The Benefits of Long-Term Real Estate Investing
In recent months, rising inflation and the erratic nature of the stock market has investors considering alternative asset classes. Commercial real estate, which has a low correlation with the equities market, is a natural choice. However, real estate prices have approached all-time highs. This has many investors on edge. If they buy today, are they buying at the top of the market? What will happen if the market begins to slide?
These are valid questions and concerns. It raises the question about hold period. Investing at the height of the market can be risky for those who have a short-term hold period (e.g., 3 to 5 years or less). As we will show today, buying with a long-term horizon is a better way to mitigate the risk associated with buying at the “height” of the market—whenever that may be – or attempting to time the market in any way.
Indeed, many people thought we were at the height of the market three years ago, and yet, values have only continued to rise. Pinpointing the height turns out to be easier said than done (and better done retrospectively).
In this article, we look at the benefits of long-term real estate investing. We will look at the ideal hold period and provide key considerations aimed at mitigating an investor’s risk, regardless of when in the cycle they invest.
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The Risks of Short-Term Real Estate Investing
There are many reasons why someone would have a short-term investment horizon. For example, someone who is investing for the first time may want to limit themselves to deals that have a 3-5 year exit strategy in order to test the waters before making a longer-term investment.
Moreover, short-term investing is a way to potentially juice returns. Someone who times the market perfectly – i.e., buying at a low, investing in the property, and then selling three years later after values rise – may easily earn double-digit returns even if all they did was ride a rising tide of macroeconomic growth.
Yet, few people are able to time the market perfectly. Even the most sophisticated investors will find that some economic conditions are out of their control. Nobody, for example, could have foreseen a global pandemic that brought the economy to a standstill.
Here are some of the other risks associated with short-term real estate investing:
Changing Market Conditions
On average, real estate cycles last about 10 years. Historically, the economy will grow for 8.5 years during that period. Therefore, someone who times their short-term investment poorly – e.g., they buy at the “top” of the market and then, the market slides, may be forced to sell during one of those down years.
Lack of Liquidity
Commercial real estate is considered an illiquid asset regardless of market conditions. It cannot be purchased and sold as easily as stocks, bonds, and other equities. However, this becomes even more pronounced during a down market. Someone with a short-term investment strategy may find themselves unable to procure a buyer for their property. Absent a buyer, that owner will continue to incur losses and in a worst-case scenario, may lose their property to the bank.
Inability to Access Capital Markets
Someone who fails to time the market correctly may find themselves with a loan that comes due at a time when the capital markets are at a standstill. An otherwise solid asset may be at risk of foreclosure if the buyer cannot refinance given market conditions. Selling the asset may be a challenge if prospective buyers also struggle to access capital given those same conditions.
The Advantages of Buy and Hold Real Estate Investing
While short-term investing can prove to be lucrative, it is also very risky. To mitigate this risk, investors should consider “buy and hold” real estate investing.
There are several advantages to long-term real estate investing, including:
Time to Appreciate
Most real estate naturally appreciates over time. The longer someone holds an asset, the more time the land and/or buildings thereon have to appreciate. Investors with a value-add strategy can also make thoughtful improvements that result in “forced appreciation.” Forced appreciation occurs when the owner can generate more net operating income through actively improving their asset, which in turn, increases the value of the property. The longer someone owns an asset, the more time they have to create this forced appreciation.
Ability to Weather Economic Downturns
Someone with a long-term investment strategy will be able to weather economic downturns better than someone who is forced to sell during a down market. For example, someone who purchased a property in 2007 (in hindsight, a market peak) who needed to sell three years later would likely have sold at a loss. If that same person had held the asset for 10 years, they would have recovered any losses from 2008 to 2010 and likely would have posted a profit by the time they sold in 2017. Most properties eventually recover their value after an economic downturn—the key is being able to weather that downturn in the meantime.
