at least 30 to 60 days (often longer) to complete. The illiquid nature of commercial real estate means that it is inherently more stable than stocks, bonds, and other equities, which can experience volatility on a daily basis.
More specifically, NNN leases provide another form of stability: investment-grade tenants in long-term Triple Net leases are less likely to default than, say, residential tenants on payment. These quality-credit tenants are also more likely to “buy out” their leases, paying the owner their rent obligations for the duration of the lease term if they need to exit the lease early.
NNN-leased properties are also often leased to businesses like coffee shops, fast food, pharmacies, and, increasingly, urgent-care clinics. These are considered essential businesses, which makes them impermeable to e-commerce competition and highly recession-resistant.
In short, in a market downturn, commercial real estate (especially Triple Net lease property) tends to hold its value. The creditworthy tenants who lease these properties can typically continue to pay rent and fulfill other lease obligations.
Real estate is a highly tax-advantaged asset class. Under the existing tax code, real estate investors can offset the benefits produced with income-generating property through an annual tax deduction: depreciation. The IRS defines depreciation as a “reasonable allowance for exhaustion or wear and tear, including a reasonable allowance for obsolescence.” Residential rental properties are generally depreciated over a 27.5-year period and commercial buildings over a 39-year period. Investors can accelerate deprecation by using what’s known as a cost segregation study, which allows them to write off individual aspects of the building ahead of others, thereby frontloading depreciation and generating additional tax benefits in the early years of owning the property. This can drastically improve an investor’s cash-on-cash returns.
Moreover, rental properties are generally subject to both ordinary income tax (cash flow) and capital gains tax (when selling the asset). Real estate cash flows and dividend-producing stocks are both examples of ordinary income that, depending on your tax bracket, could be taxed at upwards of 37% or more. However, unlike stock dividends, real estate cash flows can be offset using depreciation (see above) to result in greater overall returns for investors.
Another tax benefit to owning rental property comes from the 1031 exchange, a process that allows investors to defer paying capital gains tax on the sale of an investment property if they reinvest the proceeds of that sale into a “like-kind” asset of greater value. This allows investors to defer paying capital gains taxes, often permanently, while growing their real estate portfolios.
Depending on the nature of the deal, returns on a rental property can be two or three times as high (or more) than what someone might earn by investing in the stock market alone. A property’s return potential depends on several factors, including the property type, its location, existing condition, planned improvements, ongoing property maintenance, and quality of management. Value-add real estate investors often find ways to integrate new features or cost-saving measures to generate even higher returns.
We see this in Triple Net lease investing; NNN-leased properties can have tremendous returns. High yield, brand-named NNN locations are usually highly sought-after and, in turn, sell for high premiums. This is particularly true when an investor holds a property through the duration of a long-term NNN lease; the sheer length of time generally results in natural market appreciation. That said, NNN properties often trade at a lower cap rate than other property types as a result of these higher purchase prices.
Demand for rental property continues to remain strong, even in areas with significantly new construction. Supply is not coming online fast enough to meet demand. This is true across property types, and is why some have referred to America’s “housing crisis”; there is simply not enough housing to keep up with demand and, in turn, prices have skyrocketed.
The same is true with NNN-leased properties; these buildings tend to be very well located at main-and-main intersections, which draws many top-tier tenants. Oftentimes, major chains like Walmart, CVS, Walgreens and Family Dollar will be competing for the same retail site. They are willing to pay a premium for these properties to edge out their competition and stay front-and-center with their customer base.
Smaller NNN-leased properties are often leased to neighborhood-serving businesses, like gas stations and convenience stores, which generally remain in high demand regardless of other market factors.
Once a property is leased, there are minimal (if any) daily responsibilities for the owner, especially for those with smaller, single-tenant net-leased (STNL) properties. Larger properties, such as 500+ apartment communities or retail shopping centers, might require more oversight but the owners can typically hire an experienced property manager on their behalf.
The nature of NNN-leased properties make them particularly passive investments; insurance, maintenance and taxes are all the tenant’s responsibility in a Triple Net lease deal. The owner is only responsible for tax reporting and monitoring the general building condition.
Investing in rental property is a great way for all investors to diversify their portfolio, away from more traditional equities like stocks and bonds. Although commercial real estate has historically been considered an “alternative” asset class, it has begun moving into the mainstream, especially as more people realize the benefits that come with owning rental property. Managed properly, these investments can also be relatively low-risk.
Of course, there is always risk involved with investing of any kind, and the same is true with NNN properties. Businesses can invariably run into hard times and may occasionally default on their leases, just as any leaseholder might. Even those who don’t default may fail to maintain the building properly, so investors should remain vigilant.
At Liberty Real Estate Fund, we are focused on investing in high-quality, well-located single-tenant net-leased properties. We look for deals located in high-growth, low-cost areas of the United States. Most of our properties are Class A or Class B properties leased to investment-grade tenants. By focusing on investments with these attributes, we can hedge against market downturns while generating strong, stable returns for investors.
Are you interested in learning more about NNN lease investing? Contact us today. Our team would gladly walk you through our investment philosophy, including why we believe NNN lease investments – though often overlooked – are the best options for any investor looking to diversify their portfolios in a thoughtful, strategic manner.
Do you want to try your hand in the world of investment but don’t know how to get started? Take a look at the services offered by Liberty Real Estate Fund to learn more about what they can do to help.