Capital appreciation and other income streams — the CRE investment lifecycle.

At a Glance —

• Capital appreciation is a major benefit to consider commercial real estate investments as part of your investment portfolio. CRE is generally a long term investment, but one that historically has created wealth for investors
• Understanding your investor risk profile and how your strategy best relates to the various options within CRE investments is crucial to understand clearly before you start
• CRE investments potentially return several sources of income to investors including operating income and depreciation advantages in addition to capital appreciation
• You should understand and plan for the tax implications — both the benefits and expenses — while you hold your CRE investment and at the time of liquidation

Capital appreciation is the escalation in an investment’s market price — it is the difference between the buying price and the selling price. For CRE investments, capital appreciation refers to the growth in value of a property due to market factors such as changes in supply and demand, inflation and economic growth. Successful CRE investors strive to invest in properties which have the greatest potential to appreciate over time while still aligning with their risk tolerance and capacity. Capital appreciation is one of several ways to earn income from your CRE investments.

Match your risk profile to CRE investment options.

Before selecting CRE investments that are right for you, it’s important to consider the investment category of an investment and how it correlates to your investor profile. There are four main categories — core, core-plus, value-add and opportunistic. Read more about CRE investment categories on our post here.

In understanding these options, you can best match your investor profile to the right kinds of CRE investment opportunities. Core and core-plus are best suited to conservative and conservative to moderate investors whereas value-add suits moderate to moderately aggressive investor profiles and opportunistic is targeted to the most aggressive investor types.

Capital appreciation and investment returns will be pretty closely tied to the risk level of the investments you select.

Success and planning.

Once you’ve identified the CRE investments that best fit your investor profile, what other considerations and planning are necessary?

Let’s think of this as the lifecycle of sorts, for your CRE investments, with a beginning, middle and end —

You’ve already found which CRE investment categories best fit your investor profile. Now, to help ensure that a CRE investment has the potential for capital appreciation and other sources of income, it is important for investors to research and select properties which are situated in geographies that are experiencing, or are about to experience, economic growth. Factors such as growing population trends, strong job markets or planned redevelopment areas. By investing in properties in areas of growth, investors will more likely benefit from capital appreciation over time.

Property types, or asset classes, are also critical considerations based on the growth trends in a given location. For example, office buildings and retail spaces are more likely to appreciate in value over time when population is increasing. Generally, more people means more local employers along with an increasing need for retail goods and services. These types of properties are more likely to attract tenants and drive additional demand for CRE space. Learn more about CRE asset classes here.

Your CRE investment may provide routine cash flow during the holding period. Cash flow income generated by CRE investments may be offset, or even eliminated, by your portion of the depreciation expense each year.

An often overlooked but significant advantage of CRE investment is the tax benefit of depreciation. Your annual taxable income can be reduced by your portion of a CRE investment property’s annual depreciation expense. Learn more about the tax benefits of depreciation for CRE investors here.

A major source of income from your CRE investment is likely capital appreciation over the period of time which you’ve held the investment. As the value of the property increases over time, so does your equity stake in the property. That’s the point.

Most CRE investments are long term holds and normally fall under long-term capital gains tax. Additionally, when the investment is liquidated, you will also need to deal with the depreciation recapture calculation. This is a calculation to recapture the amount of depreciation you deducted from your income while you held the investment. Generally the tax rate for depreciation recapture typically has been lower than the income tax rate in the US. The amount you saved in taxes each year with the depreciation tax deduction will likely outweigh the taxes owed for depreciation recapture.

Be sure to speak with your tax professional to expertly plan for the taxable event of liquidation. With proper tax planning, you can mitigate any surprises in your tax bill when your CRE investments mature.

Bottom Line —

Capital appreciation is a major benefit of investing in commercial real estate — one of several potential sources of income throughout the lifecycle of a CRE investment. With a clear plan to match selected CRE investments to your investor profile, coupled with an understanding of the tax benefits and requirements, CRE can be an excellent addition to your investment portfolio.