Investment Options

Investment Outlook: Evaluating U.S. Treasuries and Private Commercial Real Estate

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author

Timothy Wallen

Principal & CEO

 


A thought on many
investors’ minds today is whether to invest in U.S. Treasuries in place of private real estate, or any other investment opportunity for that matter. 
 

Why should someone invest in private real estate, when you can have liquidity as well as cash flow in the 4% range, with an investment in U.S. Treasuries?

In my opinion, the risk of a private real estate investment is more than worth the potential return, especially when being compared to low risk, low return, U.S. Treasuries.  

When comparing U.S. Treasuries to private real estate, private real estate investments may:  

  • have the potential to produce higher gross returns. 
  • be taxed more favorably. 
  • be structured to keep risk to a minimum. 
  • provide investors with a path to utilize the power of compounding returns. 

Continue reading to hear my full thoughts on this topic and why I believe +12% overall returns are still possible in private real estate investing. Also, why the current market cycle is different from others we’ve seen in the past.  

Before continuing, remember, the decision to invest in private real estate should be based on an individual’s financial situation and risk tolerance. You should consult your advisors on what’s the best approach for you.

Part 1: U.S Treasuries or Private Real Estate? 

All investment decisions involve many considerations including returns, taxes, risk, and liquidity.  

Returns & Taxes 

While U.S. Treasuries may provide a “safe” investment option, they may only yield 3-4% returns, which can be further reduced by ordinary federal income tax rates, especially for high income earners with the highest rates.  

On the other hand, private real estate investments have the potential to produce higher overall returns. Our series of Private Funds target 11-15% overall returns to our investors and have the advantage of potentially being taxed at capital gains rates, which are often lower than ordinary income tax rates. 

The chart below compares ordinary income tax rates for a high net worth individual to the more favorable capital gain tax rates.  

Returns Comparison:

Let’s review the returns of an investment in U.S. Treasuries. In a theoretical example let’s assume you make a 4% return, but you’re also paying ordinary tax rates. With a 4% yield and the highest tax rates, roughly 40% all-in, you’re netting a 2.4% after tax return. Compared to an investment in private real estate, with a 12% return assumption, investors could net a 8.4% after-tax return.

In this fact pattern, an investment in Treasuries would be forfeiting ±6% per year in returns. We call this difference the “cost of liquidity”, or the cost of managing risk.

The Power of Compounding

Is potentially giving up ±6% per year worth it? Many investors believe that sacrificing a year or two of returns to mitigate risk is a smart move. However, timing the market is virtually impossible, especially in private real estate, in our opinion. Missing out on +6% in returns can have detrimental impacts to long-term wealth generation.

The power of compounding these differences in returns becomes a strong argument in favor of private real estate investments.

For example, if a real estate investor earns a return of 8.4% per year, under the rule of 72, their money will double every 8.6 years. If you are looking to double your equity at 2.4% (after tax treasury return rate), it will take 30 years!

The Rule of 72 is an oversimplified method of calculating how long it takes to double an investment. The calculation is simple, 72 divided by the rate of return equals the number of years to double the investment.

  • 72 / rate of return = years to double
  1. 72 / 2.4% = ±30 Years
  2. 72 / 8.4% = ±8.6 Years

Now, fast forward 8 years, a $1,000,000 investment grows roughly to $1,900,000, after tax, at a 8.4% rate or return. In that same amount of time, an investment yielding 2.4% annually would only grow to just over $1,200,000.

So, ask yourself, are you willing to give up the potential of earning $700,000 in additional returns over the next +8 years in exchange for the safety and liquidity of investing in U.S. Treasuries?

Mitigating Risk in Private Real Estate

Now, let’s switch focus to the risks associated with private real estate. It’s commonly accepted that investing in U.S. Treasuries carries less risk than many real estate investments, so can the risks associated with private real estate investing be mitigated?  

In our series of Funds, we manage our risk through three main avenues; diversification, low-to-moderate leverage, and fixing interest rates to match our intended hold period.

Our Funds target 25-30 investments across 10-15 states in multiple asset types. Our leverage targets are 60-65% loan-to-cost, and we also look to fix our interest rate for the length of time we expect to hold an asset.

