Commercial Real Estate vs. Oil and Gas Royalties

Buying Bakken commercial real estate and purchasing oil and gas royalties are both ways that you can invest in North Dakota’s energy boom. Both investments can offer healthy cash flow and tax shelter that lets you keep more of the income that you receive. Technically, both are also real estate. However, there are some real differences between the two types of investments.

Income

Both oil and gas royalties and Bakken commercial real estate properties should provide ongoing income. With a royalty investment, your cash flow is based on the total royalty payment less any expenses that get subtracted. While expenses vary, it is common to have severance taxes and the cost of transportation or marketing of the oil subtracted from the royalty payment. Commercial real estate properties vary. A multi-family building will have a range of operating expenses that get taken off of the rental income, while a single-tenant triple-net-leased asset might not have anything subtracted from its income.

Commercial real estate can offer more stable income if you choose a property that has a triple net lease. That way, the tenant bears any increases in costs. Properties where you pay the expenses leave you with more risk of having your income fluctuate. With all properties, though, vacancy is one of your biggest risks. If no one is there to pay rent, you won’t get any income.

Royalties occupy a middle ground. Your income is fixed at the production level of the well. As long as it produces, you collect. While your expenses can be variable, they should fluctuate less than what you might experience with an apartment or gross-leased commercial building.

Tax Benefits and 1031 Exchanges

Both types of investment have two sets of tax benefits. The first is that you can include them in 1031 exchanges. Since oil and gas royalties are like-kind to Bakken commercial real estate, you can trade between them and between other types of real estate investment without having to pay capital gains or depreciation recapture tax on the transaction.

You can also shelter a portion of your income from either investment from taxes. Bakken commercial real estate gets depreciated over either 27.5 (residential) or 39 years (commercial). This means that you can generally divide your basis in the building (but not the non-depreciable land) by 27.5 or 39 and take that as an annual deduction against your annual income. The IRS also lets you deplete oil and gas royalties. To claim depletion, you write off 15 percent of your gross royalties every year. Because depletion and depreciation are complicated, you may want to verify this with your accountant.

The Long Term

In the long term, the two types of investments diverge. Over time, oil and gas wells gradually run dry. While it could take decades, your mineral rights will eventually become essentially worthless. Bakken commercial real estate, on the other hand, has built-in intrinsic value. Even if the building loses value – which is common if you don’t periodically invest back in it – the land should still have some usefulness and some worth. Because of this, this may make the real estate a better investment for you, especially if you are looking on a very long time horizon.