The real estate landscape has seen its share of upheaval in 2020. Between economic shutdowns, eviction moratoriums, mortgage forbearance, travel restrictions, and a litany of other new wrinkles and obstacles, the real estate industry, and the country as a whole, has had a lot to cope with.
Quarantine and travel limitations initially devastated the hospitality industry. Increasing unemployment and business closures drove historic drops in retail spending. Work-from-home mandates have brought into question the future of office properties.
But it’’s not all bad news – self-storage has continued to perform due to a slow- down in move-outs. The industrial sector has benefited from increasing e-commerce market share. “Essential business” retail – think pharmacies, grocery, auto-supply - has defied the larger retail downturn. And stimulus checks and expanded unemployment benefits have largely mitigated the impacts on institutional multifamily rent collection.
That being said, the uncertainty of the past few months has been enough to make the most avid and active real estate investors rethink their investment strategies. Even prior to Covid-19 related hurdles, normal tenant troubles, property maintenance, leasing agents, and property managers make for a headache and a hassle. Direct real estate ownership is not a passive endeavor, and it is not for everyone.
Potential Advantages of Real Estate Ownership
Despite these pitfalls, real estate can potentially be a very attractive investment vehicle for those looking to build their wealth potential or put their cash to work. Real estate ownership can provide a number of potential advantages:
- Portfolio diversification for investors that are heavily weighted in the stock markets
- Investment in an asset class that has historically been viewed as a hedge against inflation
- Potential for cash flow, with tenants or operators paying rent
- Access to financing, allowing investors to leverage their equity to buy more real estate
- Tax-advantaged pass-throughs like depreciation, interest deductions, and other expenses can reduce taxable income
- Possible appreciation in property values realized upon sale (and lower taxes on capital gains)
- Option to defer capital gains and depreciation recapture through the 1031 or 1033 exchange
- Ability to invest through Self-Directed IRA’s and other qualified retirement plans
Passive Real Estate Investment
Fortunately, there are passive ways to invest in real estate to capitalize on some or all (depending on the investment vehicle) of the possible advantages while potentially minimizing headaches. I’ll briefly touch on 4 different types of passive investments. Please keep in mind that this is not intended to be a direct comparison, as each of these types of real estate investments are very different.1. Delaware Statutory Trusts (DST’s)
The DST is unusual relative to most other passive real estate investments in that it is eligible for the tax-deferred 1031 or 1033 exchange, as articulated by IRC Rev. Proc 2004-86. Through the DST and the 1031 exchange, accredited investors are able to purchase passive, fractional ownership of larger real estate assets.
Because of the IRS rules for the DST (known as the Seven Deadly Sins), these are not blind pool investments. The properties are acquired and operated by the sponsor company prior to being offered to investors.
The use of the DST in the 1031 exchange makes it a tool frequently used by accredited investors to “exit” their current, actively managed real estate portfolios, while potentially deferring capital gains taxes. The DST allows accredited real estate owners the option to sell out of their local real estate market and diversify nationally and across asset classes. Minimums can be as low as $50,000 or $100,000, making it possible to diversify out of a single actively managed asset into a portfolio of passive DST investments.
2. Real Estate Investment Trusts (REIT’s)
REIT’s are an asset class that many are familiar with, as many are publicly traded like stocks. They are corporations that receive special tax treatment of dividends by adhering to a number IRS rules. There are REIT’s that are specific to just about every real estate asset class, from residential mortgages to hotels, and everything in between.
Like publicly traded stocks, publicly traded REIT’s have values that can change daily. They also may enjoy daily liquidity, allowing investors to buy or sell at a moment’s notice. However, REIT’s do not pass through losses like depreciation and cannot be included in a 1031 exchange.3. Land Lease
A land lease is exactly what it sounds like – an investor owns a piece of land and leases it out to a tenant. The tenant, oftentimes a business, develops and operates a building on the land. Land leases are generally much longer term than even the average commercial lease, often clocking in at 99 years. At the end of the lease, the landowner even owns the “bricks and sticks” – the building the tenant constructed.
While a land lease does include a tenant, there are is generally little or no maintenance required, and few expenses, if any, other than property tax. Ninety-nine year leases also mean that tenant negotiations are few and far between.
4. Syndications (LP’s, LLC’s, TIC’s)
Whether a Limited Partnership (LP), Limited Liability Corporation (LLC), or Tenant-In-Common (TIC) structure, syndicated investments usually include two types of investors. The “Sponsor” or “General Partner” (GP) or “Manager” of the entity does all the work. The “Limited Partners” (LP) or “Silent Partners” or “Shareholders” are the passive investors. The goal of investing in this manner is to benefit from the expertise, experience, and work of the GP or manager.
Investments like these may include a stated “preferred return.” This is a percentage of invested capital (on top of return of principle) that is due to investors before the sponsor or GP participates in any profits. For example, an investment of $50,000 in a Limited Partnership with a stated preferred return of 10% would be owed $5,000 dollars, in addition to the return of their original $50,000, before the Sponsor or GP receives any share of potential cash flow or profit. Investors may also receive a percentage of any excess cash flows or profits upon a property sale.
Investments of this sort pass through passive losses like depreciation, often sheltering the income they generate. They are considered to be “illiquid” as they are not publicly traded. This means that investors are potentially locked in for the full life cycle of the investment.
For any questions about the passive real estate investments described here, and even those that aren’t, contact us. Our team at Fortitude is here to answer any questions you have on capital gains tax deferral, passive real estate investment, tax-advantaged investing strategies, and anything in between.