Some of you may remember the old E.F. Hutton commercials where they coined the phrase, “When E.F. Hutton talks, people listen.” Well, when the likes of Warren Buffet and even Donald Trump talk about a stock market bubble…you better be listening. These are people that make billions, with a “B”, and their words and advice should not go unheeded. Another point…both of these billionaires are strongly invested in real estate. Why? Because real estate is one of the safest places to put your money in the United States. Not so fast you say? What about the real estate crash of 2007-08? In reality, the commercial property value crash followed that residential crash by about two years, it was closer to the 2009-10 time-frame when we saw the bottom drop out on commercial. However, if you were not leveraged to the hilt and you were a responsible and wise investor; you would still have those assets, they would have likely been paying a decent return, and they would be worth more than you paid for them…certainly more than their downturn valuations. Let’s take a look at the chart below by CoStar Group:
This chart clearly shows how all sectors of the commercial real estate market were up, took their hit near the beginning of the recession and are back up to those higher level again…but not outrageously high. Let’s talk a little more about the benefits we can achieve from diversifying our portfolios to include more hard assets like CRE, to include strong NNN leased assets and Multi-Family investments.
The writing is on the wall folks, and we will see the bubble burst in the stock market, so why not cash out some of those stocks and roll your gains into hard tangible assets that pay decent returns and work towards preserving your wealth and offering you a tax benefit, as opposed to a tax consequence? When picking CRE assets to invest in, consider assets that will perform during all economic weather conditions such as:
QSR’s – QSR’s or Quick Serve Restaurants are a good hedge in a faulty economy. Why? When people are cutting costs, fast food is a good alternative to feed and average family of four for under $20 bucks.
Dollar Stores – These were all the rage during the downturn, as many investors understood that when the money dries up, people look for bargains…and these stores filled that void. However, many are located in sparsely populated areas that offer little opportunity for re-purposing if the store goes dark. Those who bought back in 2010-11 are now getting short on their leases and offering these stores to the market at higher cap rates. If you are savvy and pay attention to the demographics, location, and historical store sales, these can be quite good investments that will carry a strong weight in your portfolio during the next economic downturn.
Dine-In Restaurants – Think Chili’s, Applebee’s, Texas Roadhouse, etc. Long term leases with corporate guarantees. I like them. These restaurants offer a good alternative to fast food options and will not break the bank. For a family, they are great options for an inexpensive dinner out and not bad for the guy courting his date either. Most also serve liquor, which increases sales, even in down times. Which leads me to my next good net leased investment…
Liquor Stores – ABC Liquor and Total Wine perform well even in the worst of times. In fact, as sad as it is, people tend to actually drink more in poorer economic times. Good times or bad…people are drinking alcohol…and a lot of it. Most of the Total Wine locations are in strong retail centers with other national anchors and many ABC’s are located in stand-alone locations on busy thoroughfares, and on big lots – offering easy re-purposing if required. The corporate guarantees reduce your return, but it is well worth the safety they offer.
Auto Parts Stores – Think O’Reilly’s, Discount Auto Parts, etc. Again, great performers during economic downturns and both offer corporate guarantees. Their stores are many times on hard corner locations or out parcel pads located in busy, nationally anchored plazas. When times get tough, people pull back on luxury purchases and they will keep their cars longer…which will increase the need for maintenance and repairs. Lending also tends to tighten, credit scores stumble and lending is reduced to the consumer…essentially forcing the consumer to stay put.
On the logic side of this, just consider the fact that when a company you have stock in goes bust or loses value, you are left with the losses. Sure, you could hold on to your stock and weather the storm, but there are no guarantees. With a solid NNN or other net leased asset, the one thing you always have is that hard, tangible asset that is the building and the land. If you invest wisely, that asset may lose value in terms of cap rate, but that income will be coming in no matter what (unlike dividends) and you will always own something that you can see, touch and feel.
How about tax advantages? Do stocks offer you the ability to depreciate them? No. When you own commercial property, you can depreciate the building and offset your gains. One caveat here…ground leases do not offer this tax advantage because you cannot depreciate land. If you have little or no need for the depreciation, a ground lease is still a very viable option for you. I’ll explain…
Ground Leases – Simply put, in a ground lease you own the underlying dirt, but not the building…not yet. Most have longer lease terms like 20-25 years….some even 50 or 99 years and they are usually guaranteed leases by strong credit-rated, publicly traded companies. Ground leases and Absolute NNN leases will yield on the lower end of cap rates depending upon the asset and location, but they are a great “bond” type of commercial real estate investment that offer a safe hedge in an otherwise questionable economy. Most ground leases allow for the reversion of the building to the land owner at the end of the lease, or early termination. This means you get the building for free at some point in the future.
