Why Invest in Private Real Estate When Treasuries Pay 5%?
"Why should I invest in private real estate right now when I can earn 5% in risk-free treasuries…and stay liquid to catch the bottom of the real estate market!"
I've heard this comment more than a few times this past year.
I understand and respect that position.
However, this is viewpoint is often short-sighted and can result in significant opportunity costs for investors hoping to beat inflation and build wealth over decades.
This post outlines several considerations for investors when choosing between treasuries/money market funds and real estate.
I will do my best to be balanced and include thoughts on when investing in treasuries/money market accounts rather than real estate can make sense.
Who am I?
Before we get into the rest of this article, you should know that I am a bit biased. I sold my company to a public firm in 1997, and I've been investing in real estate full-time since 1999. After years in the residential real estate investment space, I transitioned in 2011 to commercial real estate and never looked back.
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The Case for Treasuries and Money Market Funds in Q2 2024
Treasury bills (T-bills) are short-term U.S. debt securities issued by the federal government that mature over four weeks to a ten-years. T-bills are considered very low-risk investments since they're government-backed.
Treasuries are often held by investors with cash who want a higher return than savings accounts.
As I write this in early April 2024, the USA’s interest rates are near the highest level since 2007. High inflation has resulted in sharp Fed hikes, and corresponding instability in some sectors of commercial real estate has spurred the question that opened this post.
Warren Buffett's Berkshire Hathaway has famously held a boatload of treasuries while seeking their next investment. At the end of 2023, Buffett and company held $168 billion in T-bills and other cash equivalents.
Many investors believe it is time to imitate Buffett in this regard. Some salivate as they recall fire sale prices in the Great Financial Crisis. By maintaining liquidity with money markets or treasuries, many hope to time the market to catch a market bottom.
At this moment, treasuries certainly seem like a viable option for investors looking to get a low-risk return in the range of 5% annualized. But are they missing anything?
What Are Treasury and Money Market Fund Investors Missing?
Investors who directly compare returns from T-bills or money market accounts to real estate may be missing some important factors in their analysis.
One-dimensional T-bill yields can pale compared to multi-dimensional private real estate returns. While the risk is certainly lower on T-bills, the total returns are not comparable.
Beating inflation is a critical component of building wealth. Many savvy investors view real estate as an effective hedge against inflation. Rental rates and property values typically rise with inflation.
Treasuries are not considered a long-term hard asset. While fixed-rate Treasuries often fall behind inflation, real estate, like other hard assets, frequently preserves and enhances your purchasing power over time.
But real estate benefits investors in multiple ways where many other hard assets fail.
Real estate returns can be summarized by the acronym CAPT. (It's not a great acronym, but it's better than the one derived by switching the last two letters, which some have done.)
C = Cash Flow. Real estate investments typically produce cash flow in the form of net rental income. The cash flow is often in the range of 4% to 10% annually or so. Solid real estate investments typically provide growing cash flow as rents escalate in conjunction with inflation.
Most people faultily comparing treasury yields to real estate limit their comparison to this cash flow figure alone. This is understandable but severely inadequate.
A = Appreciation. As a hard asset, one of real estate's great virtues is its growth potential. Though it's certainly not guaranteed, residential and commercial real estate generally appreciate over time.
Some would compare this with current "risk-free" treasury rates and choose the T-bill. But they would miss the substantial appreciation that our investors have enjoyed. Much of this appreciation is invisible to passive investors until assets sell.
Cash flow is king. But the appreciation can be substantial as well. To calculate the gross equity appreciation (the investors' share), divide the percentage value increase by one minus the LTV ratio. The LTV (loan-to-value ratio) at the time of refinance can be determined by dividing refinance proceeds by the appraisal value at refinance.
Let’s use a recently refinanced property in a Wellings fund as an example. We divide refinance proceeds of $2,329,000 by the appraisal of $4,210,000 to get the LTV of 55.3%. Then divide the asset value increase of 91.4% by (1 - 0.553) to get a gross equity appreciation of 204%.
To boil that down into an estimated annual return from appreciation, divide that by the hold time of approximately ten years to get an estimated yearly appreciation return of about 20%.
Investors who compare this Wellings fund's current yield (cash flow) of 8% to lower-risk treasury rates of 5% leave an additional 20% estimated annual return from appreciation out of the equation!
But real estate investors get more than just cash flow and appreciation. Investors should consider two more components in their comparison.
P = Principal Paydown. Real estate investors can benefit from from the use of conservative debt. Debt increases risk, but prudent investors can manage this risk by using debt with fixed rates and low loan-to-value ratios.
Net operating income does not translate directly to net cash flow on debt-financed properties. The operator pays the lender interest and (usually) principal payments before distributing free cash flow to investors. The paydown of principal creates a delayed but real additional return for investors.
In the example above, I expect the principal paydown over about a seven-year hold (from refinance to sale) to be almost $300,000. This means the loan payoff at the time of sale should be a little over $2 million rather than the original $2.329 million.