Continued Economic Growth
The U.S. economy generally grows each year, even if marginally. There are some exceptions to this, such as in the case of a recession. However, most recessions are short-lived. Moreover, during recessionary periods, construction generally grinds to a halt and real estate inventory becomes constrained. As the market recovers, existing properties generally rise in value as it takes time for inventory to catch up to supply. Someone with a long-term investment strategy can take advantage of this supply/demand imbalance as the economy recovers.
The Ideal Real Estate Hold Period
As noted above, the U.S. economy generally grows 8.5 out of every 10 years. This means that demand generally grows about 8.5 out of every 10 years—with the economy sliding backward for about 1.5 years during that 10-year period. Sometimes, there’s a marginal dip. Other times, like during the 2009-2010 Global Financial Crisis, the economy plummets.
Those who have a long-term investment horizon will find that this makes 10 years the ideal minimum hold period. Ten years is a sufficient amount of time to weather most downturns. An asset may experience some turbulence during that 1.5-year window (on average). It may be difficult to access capital. The market may prove to be illiquid with few buyers willing to invest. However, those who hold the asset and endure this turbulence will find that the asset eventually recovers its value (and then some).
Historical data bears this out.
Data from the National Council of Real Estate Investment Fiduciaries (NCREIF) and an analysis of the largest U.S. Real Estate Investment Trusts (REITs) suggests that on average, a 10-year hold is the ideal minimum period in which to ensure a positive return. Rarely do real estate investments generate negative returns over a 10-year period. In fact, most will earn a solid 7 to 9 percent annual return during any 10-year period.
Why Leverage Matters to the Hold Period
One of the biggest mistakes people make, regardless of the length of their hold period, is being too highly levered i.e. they take on too much debt.
For example, someone may put a lot of debt on a property (e.g., 80-85% leverage). If there is a downturn in the economy that results in a drop-off in revenue, the owner may not be able to make their debt service payments. What’s more, a corresponding decline in values can essentially wipe out all of the equity in that property. During a downturn, this equity-to-debt imbalance may result in someone being forced to sell the property at a loss.
Conversely, someone with lower leverage can better withstand downturns in the economy. Yes, their equity may not earn as high returns as someone who takes on more leverage, but as long as they do not lose their property to the bank, someone with a long-term mindset will eventually preserve their equity and see it grow again during the next bull market.
Final Considerations with Long-Term Investing
Those interested in long-term real estate investments will want to pay particular attention to two things: the quality of the sponsor and the quality of the asset.
The sponsor of a deal is arguably more important than the actual physical asset or the deal profile. This is because the sponsor is responsible for executing the business plan. Two sponsors could have two very different business plans – including different hold periods and/or approaches to leverage, both of which can impact returns.
Before investing in a real estate deal, consider the sponsor’s qualifications. Look at their experience with that asset class. Review their previous deals, as these are an (albeit imperfect) indicator of future performance. Look at how a sponsor has weathered previous economic downturns, if at all.
Typically, high-quality sponsors (e.g., those who take on low debt, and who are both very experienced and well-capitalized) will perform better than others during an economic downturn. Good management will still make mistakes on occasion, but they will be better able to recover than those with less experience.
Quality of the Asset
The quality of the real estate asset is another important consideration. Typically, “good assets” – e.g., those that are well-located and in superior condition – will perform better during economic downturns. We like to say that “good things happen to good properties more so than bad properties, and bad things happen less frequently to good properties than the bad.”
Both short-term and long-term real estate investing can be lucrative. However, the former carries more risk than the latter. Those who are looking for safe, consistent returns and for who principal preservation is a priority, will want to consider investing alongside a sponsor like Bravante Farm Capital who utilizes a long-term, buy and hold strategy.
While none of us can predict the future, including if/when a recession will occur, there are steps we can take to prepare for an inevitable downturn. One of those steps is to invest with a long-term mindset that will protect investors’ equity during periods of turbulence. Those who take this approach will be well positioned to reap the benefits of improving economic conditions as the pendulum swings back toward growth.