Investor Resources

Most investors want a high rate of return along with a low level of risk. Stocks (Equities), mutual funds, and real estate are investment vehicles that investors often consider. These options can provide positive long-term returns. However, investing in commercial real estate provides an investor with numerous advantages over stocks and mutual funds. It can experience less pricing volatility than stocks; it provides returns from two sources — rents (aka cash flow) and value appreciation; and it offers investors significant tax advantages through depreciation, tax-free refinance proceeds, and 1031 tax-deferred exchange programs. Kenwood’s real estate investments have provided its investors with these tax advantages along with cumulative returns that have exceeded the S&P 500 for every “mature” property in its portfolio (owned for more than 10 years). Most notably, these returns were generated only from cash flow and refinance proceeds. They do not include any distributions generated from a property sale, which should further enhance overall returns. With every property that Kenwood has owned for more than 10 years, our investors have experienced returns that have exceeded those generated from the S&P 500.

Handling Volatility 

During every crisis, the stock market has experienced significant volatility. Whether it was the dot-com bubble at the beginning of the 20th century, the Great Financial Crisis from 2008-2010, and now with coronavirus pandemic, investors often become uncomfortable with market volatility and consider alternatives to diversify their investment portfolios. Investors often contemplate these types of questions:

• Are there investments that don’t experience significant price volatility?  
• Can real estate investments offer more stable investment returns?  
• Can real estate provide an effective diversification to my overall portfolio?  
• Can real estate offer tax advantages that typical stock investments don’t offer?  
• And lastly, how have Kenwood’s real estate investments performed over time?  

Diversification 

Commercial real estate investments that are managed by an experienced operator, offer investors many advantages. At Kenwood, we focus on acquiring properties that are leased to numerous tenants, representing many industries and various credit levels. We describe this as a diversified rent roll.  Similar to a diversified mutual fund, we have found that by acquiring properties that are leased to a broad spectrum of companies, our investments produce more stable returns. If one industry experiences economic difficulties, and only one or two tenants are affected, it has less impact on the overall investment. Similarly, if one small tenant fails or moves out, its impact on the overall cash flow is limited. This is similar to applying the advantages of mutual fund investing to real estate and explains why Kenwood focuses its investment criteria on multi-tenant rather than single-tenant ones. It’s all about diversification and how to increase returns by reducing risk levels. This is how investing in multi-tenant properties reduces volatility. It better stabilizes the cash flow and a property’s value thereby remains more consistent.   

According to a Josef Stadler in a recent Bloomberg article entitled “Billionaires Hunt Real Estate Bargains in Shadow of Pandemic”: “Almost half the 121 family offices surveyed by UBS Group AG are looking to increase their allocations to property as they hunt for opportunities and potential bargains, according to the Swiss bank’s Global Family Office Report 2020. The firms also expect to be more aggressive in putting their cash to work than most other investors. Covid-19 has reconfirmed that diversification is the game to be in,” Stadler, head of UBS’s global family office unit, also said, “Real estate has always been an asset class for diversification, and it obviously has reconfirmed its status.”

Valuations and Appreciation

Stock valuations are generally based on a company’s future earnings. Wall Street analysts create models that project a company’s future earnings and then apply a Price-To-Earnings (P/E) ratio to determine its stock price. So the two components to determine a company’s stock price are its projected earnings and the P/E ratio. A stock’s ability to increase its price is generally tied to its plan to enhance its earnings and its effectiveness in implementation. Changes in a company’s or industry’s P/E ratio are generally related to perceptions in the national economy. When an economy is growing, often the P/E ratio will increase.

Note that the concept of asset appreciation is overtly absent from this equation. For example, if you purchase a box of Clorox today and let it sit on a shelf for five years, it isn’t going to be worth more in the future. Someone won’t pay you a premium for that old Clorox compared to the current price for a new bottle. Wall Street doesn’t understand or have a mechanism to model asset appreciation. As a result, it doesn’t impact or enhance a company’s stock price. However, for real estate investments, asset appreciation is a major component of the overall return. Like stocks, real estate investments produce current earnings via rents (cash flow) but also add the appreciation component to the investor’s overall return.  

Benefits of Real Estate Investments

Rents from tenants are paid monthly. This produces regular cash flow, similar to earnings from any publicly traded company. From this cash flow, real estate sponsors generally pay their investors a “preference payment,” which is similar to a stock dividend payment, on a regular basis (i.e., quarterly, semi-annually, or annually). Real estate investments often provide higher preference payments to their investors than stock dividends that are issued to their shareholders. For example, many dividend-paying stocks currently offer their shareholders yields ranging from 1%-3%.  Kenwood’s preference payments typically provide its investors an 8% return. In addition, asset appreciation will further enhance Kenwood’s overall investment returns.  

Real estate also offers its investors the advantage of leverage or using inexpensive debt to further improve their overall returns. Interest rates on loans that are backed by commercial real estate are currently at historically low levels. It is not uncommon to have a commercial real estate loan interest rate below 4% based on a loan-to-value ratio of up to 70% (the remaining 30% being the equity provided). It was only a few years ago that interest rates were 100 to 200 basis points higher. Utilizing leverage effectively provides the opportunity for investors not only to benefit from having their equity grow much faster but also to have their entire investment be returned through value appreciation. Kenwood investors can experience this while still owning the property and still receiving regular distributions from cash flow. This is possible through equity appreciation and refinance distributions, and is one of Kenwood’s primary investment strategies.  