Like appreciation, this return is not received as part of cash flow during the hold time but should be counted in the total return when comparing to treasuries.
T = Tax Benefits. Real estate is famous for its many tax benefits. T-bill returns are subject to federal taxes, and real estate is, too. But the appreciation component of real estate returns (for assets held over a year) is typically taxed at the lower capital gains rate.
For example, a married couple earning $300,000/year in 2024 has an effective Federal tax rate of about 17.5%. If this couple invested in T-bills earning 5%, the Federal tax hit takes their net return from the T-bills to about 4.1%. A couple earning more than $300,000/year would have an even bigger tax hit.
Additionally, most real estate investors can benefit from cost segregation studies, which allow significant paper losses from accelerated depreciation.
These paper losses often offset the cash flow from the investment, meaning investors could avoid federal and state taxes for several early years of their hold-time.
While these taxes are recaptured at the asset's sale, they are typically paid at a lower rate, which can provide an additional benefit to investors. At least those who pay this tax. Some never do. How?
Some real estate owners enjoy forgoing taxes by utilizing a 1031 exchange or a lazy 1031 exchange when selling commercial properties.
This allows them to avoid capital gains and depreciation recapture taxes by effectively exchanging one asset for another at the time of sale.
Some investors take this further by arranging a step-up in basis at death to eliminate these income and capital gains taxes permanently.
What Else?
I've summarized the comparison of CAPT returns in real estate compared to the one-dimensional yield from treasuries. But there are other considerations.
I mentioned that many investors are parking their funds in treasuries to keep dry powder, hoping to pick up deeply discounted assets at the bottom of the market. That makes sense.
Unlike in the 2008 downtown, institutional players today are hoarding cash. An October 2023 estimate said over $400 billion is on the sidelines, earmarked explicitly for acquiring commercial real estate.
Also unlike the 2008 era, we don't have reason to believe there will be deeply discounted real estate deals available. These two factors make me doubt that most investors will significantly benefit from this downturn.
Additionally, we must come to grips with the fact that we can only know the bottom of a market cycle in a rearview mirror. It's simply impossible to time a market bottom (or top).
And most investors don't have the fortitude to buy in the event assets take a plunge as they did in the GFC.
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When to Choose Treasuries Over Private Real Estate
There are undoubtedly times to choose Treasuries over real estate. Here are a few examples…
You don't know how to invest in real estate, or you don’t have an interest in allocating to real estate either actively or passively. This is problematic, but I assume this is not you if you are reading this post.
You need significant liquidity at all times because of your business or other personal circumstances. Many investors need liquidity. They have an upcoming expense, and they need dry powder. Real estate is obviously not liquid.
Some investors I meet desire liquidity, but it's based more on subjective feeling than actual need. Sometimes that feeling is fear of the unknown. I wrote a post about the undervalued benefits of illiquidity, and you can read that here.
You don't have enough cash for broad diversification. We don't recommend putting all your eggs in one basket, and since real estate does carry risk, I don't think you should generally invest all your cash into one asset type. Treasuries can be a good option if you have a modest amount of cash, less than the minimum to wisely invest in real estate.
You can't find cash-flowing investment opportunities right now. If you can't, please don't go out on a speculative limb and buy a property with negative cash flow based on its likelihood of increasing in value over the coming years. This has been a significant mistake for many investors for a long time, particularly since real estate investing has exploded in popularity over the past ten years or so.
Similarly, if you are acquiring a modestly cash-flowing asset, you may find that it really isn't as profitable as you expect. I lost count of how many times I've seen years of profit on rentals evaporate due to a large, unexpected expenses like a new roof, HVAC, a bad tenant, and more. I just saw this post on X that should serve as a reminder:
5. Investing in real estate as a side hustle can be a big mistake, regardless of what you saw on HGTV. This photo above illustrates this. If you're a busy professional with a high-paying career…and a family…and hobbies…and a life…or retirement, then I've got some news for you:
Many investors find that the profits are less than expected and the hassles are more than they ever dreamed. I've spoken to countless professionals who've tried this and failed.
Others are still grinding it out, but they pay a steep price for their side gig. And they grumble about doing $20 per hour work dealing with toilets, tenants, and trash on evenings, weekends, lunch hours, and vacations.
Many investors want the cash flow, appreciation, and other benefits of real estate without the hassles and risks. They have learned to tap into diversified portfolios of professionally managed assets that produce CAPT and more while they enjoy their careers and families and lives.
If you have any questions, please email us at invest@wellingscapital.com or use this link to set up a call.
DISCLAIMER: The information contained in this article is for information purposes only, does not constitute a recommendation, and should not be regarded as an offer to sell or a solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be in violation of any local laws. All investing involves the risk of loss, including a loss of principal. Past performance is no guarantee of future results. We do not provide tax, accounting, or legal advice, and all investors are advised to consult with their tax, accounting, or legal advisers before investing. Information and any opinions contained in this article have been obtained from sources that we consider reliable, but we do not represent that such information and opinions are accurate or complete and thus should not be relied upon as such.
