Taking stock of real estate investments

Key Points

• In the Aggregate, Stocks Win Out
• Real Estate vs. Stocks: Annual Returns
• Investment Structures Can Impact Performance
• Focus on the Fundamentals
• Points to remember

During the early years of the new millennium, many investors shifted their gaze to real estate as property values soared while stock markets languished. But as recent history has shown, real estate can go down in value as well as up. For investors looking to diversify their holdings with real estate, it's important to consider how real estate performance stacks up to stocks in the long run and what tax or other factors should be considered when comparing real estate investments with equities.

Back to top

In the Aggregate, Stocks Win Out

As an asset class, real estate has been close to that of large-cap stocks over the long term. For the 20 years ended December 31, 2008, domestic real estate recorded an average annual return of 7.90%, compared with 8.43% for the S&P 500. Long-term government bonds have managed to outpace both stocks and real estate, with an annualized return of 9.79% during this time period.¹

But real estate is not recession proof, as recent history has shown. In fact, real estate is noted for its historical cyclicality, with market prices — especially for commercial properties — varying considerably with the business cycle and new construction activity. One need look no further than the early 1990s to see a dramatic drop in prices of office properties brought on by overbuilding and a slow economy. Nor is residential property immune to price drops. House prices in the United States decreased on average during 2006, 2007, and 2008. And in Japan, real estate prices in many locations tumbled 50% or more from their peaks of the early 1990s.²

Back to top

Real Estate vs. Stocks: Annual Returns

Both real estate and stocks have experienced ups and downs, but in the aggregate, stocks have outperformed real estate during the past 20 years. Of course, past performance does not guarantee future results.

Sources: NCREIF; Standard & Poor's. Real estate performance is represented by the total returns of the National Council of Real Estate Investment Fiduciaries' (NCREIF) National Property Index. Stocks are represented by the total returns of the S&P 500, an unmanaged index that is considered representative of the U.S. stock market. Individuals cannot invest directly in any index. Past performance cannot guarantee future results. CS000160.

But looking at aggregate real estate performance can be misleading; Real estate values and appreciation vary widely depending on the property type and location. Office space in one city, for instance, may increase in value while prices of warehouse space in the same or another city may be declining.

Back to top

Investment Structures Can Impact Performance

While most stocks are bought on an exchange, directly, or through a mutual fund, there are many more options for purchasing and owning real estate. You can invest directly in a specific property or indirectly in any number of properties through a structure such as a real estate investment trust (REIT) or limited partnership.⁴ Each of these different ownership structures offers a different tax treatment and has unique characteristics that can significantly impact investment performance.

Direct ownership — buying an income-producing property directly — offers potentially significant tax advantages.⁵ If you have an adjusted gross income of less than $100,000, and own at least 10% of an income-producing property and actively manage it — finding tenants, collecting rents, supervising maintenance — you can deduct up to $25,000 in losses per year generated by the property.⁶ And since you can deduct the costs of maintaining and upgrading the property, as well as depreciation, a property with positive cash flow can generate tax losses. Ideally, an income-producing property will generate positive cash flow and tax losses, and will appreciate over time.

In reality, however, direct ownership of an income-producing property has its drawbacks. For one, properties don't always produce positive cash flow. Nor do they necessarily appreciate in value. For another, property is a fairly illiquid investment; don't even consider direct ownership unless you're willing to go the long haul. Most importantly, you may not have the time or inclination to actively manage a property. This can easily be a full-time occupation, complete with leaky roofs and tenant complaints. But for those who do choose to go this route, the rewards can be compelling, especially if the property is leveraged.

The key here is positive cash flow. That means keeping the property fully tenanted and incurring no major maintenance problems. Moreover, property appreciation is a function of many different factors and there is no guarantee that a given property will increase in value. So, if you are considering buying an income-producing property directly, keep in mind that it can be a labor-intensive proposition and the potential returns — however lucrative — must be weighed against the risks.

Indirect ownership — purchasing shares of a REIT or limited partnership — can be a more viable alternative for those seeking real estate alternatives to stock investments. REITs stand out by far as the most accessible way to invest in real estate. REIT shares are publicly traded with no required minimum investment. REITs generally own a number of commercial properties, often diversified by type and location. REITs enjoy certain tax advantages but must meet certain requirements. Among these is the requirement that at least 90% of taxable income be paid in the form of shareholder dividends. By meeting this and other requirements, REITs can "pass through" income to shareholders without being taxed.

Limited partnerships (LPs) are considerably less liquid than REITs; shares are generally not publicly traded, most offerings are restricted, and many have high investment minimums ($2,000 or more). Private partnerships can own one property or many, and can own equipment or virtually any other type of income-producing asset. Accordingly, investment parameters vary significantly from partnership to partnership. On the positive side, LPs offer limited pass-through of tax losses, which may then be used by investors to offset taxable gains. Performancewise, there is little publicly available information on partnership performance, since most are private offerings and many are structured specifically as tax loss generators. Results also vary widely depending upon the type of property, its location, and the partnership's management team.

Back to top

Focus on the Fundamentals

Keep in mind that any real estate investment performance is primarily a function of the property being invested in — its type, location, leasing status, condition, management, and market. How an individual property or investment performs will ultimately depend on these factors more than its structure. So remember to look closely at the property portfolio and talk to your investment advisor before investing.

Back to top

Points to Remember

1. As an asset class, real estate returns have been close to large-cap stocks over the long term.
2. Real estate investment performance, however, is primarily a function of the property being invested in — its type, location, leasing status, condition, management, and market.
3. Real estate is noted for its historical cyclicality, with market prices — especially for commercial properties — varying considerably with the business cycle and new construction.
4. Ownership structure plays a critical role in performance. Various ownership structures are treated differently for tax purposes and each has unique characteristics that can impact investment returns.
5. You can invest directly in a specific property or indirectly in any number of properties through a structure such as a real estate investment trust (REIT) or limited partnership.

Back to top

¹Sources: National Council of Real Estate Investment Fiduciaries (NCREIF), Barclays Capital, Standard & Poor's. Real estate represented by the NCREIF National Property Index; stocks are represented by the total returns of the S&P 500; bonds are represented by the total returns of the Barclays Long-Term Government Bond index (prior to November 2008, this index was compiled by Lehman Brothers).

²Source: The Economist, March 28, 2002.

³Regular dividends from REITs cannot be guaranteed and will depend on the cash flow of the underlying real estate investments after expenses.

⁴Investing in a primary residence or vacation home (not addressed here) can offer even greater tax advantages.

⁵Other restrictions to deductibility may apply.