By Andrew Gaines

The rewards of investing most often accrue to the patient investor.  The power of compounding is manifest most profoundly over a long time horizon.  For buy and hold index fund investors this is especially true because the primary source of return is share appreciation, which requires time to be realized.  Current income is not necessarily an important consideration. Even though holding shares for more than a year ensures taxation of gains at lower rates, income generated from these investments are taxed at the investors highest marginal rate.  So, for the high-income professional, it often pays to avoid income-producing funds and to sit tight for the long-haul allowing the power of compounding and appreciation to work its magic.  

There are few opportunities to invest for the long-term and also reap benefits in the present, but direct investment in multifamily real estate is one of those opportunities.  Here are five ways an investment in commercial multifamily real estate can improve a high-income professional’s financial situation in the immediate future.

1.     Add a new source of passive income

Most high-income professionals like physicians, executives, and attorneys depend on their primary income source to fund living expenses and savings.  They have invested years of their lives and hundreds of thousands of dollars to get to where they are. They are committed to their work and often view their work as a calling.  Their time is constrained and opportunities for side gigs and alternative income sources are limited.  An investment in multifamily real estate can provide an almost immediate new source of passive income.  In general, apartments are a stable income producing business model due to the economies of scale achieved in larger projects and the steady demand derived from the basic need for shelter.  A professionally managed apartment investment translates to steady current income for investors in the short term and capital appreciation over the long run. A new passive income stream can increase margin and flexibility in a professionals’ daily life and financial plans.

2.     Decrease taxes on investment capital

Tax-efficiency is a key consideration when investing, especially when allocating after-tax dollars.  To avoid taxation at a higher marginal rate it is generally advisable to invest after-tax capital in securities that will be held for at least a year or longer.  For many paper assets that generate some income, this still means paying taxes on that income. A commercial real estate investment is one of the few exceptions because of the favorable tax treatment real estate has received by the IRS.  Current income from a real estate investment can often be offset by the depreciation expense accrued in that year, resulting in no tax liability. Utilizing these depreciation rules, a real estate investor may be able to defer taxation on income for years.  This allows the investor to take advantage of the time value of money and pay taxes on current gains with future, less valuable dollars. Thus, the tax liability on current investment dollars is decreased relative to an alternative investment type that lacks the favorable tax treatment of real estate.

3.     Decrease volatility of the investment portfolio

Portfolio volatility is a concern for most investors and identifying ways to increase returns while decreasing volatility can be a fruitful endeavor.  It is clearly not possible to avoid volatility entirely. The cyclical nature of markets is an embedded reality. However, some markets are more cyclical than others.  Private commercial real estate tends to have lower volatility levels than other asset types. Within the universe of commercial real estate, multifamily tends to be the least volatile subset of investable assets. This is because the demand for apartments is driven primarily by demographic and psychographic factors, which change slowly. Whereas the economic and business cycle factors that drive the stock and bond markets can change rapidly.  That is why adding multifamily real estate to a portfolio of paper assets can reduce the overall portfolio volatility.  

4.     Improve the performance of the current portfolio

Diversification is another centerpiece of portfolio construction.  Ideally, a well-diversified portfolio consists of assets that have a low correlation to one another such that when one asset class is underperforming another is doing better than expected.  Taken together a portfolio is constructed of multiple asset classes that should achieve a target return over a long period of time. If it is possible to add a new asset class that has a low correlation with other portfolio components this should improve performance.  Commercial multifamily is such an asset class. Because it has a unique cyclicality, based on long demographic waves, it can be an uncorrelated additional diversifier that improves portfolio performance.

5.     Take a step closer to financial freedom

Financial freedom is the flexibility to do what we want when we want and with whom we want. It also provides a great form of margin.  Achieving financial independence is a worthwhile but complex task and requires a number of elements like sustained effort, discipline and specialized knowledge.  It requires a reasonable portfolio and tax-efficient investing. Passive income is not be required to achieve financial independence because assets can be sold to fund expenses, but it does provide more flexibility because income-producing investments can be used without liquidating the underlying asset. There are few asset classes that provide the unique combination of income, appreciation and tax efficiency that investment real estate does.  Having some capital deployed in this space is a reasonable consideration and can take an investor one step closer to their financial goals.