apartments or oil wells? which way is better? i don’t know oil. how can i learn more?
“I understand real estate investing. But I don't know much about investing in oil and gas, or really even how the business works.”
Great feedback that usually comes early in conversations with prospective partners. While oil and gas can seem like unfamiliar territory, understanding real estate investing provides utility for understanding oil and gas investing.
The reality is that both are viable investment options, each with its own unique characteristics, advantages, and risks. The key is determining alignment to your priorities by exploring their similarities and differences.
And when it comes to people, money, and trust...alignment is critical.
I love how the Old Testament prophet Amos poses a question that reveals the depth about the very personal nature of this kind of alignment.
“Do two walk together, unless they have agreed to meet?” – Amos.
For the passive investor, investing in either of these pathways is a longer-term journey. And no one is walking anywhere, together, without agreeing to meet.
So, let’s do that first by setting a baseline.
SETTING A BASELINE.
Real Estate.
Type. Real estate investing includes many opportunity types...flipping, single family rentals (short and long term), multi-family (active and passive), and so much more. Today’s focus is a passive investment in a new-build, multi-family project.
Value Creation. Long-term value creation primarily comes from market-driven appreciation achieved through the right property at the right location with the right management.
It can also be derived from tax deductions (more on that in a bit), opportunistic buying, value add tactics in construction and amenities, creative financing, shrewd management, proximity to strong retail developments, and more. And real estate is almost always at its best as a long-term play designed for wealth building.
Oil & Gas.
Type. Oil and gas investing also includes many opportunity types...mineral rights ownership, drilling exploration and production projects, oil company stocks, oil ETFs, and more. Today’s focus is a passive, multi-well drilling exploration and production project.
Value Creation. Value creation primarily comes from profitable production that efficiently pays off the initial capex cost to produce it. Like real estate, the right well(s) in the right location(s) with the right management generates value.
Again, like real estate, value can also be derived from tax deductions (more on that in a bit), opportunistic buying, value add tactics applied to legacy wells, creative financing, shrewd management, proximity to multiple, repeatable drilling locations, and most importantly reinvestment of cashflow (more on this later). And oil & gas is almost always at its best as a long-term play designed for wealth building.
In both these examples, the investments are passive, so investors are considering the track record and experience of the operators in delivering on the proposed business case for the project. In both these examples, the hold period (time gap between wiring the investment and the first distribution) is likely at least 2-3 years because the value creation takes time.
To help simplify things, below is a comparison table we use in our deck to educate prospective partners.
KEY DIFFERENCES.
Tax Deductions.
Both real estate and oil and gas offer valuable tax benefits, but they function differently.
Real Estate. Investors can benefit from depreciation, mortgage interest deductions, and the ability to defer capital gains with a 1031 exchange.
However, unless an investor can meet the qualifying criteria for being a real estate professional, real estate deductions are subject to the passive loss rules of the tax code meaning applied deductions are limited to passive income. This means no deductions against capital gains or W2 income.
Oil and Gas. Investors can benefit from Intangible Drilling Cost (IDC) deductions, and a variety of other depreciation-driven deductions known as depletion allowances which function similarly to depreciation but apply to the extraction of natural resources.
The IDC deduction typically represents 60-80% of invested capital in a development project focused on new drilling. Investors can take that deduction via K1 in the first year or divide it equally over the next 5 tax years. Translated, an investment of $100k delivers a deduction of $60-80k.
An IDC deduction is unique from real estate in that, for passive investors, it is not restricted to passive income but can be used on active income, including W-2 earnings and capital gains.
(For a deeper dive on the IDC deduction, you can read here. Also, for an illustration of an actual tax deduction scenario, click here.)
Think of real estate tax benefits like receiving a modest discount on your annual tax bill (unless you are a full-time real estate professional making the tax benefits substantially bigger), while oil and gas tax advantages can provide a substantial upfront tax savings—particularly beneficial for investors looking to offset active income such as capital gains and/or W2 earnings.
Value Creation.
Real Estate. There are multiple strategies that work to deliver ROI. It depends on your risk tolerance, capital structure, and your investing priorities and goals. Here’s a breakdown of a short-term, mid-term, and long-term strategy for maximizing the equity multiple and IRR in Real Estate development project.
In Real Estate, ROI is significantly affected by factors like: location analysis accuracy (primary vs. secondary vs. tertiary markets), leverage (loan-to-value ratios), interest rate environment, operational efficiency and rent growth.
Oil and Gas. There are multiple strategies that work to deliver ROI. It depends on your risk tolerance, capital structure, and your investing priorities and goals. Here’s a breakdown of short-term, mid-term, and long-term strategies for maximizing the equity multiple and IRR in Oil and Gas development.
So, what conclusions can we draw from all this?
Investments in Real Estate and Oil and Gas share similar prime objectives and even similar development paths.
But there are differences too. Drilling a well and harvesting hydrocarbons is a different way to make a profit than building an apartment complex and renting units to make a profit. Market variables, risk mitigation strategies, and operator management expertise are all different.
In the end, they both function within an economy where demand generally outpaces supply. And wherever that exists, so does opportunity.
Armed with a more informed perspective on Oil and Gas, how could such an investment help you meet your goals?
Here are 7 questions to consider...
What impact will a tax deduction against my active income have for me this year?
What will the ROI do for my mid- and long-term wealth building goals?
What kind of risks are there to me with the reduced liquidity such an investment creates?
How will this help me diversify my strategy?
What is my real tolerance for risk and reward?
How could such an investment meet a specific aspirational goal like creating more time freedom and money to travel, or that create space for that hobby that’s been sidelined for a while, or maybe it could help put more capital and time into my favorite philanthropy or ministry?
What’s the best framework for doing the due diligence on a project and the operator?
If you want help answering these questions, or you have some of your own, let us know and, in the spirit of the OT prophet Amos, we can agree to meet before walking together.
Best,
Disclaimer. This blog is for education purposes only. It is not an offer to sell securities. I am not a financial advisor and I don’t play one on tv either.