For instance, if we plan to own an asset for 7 to 8 years, we’re going to do longer term fixed-rate financing. If we plan to own an asset for 3 years, we’ll do something that’s more similar to a 3-year floating structure or a 3-year fixed-rate setup to better match the risk parameters of the transaction. As always, MLG assesses the risk of floating rate debt very carefully, this almost always involves buying caps on floating rate debt preventing the interest rate from growing beyond a certain threshold.

Our investors are not looking to roll the dice with high-risk investments, they intend to grow their wealth responsibly over time. MLG’s ownership and team members are heavily invested in our funds and thus risk reduction and preservation of capital are very important to us.

Depending on your risk tolerance or your need for liquidity, it may be smart to invest in U.S. Treasuries. However, if your focus is not on immediate liquidity, then the additional return potential of private real estate is very compelling.

In Summary

While U.S. Treasuries are considered a safe investment due to the government’s backing, they do come with lower yields and higher tax rates.

Private real estate investments can be a good alternative, but it’s important to manage risk through diversification and careful management of debt and interest rates.

Compounding is a powerful force and can have a significant impact on investment returns over time. It’s essential to weigh the costs and benefits and make an informed decision based on your individual circumstances and goals.

Part 2: Are 12% Returns Still Possible in Private Real Estate?

Yes, but not for everyone! If there is one thing we have learned as a company over the past 35 years and many market cycles, it’s that there will always be opportunity in real estate due to human error, operator and owner mistakes, in-efficient management, and key relationships in the marketplace. Irresponsible sponsors will always exist, which is why it is crucial that investors fully understand the details of the investment opportunity and of the sponsor before making investments.

Evaluating your partners and sponsors is one of the most crucial factors when making an investment decision. Here are five reasons why the MLG Capital Team believes in our investments and how we continue to find smart real estate deals year-after-year.

First, we focus on disciplined, consistent, and time-tested underwriting.

It’s pivotal to the success of any deal. MLG defines our deals as smart, where critical assumptions are both believable and achievable at the time of review.

Second, we have access to an extensive deal flow.

MLG has a dual sourcing strategy where we both partner with other real estate firms (a joint venture strategy) as well as complete deals on our own in markets where we have an operational presence (direct strategy).

With this combined sourcing strategy there is an average of 100+ deals per month reviewed. This presents the opportunity to be selective, review through the lens of believable and achievable assumptions, and arrive at solid investments that fit our parameters.

Third, The Fed.

You want to invest in bonds when interest rates are high and you expect the rates to go back down. When interest rates go down, the value of bonds go up. Private real estate investments have the same benefit as interest rates going down.

When that happens, the value of real estate goes up. Currently, we have a higher interest rate environment caused by inflation.

Let’s not forget that the Federal Reserve has approximately $31 trillion of debt and a 2% higher interest rate for the U.S. Treasury is almost as much as the whole defense budget for the year.

The Federal Reserve has a targeted 2% inflation rate. With this target rate and the $31 trillion in federal debt, I believe the Fed will likely hit the 2% inflation rate, because the federal government can’t afford to have high rates long term. With a 2% inflation rate, it’s our opinion that you’ll likely see 10-year treasuries down to the 2.25-3.00% range over time, which will drive private real estate prices higher.

Fourth, we buy through all cycles.

Today, MLG is buying assets in this higher interest rate environment and seeks to acquire through all cycles. In underwriting and analyzing deals, assumptions are based at certain cap rates which are based on current interest rates.

In our assumptions, when selling 5-8 years from now, we underwrite as if interest rates are still high. We’re not assuming that rates are going back down in our math of today.

In these assumptions our math works, and it shows that we can hit our 11-15% target overall rates of return with reasonable assumptions that are believable and achievable.  

If rates do go down when we sell 5-8 years from now, cap rates are likely going to be lower, and values will likely be higher than our projections. With that occurring, the original assumptions would be beaten creating higher overall returns.

Every cycle has its unique attributes to consider when buying private real estate. The key is to be real about your assumptions, creating believable and achievable assumptions while also managing your risk. Last, never forget the human error element involved in private real estate. It’s a very fractured and fragmented industry with many players involved and varying degrees of talent. It’s our job to find fixable errors that create value for our clients.