Typical commercial real estate loans have a 10-year term and are not fully amortizing over that time. As a result, on the 10th anniversary, the property will need to be refinanced. A new loan is then necessary and its proceeds will be based on the current, hopefully appreciated, property value. For example, let’s look at a property purchased 10 years ago for $10,000,000, assuming the loan was $7,000,000, and $3,000,000 represents the equity provided. After 10 years through appreciation, the property is now worth $14,500,000, at 3.8% compounded growth per year. If a lender provides proceeds based on a similar 70% loan-to-value ratio, the total proceeds will be $10,150,000. The initial $7,000,000 loan will then be paid off and there will be more than $3,000,000 available to return all of the investor’s initial equity. Now an investor has received all their money back, continues to own interest in the property, and will still receive regular distributions based upon available cash flow.

Return Comparison 

Let’s examine some “real world” examples from the Kenwood portfolio of the benefits of regular preference payments combined with asset appreciation and distributions from refinance proceeds. We purchased the Kenwood Building, our first acquisition, in December 1996. The Kenwood Building is a multi-tenant office building located in Bethesda, Md., where the average size tenant space is less than 2,000 square feet — a great example of the “lots of small tenants” model.  Since then, investors have received all of their initial equity back plus approximately three times their initial investment back from excess cash flow and refinances, and based on a recent appraisal, still have approximately ten times their initial investment in equity in the property. The graph below depicts the investor’s cumulative annual returns solely from cash flow distributions and refinance proceeds. Since we still own the property, there are no disposition gains represented in these figures. We have overlaid on the graph the S&P 500 performance over the same period. We picked the S&P 500 as a standard benchmark utilized by many stock and mutual fund managers to gauge their performance.  

Now let’s see how the balance of Kenwood’s portfolio has performed for all properties which have been owned for more than 10 years. We purchased NOVA Industrial, NOVA Storage, Dulles Design Center, Lottsford Business Center, Hampton Commerce Center, Preston Court, and Westmore Avenue between 1998 and 2009. As with the Kenwood Building, in every case, our investor’s overall returns have exceeded those from the S&P 500 over the same period.  

The chart below summarizes the overall returns depicted from the graphs above. As you can see, Kenwood’s returns including only cash distributions and refinance proceeds, and NOT including the ultimate disposition of the property, have exceeded the S&P 500’s dividends distributed plus stock appreciation. In fact, in many investments, Kenwood’s returns have not only exceeded the S&P 500 but in some cases have been significantly higher.

Tax Advantages 

Real estate investments offer investors tax advantages that are not available to stock shareholders. Three notable tax advantages are: depreciation, tax-free refinance proceeds, and 1031 tax-deferred exchanges. Depreciation provides investors with the ability to shelter certain income through a property’s depreciation. Commercial properties are depreciated over a specified time. The annual depreciated value can then be used to reduce an investor’s tax liability from other sources. By utilizing cost segregation, that depreciation amount can also be significantly enhanced in the early years of an investment.  

According to a Forbes magazine article entitled “Understanding Real Estate Tax Benefits: Depreciation, Accelerated Depreciation, Bonus Depreciation”: “Real estate investors have been benefiting from the substantial tax savings inherent in this asset class for decades. The Tax Cuts and Jobs Act of 2017 and its expansion of bonus depreciation have made these benefits significantly better.”

As we noted above, through refinance proceeds Kenwood’s investment strategy is to return all or most of an investor’s initial equity. When this occurs, those distributions are tax-free. An investor can do anything with those proceeds, including investing them in another real estate opportunity.  

Lastly, through a 1031 exchange, an investor can defer any gains from the property sale if a similar like-kind property is purchased within certain time periods. These are all very powerful and beneficial advantages to real estate investing.

At Kenwood, we are here to increase investors’ understanding of the advantages of real estate investing, how it helps diversify an investment portfolio, and why certain real estate investments can outperform others. Please let us assist you and answer any questions that you may have.   

Disclaimer: This article may contain “forward-looking” statements that are based on the Kenwood’s current expectations, estimates, and projections about future events and financial trends affecting Kenwood. Forward-looking statements can be identified by the use of words such as “may,” “will,” “should,” “could,” “believe,” “anticipate,” “expect,” “estimate,” “plan” or other comparable terminology. Forward-looking statements are inherently subject to risks and uncertainties, many of which the Kenwood cannot predict with accuracy and some of which the Kenwood might not even anticipate. Although Kenwood believes that the expectations, estimates, and projections reflected in such forward-looking statements are based on reasonable assumptions at the time made, the Kenwood can give no assurance that these expectations, estimates, and projections will be achieved. Kenwood acknowledges that prior results are not necessarily indicative of future results. Future events and actual results may differ materially from those discussed in the forward-looking statements and the Kenwood undertakes no obligation to update or supplement any forward-looking statements.