Investors and lenders who participate in commercial real estate deals do so with the expectation that they receive their principal money back and additional earnings. After all, that’s the point of investing!
In the case of a typical commercial real estate investment, investors recoup some of their money regularly through rental income, but the majority of money and profit will be distributed when the property is sold or refinanced. As a result, the general partners or operators of a commercial real estate deal provide their lenders and investors with an expected “holding period” before the acquisition so that everyone in the deal understands the timing of their financial returns.
What is the Definition of a Commercial Real Estate Holding Period?
The definition of a holding period in commercial real estate is the amount of time an investor intends to “hold” an asset. The holding period starts on the day the property is acquired and ends on the day the property is sold. A common holding term for commercial real estate investing is between five and 10 years.
Why Does the Holding Period Matter?
The holding period is important for several reasons, but the most important reasons include expectations, returns, investment strategies, and tax implications.
To begin, when seeking investment capital, one of the first questions a lender or investor asks is, “How long will it take for me to get my money back?” This is a fair and practical question from lenders and investors because their money is illiquid when invested in real estate, making it impossible to access during the holding period in most circumstances. Therefore, it’s important for the general partners and operators of the deal to create a timeline for the investment and confidently show their lender and investors a realistic estimate of when they can expect to see their money returned.
Second, a holding period is necessary to properly calculate and evaluate the return on a commercial real estate investment. Internal Rate of Return (IRR), Equity Multiple, Capital Gains, and Cash on Cash Return are all common metrics used to calculate and evaluate a return. All of these metrics require a holding period as part of their formula.
Third, creating and executing a commercial real estate investment strategy requires time. Real estate is a fairly slow-moving investment compared to other investments such as stocks and bonds. Renovations, rent stabilization, and shifts in the market can all impact the timeline for selling a property, and they can all take months or years to complete. The longer you hold a property, the more likely you are to turn a profit (historically speaking). However, the longer you hold, the longer you keep capital tied up in the property rather than turning it around and putting it to work in another property. These are all reasons that timing (the holding period specifically) is crucial to your real estate investing strategy.
Finally, the holding period has significant tax implications for selling the property. Let’s explore these in more detail.
Tax Implications of Real Estate Holding Periods
In general, commercial real estate investing provides a great deal of tax benefits compared to other investments. However, if you’re unaware of them or don’t implement them, you’ll be subject to a significant amount of tax liability if you successfully sell a property for profit. The holding period is one component that determines how the IRS will tax your gains.
Similar to stocks, any profit on an investment held for more than one year is classified as a long-term capital gain, which receives preferential tax treatment. Long-term capital gains are taxed at a rate of 0%, 15%, or 20%, depending on your income, and the rate you pay will always be lower than your regular income tax bracket.
Any profit on an investment held for less than one year is classified as a short-term capital gain and is taxed as ordinary income at a higher tax bracket than long-term capital gains.
As an example, suppose you invest $100,000 into a commercial real estate property, and the investment grows to $118,000 within one year. If you are in the 32% marginal tax rate, which puts you in the 15% capital gains bracket, and sell your investment before one year, you will be taxed at 32% on the $18,000 profit, or $5,760. If you sell after one year, you will be taxed 15% on the $18,000 profit, or $2,700.
Assuming you have a profit to realize in your investment property, the tax implications of short-term vs. long-term capital gains should be a significant consideration.
When Does the Holding Period Begin for Commercial Real Estate?
The holding period for a commercial property starts on the day the property is acquired.
When Does the Holding Period End for Commercial Real Estate?
The holding period for a commercial property ends on the day the property is sold.
Does the Holding Period Ever Change?
Yes, the holding period of a commercial real estate investment property can change. This often happens if the predetermined objectives of the investment are met early. For example, if the general partners are aiming for a 16% internal rate of return and that number is exceeded in three years rather than the five years they initially estimated, the general partners may decide it is more advantageous to sell the property before the end of the scheduled holding period and return the lender’s and investors’ money sooner than expected with a higher profit than projected.
However, on the opposite end of the spectrum, there are occasions when an investment is nearing the end of its scheduled holding period, and the real estate market experiences a downturn or becomes more volatile. In this instance, the sale of the property may not allow the general partners to meet the desired returns they originally presented to their investors. In this circumstance, the general partners may decide to extend the holding period and wait for the market to stabilize and begin rising again rather than providing their investors with a lower-than-expected return—or worse—a loss.
How Long Should You Hold Real Estate Investments?
There’s no perfect one-size-fits-all answer to this question. However, on average, by holding a commercial real estate property for five to ten years, investors typically have the opportunity to increase the value of the property, weather a market downturn, and sell for a profit.
Historically, the United States economy tends grow approximately 8.5 years out of every 10 years. During the 8.5 years of growth, the demand for commercial real estate generally increases as a reflection of the economy as a whole. If you plan to hold a property for three years and the economy has been growing for seven, there’s a chance you’ll be trying to sell during a market downturn. On the other hand, if you plan to hold a property for five or seven years, and the economy has been growing for seven, there’s a better chance that you’ll hold the property through a downturn and have time to sell when the market is recovered.
These time periods are simply provided to illustrate how you could invest in a property and have a holding period set to end during a market downturn. There’s no way to predict these cycles or time the market. Therefore, generally speaking, investors typically like to hold properties for five to ten years in order to provide ample time to improve the value of the property and reduce the chance that they need to exit the property with a loss.
Key Takeaways for Real Estate Holding Periods
As you’ve learned, the holding period for a commercial real estate investment is a simple term. However, despite its simplicity, it has a lot of serious and important implications that range from investor expectations to tax implications and more.
As always, you should discuss any commercial real estate investing opportunity with experts and consult professional counsel before making any decisions. Here are the key fundamental takeaways you need to help you have those conversations:
- A commercial real estate holding period is simply the amount of time that an investor plans to hold a property before selling.
- The holding period for commercial real estate starts on the day the property is purchased.
- The holding period for commercial real estate ends on the day the property is sold.
- The planned holding period matters for multiple reasons: to align expectations around when lender’s and real estate investors will get their money back, to calculate returns and evaluate the success of the deal, and to properly execute the property’s business plan based on the investment strategy.
- It’s possible for the holding period to change and usually does so for one of two reasons: 1) the general partners achieved the objectives of the property sooner than expected and find it advantageous to sell early 2) The market conditions declined, and the general partners decide it’s worthwhile to extend the holding period, so they don’t sell for a less-than-expected amount or a loss.
- The holding period varies by investment, but the average commercial property holding period is 5-10 years.
To continue building your investing vocabulary, explore our list of important real estate investing definitions.