Seeking yield? Think real estate

Reader alert: This is Part 1 of a series.

It may be a bit of an understatement, but thanks to the 2008 market crash sparked by the U.S. housing bubble, real estate investments have lost some of their luster. Yet to paint both the residential and commercial real estate sectors with the same brush would cause advisors to overlook the unique benefits offered by commercial real estate investments.

As an alternative asset class, which represents a third of the world’s wealth, real estate generally—and commercial real estate specifically—provides an inflation hedge and reliable cash flow that’s helped it earn a permanent position alongside traditional asset classes in sophisticated investment portfolios.

Investors’ growing need for yield, driven largely by the baby-boomers, has led many institutional investors to carve out position in their portfolios for commercial real estate. Recently, Canada Pension Plan Investment Board increased its real estate holdings by buying $300 million (U.S.) stakes in eight American apartment buildings.

The purchase highlights the negative correlation between multi-family apartment buildings and the housing market. When homeownership falls, people still need a place to rest their heads at night. Rental apartments stand out as the winners of the collapse of the U.S. single family housing market.

The CPP Fund’s real estate allocation, which consists primarily of U.S. commercial properties, has increased to $12.6 billion from just $800 million in 2005. And that allocation may increase still, as the fund uses a risk-adjusted asset allocation approach as opposed to the traditional fixed mix methodology.

“Since 2009 we have made a number of real estate investments in the U.S., in the office, retail, and multi-family sectors,” says Linda Sims at CPPIB. “If and when a sustained recovery in the U.S. market occurs, inevitably pushing prices higher, there may be a time when we will step to the sidelines again.”

Cash is king

Undeniably, commercial real estate’s cash flow producing ability is not unique; equities also generate reliable source of income, particularly bank stocks.

Where real estate differs from equities is that a higher proportion of the long-term return is derived from income and less from capital gain. With equities, it’s generally the reverse, explains John Nicola, partner and financial planner at Nicola Wealth Management. As long-term total return (cash flow plus capital gain) tends to be similar between the two asset classes, more income is generated from real estate.

“Average stock dividend yield on a TSX S&P 500 is between 2% and 2.5%. The average capitalization rate of commercial real estate in Canada would probably be 6% to 7%,” says Nicola. “If I put a million dollars in the TSX, I’m going to get roughly $20,000 to $25,000 worth of income to start with. But if I put that amount into real estate, I’m going to get $60,000 to $70,000 a year of income.”

The reason real estate is able to produce higher cash flow typically has to do with the fact that rents need to be higher than the financing rate for the property. “You wouldn’t buy a building with a mortgage that’s costing you 5%, and the income on the building is only 3%,” Nicola points out.

But that’s not to say real estate is better than equities, he adds. They are different and work well together in reducing overall volatility in cash flow and pricing.