Last, supply and demand, especially in multifamily apartments.

Today, looking at apartments, one could say that the United States has a housing crisis. As a nation we have not been producing enough housing, both single-family and multifamily, to meet the overall household formation and population growth type numbers in our country. This is why we had peak occupancy numbers these last few years in the 96%+ range.

Now, one would expect some of these occupancy figures to fall off with a possible recession, but no major, glaring, imbalances in our housing market right now from a supply and demand perspective.

In addition to supply and demand, it’s important to discuss the cost of building new. In looking at the cost of construction costs since 2000 and comparing to rental growth, you’ll see an interesting story.

The average annualized rental growth rate has trailed the cost of construction in the same time period, suggesting that rents have room to continue to grow. The significant increase in the cost of construction suggests that the cost to build new is and will be a constant hindrance to new supply creation. In our opinion, supply and demand for multifamily remains intact, which keeps MLG primarily focused on acquiring multifamily properties.

Part 3: What has History Taught Us About Real Estate Investing?

Let’s take a trip back down memory lane. The Reagan tax bill back in the mid-80s is when the government put passive loss rules in place. Prior to the changes there was a lot of real estate being built for tax reasons and income tax reasons, not for economic reasons. When these laws changed, retroactively, an incredible supply of real estate was created, not because there was demand for it, but because of income tax benefits that new developments provided. This overhang of excess supply vs. demand caused prices to dramatically fall. In this cycle, the basic economics of supply vs. demand were ignored.

In the 2008/2009 timeframe, we had a different scenario which started in the single-family housing market. The government’s policy of the no-doc, low-doc loans (which allowed individuals to buy multiple homes with only a down payments and no proof of income) created artificial demand for single-family homes and, thus, increased the supply. The government then realized that individuals were unable to make payments and stopped the no-doc, low-doc policies. The massive supply affected the multifamily investment industry as people were pulled out of renting and pushed into ownership. As we all remember, this collapsed the financial system of our country, we then had a banking crisis and a great recession.

Those are two cycles where we had major challenges to work through in private real estate investing, influenced by poor policy decisions.

Today, there appears to be a typical recession type environment caused by the Federal Reserve seeking to correct inflation, but no major excess supply problems exist.

In summary, we have no major excess supply imbalances in our housing market, and our supply and demand story is very much intact. Looking ahead, less supply is likely with higher interest rates and higher costs, so the supply side is very much in control. Yes, there will be some submarkets where they build too much, but overall supply and demand stories are very much intact for multifamily nationwide.

Connect with us to learn more about how to you can invest in private real estate today.

 

 

Listen to an interview between Tim and MLG Capital Vice President, Nathan Clayberg, on these topics:

 

About the Author

Tim Wallen is a Principal, the Chief Executive Officer (CEO), and he sits on the investment committee for MLG. Tim joined MLG in 1989 as the Chief Financial Officer and Principal. In 2000, he assumed the role of CEO. He serves on the Board of Directors, and he is an Officer for the MLG Affiliation of Companies, including MLG Capital, MLG Development and MLG Management.

As CEO, Tim remains committed to and involved with the integral day-to-day functions of the investment and development teams. This includes involvement in long-term and short-term business strategies, the creation of innovative debt financing structures, and the development of complex partnership structures.

Prior to joining MLG, Tim was a Tax Manager with PriceWaterhouseCoopers in San Francisco and Milwaukee. He specialized in income tax planning for partnerships and corporations in the real estate  industry. In 1989, he transferred to the Milwaukee office where he was promoted to the position of manager.

The author, MLG Capital, its representatives, employees, officer, directors, members, respective partners, agents and its affiliates (“MLG”) do not represent any recipients of this article (“Recipients”) and all statements made by MLG shall not be considered tax or legal advice.  Recipients shall consult with their own tax or legal professional regarding their personal financial and tax situation and its relation to the information presented in this article. This article does not constitute an offer or solicitation in any state or other jurisdiction to subscribe for or purchase limited partnership interests in an offering. An investment into a private offering is subject to various risks, none of which are described herein. Recipients of this article agree that MLG shall have no liability for any misstatement or omission of fact or for any opinion expressed herein.

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