P/E Ratios and EPS and DPS vs. NNN CAP Rates
Every stock investor is looking at the P/E ratios of the companies they are investing in, or looking to invest in. The higher the P/E, the more stable the investment…or possibly over-valued but we will not get too deep into that. Another important factor, and one which the P/E ratio is derived from, is the EPS or Earnings per Share. This is the measurement to determine how profitable a company is per share after dividends to preferred stock holders have been paid. Of key importance to you, the shareholder, is dividends or DPS (Dividends per Share). Ok, so once all special dividends have been paid out, a company gets to pay dividends to their other shareholders…assuming they are paying dividends at all.
For this, I want to use an example…two credit rated, publicly traded companies side-by-side…Apples to Apples so to speak. Apple (APPL)…everybody loves Apple and it is considered to be one of the best out there. For our NNN investment, we will use a corporate Walgreen’s. as the tenant. You have $3,500,000 to place.
Let’s take a look at Apple’s 2014 performance and make an assumption that you held 45,800 shares of Apple that you purchased on Jan. 2nd, 2014.
Opening APPL price on Jan. 2, 2014 = $76.42
You bought roughly 45,800 shares with a total investment = $3,500,036
Fiscal Year 2014 DPS was $1.376.
Calculate Your Earnings for the year @ 45,800 x $1.376 = $63,020.80
Your Yield for 2014 on that sweet stock you purchased? 1.8%…yes…that’s right….but wait a second…we need to factor in inflation. The “official” inflation rate for 2014 was 1.5%. BOOM! So, you actually made 0.3% of your original investment or $10,500.11, but guess what? We are not done yet…you didn’t get to write down your gains because of inflation…that’s crazy talk folks! But you did get to pay tax on that “unearned income”. For most of you, this will be taxed at 15%, so we will use that:
Your Unearned Income = $10,500.11
Taxed at 15% = $1,575.02 to the friendly hands of Uncle Sam
So, in actuality after inflation and taxes you made $8,925.09 on your original investment of $3,500,036 or put into a percentage, you made .0025% or 25/100th of 1 percent. Lucky you!
How about that Walgreen’s? Here is the breakdown:
Purchase Price – $3,500,036
Lease term – 10 years
Rent Accelerators – 2.5% annually
Landlord Responsibilities – None – Full NNN Lease
CAP Rate – 5.5% (plus additional 1% explained below)
Annual Income Year 1 – $227,502.34
Ok…so we are only going to use Year One here, as we only used one year of APPL. Right off the bat we can see that we have a 5.5% return and a nice hedge with the 2.5% annual increase. With inflation at 1.5%…we are actually realizing a return of 6.5% in the NNN lease. As such, in this rundown, we are not even going to need to factor in a 1.5% loss to inflation, but we will need to factor in our gains at 6.5%.
Income $227, 502.34
Unearned Income Tax @ 15% = $34,125.35
Total Net after taxes = $193,376.99
If we stop here, we can see a 5.5% net return…but there is more…you own this building and can depreciate it. For simplicity, we will assume a land value of $1M and a standard 39 year depreciation rate.
Building Value = $2,500,036 / 39 years = $64,103.48 in depreciation that can be applied to your passive gains and unearned income. Being that everyone’s taxes are different, I am not going to delve too much deeper in this…but you get the point.
So there you have it folks…apples to apples a NNN lease investment property beats that Apple stock hands down by over 5 points AND you get depreciation! Oh…one more thing, by Year 10 when you are negotiating the first option on your NNN investment property…this investment will have almost fully amortized over that first 10 years and your entire initial investment will have nearly been recovered in NOI and tax savings. How nice is that?
Of course, the stock market can be a big winner if you have the stomach for uncertainty and can get in and out at the right times, but commercial NNN and ground lease investments can offer you much more safety and better returns over both the short and long term, while mitigating your exposure to the risk of lost fortunes.
Ricardo Ruiz del Vizo is the Managing Director of KW Commercial in Sarasota, Florida who runs his own team, Optimus Commercial Real Estate Investment Advisors, who specialize in net-leased investment, multi-family, and hospitality investments. Ricardo can be reached at firstname.lastname@example.org or www.1031ExchangeSource.com
Ricardo Ruiz del Vizo and Optimus CREIA are not tax professionals and we always recommend that you seek the professional advice of a qualified tax advisor when making any investment.