As the U.S. economy enters a phase of greater volatility, more investors are focusing on diversification and asking if real estate is a good alternative to traditional stocks and bonds. Here’s how it can benefit your portfolio.
There’s one exception to this correlation factor — publicly traded real estate investment trusts (REITs), which trade like stocks on the public exchanges. REITs provide a convenient way to invest; however, the ease of selling also makes them a ready target for investors needing quick cash; the diversification benefits can be quickly lost if the REIT gets caught up in the momentum of a dropping stock market. Sometimes things can be too easy to sell.
When considering adding real estate to your portfolio, it’s important to be clear on the overall risk tolerance and investment strategy. For example, your goal might be cash flow to produce recurring income for living expenses. Or perhaps you’re looking for appreciation on capital and don’t mind the development risk associated with value add or opportunistic investments.
When considering adding real estate to your portfolio, it’s important to be clear on the overall risk tolerance and investment strategy.
In terms of what size to make a real estate allocation in your portfolio, a typical range would be 5–10% of a diversified managed portfolio. Where the investment allocation falls within the range is largely dependent on the real estate assets you’re buying. If you’re investing in a diversified core or core-plus real estate portfolio or fund you might be more comfortable with the higher end of the range. If the investment is in a higher-risk category or less diversified, then less than 5% of your overall portfolio might be more appropriate.
Next, if allocating to real estate from an existing portfolio of stocks and bonds, investors must consider where the funds for the real estate investment will be taken from. This largely depends on the characteristics of the investment — for example, a core-type property investment with good buildings and a steady income stream will have some fixed-income characteristics, so a portion of the allocation to real estate may be funded from a bond allocation. If there’s significant leverage, volatility, or speculation involved, then the additional risk would point to funding a majority, or all of the position, from equities.
The most important thing to understand is how all the different elements of the portfolio behave together. It’s client-specific, and there are no “one-size-fits-all” solutions. Always speak to your investment advisor relative to your portfolio, goals, risk and timeline.
Investing for diversification
So how do you achieve the benefits of diversification while avoiding the risk of highly liquid REITs? One option would be to build a portfolio of directly owned real estate properties in various geographies and of various property types. This method would require a substantial amount of capital and requires a significant level of management. Another alternative would be professionally managed private partnerships or investment funds. With this option, you can gain the expertise and scale of professional real estate managers and, through partial interests, the capital required is significantly less than trying to replicate this independently. Unlike a REIT, these less-liquid structures usually require investors to exit at preset intervals and provide the manager the option of stopping all redemptions if they can’t raise cash in an appropriate manner. While this may sound overly restrictive, it can be good protection because long-term investors won’t be harmed by other investors that are panic selling to raise cash.
Another alternative would be professionally managed private partnerships or investment funds.
Levels of risk in real estate investing
As with any type of investing, understanding your own risk tolerance and investment objectives is typically a good place to start in developing a real estate portfolio. Real estate strategies are broadly split into the following four categories based on the risk-return expectations of the investment:
- Core: Core assets typically have the lowest potential return but also the lowest risk. These are called “A” properties — those with the best locations and the highest occupancy rates. They’re the most stable properties in general and therefore the least risky for investors.
- Core-plus: Core-plus assets are similar to a core property but with a few deficiencies that demand more return for the additional risk taken. An example would be a property that’s historically been 95% leased being sold with 88% occupancy. Investors are taking the risk that they can lease up the property to stabilize returns.
- Value add: The classic value-add example is the purchase of a multifamily property that needs new floor coverings, appliances, and countertops, etc. In exchange for the additional capital investment, the investor expects to get a little more money in rent, and some additional return for the risk that construction will be on time, on budget, and that the assumed additional rent is achieved.
- Opportunistic: On the far end of the risk spectrum is the opportunistic development. These are typically “ground-up” developments or properties in significant distress that will go for a period of time without any cash flow — typically one to three years. Delays in construction, unexpected costs, and uncertainty around the future market and rents can also increase the project’s risk and thus these types of properties should have a higher level of expected return. One area of opportunistic real estate investing that’s been getting considerable media attention recently is opportunity zones. Opportunity zone investments can provide attractive tax incentives for the right investor, but it’s important to heed the mantra, “They don’t make a bad investment good; they make a good investment better.”
One area of opportunistic real estate investing that’s been getting considerable media attention recently is opportunity zones.
Evaluating a real estate investment
If a prospective real estate investment seems to be a good fit for an investor’s risk-return criteria, the capabilities of fund manager, its management, and specifics of the markets it covers should be evaluated. This includes questions such as:
- Fund manager: The main goal in underwriting a fund manager is gaining confidence on the proven capabilities to execute on strategy. Has the fund manager successfully completed similar projects and/or strategies previously? How does their track record compare to their peer group? How well has the fund manager put the deal together? Has adequate consideration been given to downside protection? Have risks been identified upfront along with the mitigants for that risk? Has the fund manager projected what could happen if the downside occurs and whether they’re comfortable with that return? This is especially important when considering how much leverage they will have on the property.
- Market volatility: Does the market (geography and property type) experience boom and bust cycles with very “high highs” and “low lows?” Or does it have a generally stable economy? At what point in the cycle will investors be buying?
- Diversification of property type: How diversified is the portfolio in terms of geography and property type? For a general investor, it’s important to diversify geographically as well as by property type.
Once you have gained comfort in the fund manager and their overall strategy a more detailed underwriting of the opportunity should be performed. In single property syndications, much of the detailed underwriting can be performed. Less information may be available for multiasset funds where some of the assets that will go into the fund haven’t yet been identified. In the latter scenario, you’re putting even more weight on the manager’s ability to execute on a strategy. Here are some of the key questions we consider when doing property level due diligence:
- Basis: What will be paid for the asset? How does this compare to the market for similar assets?
- Returns: What is the initial capitalization rate (net operating income divided by the purchase price)? How does this compare to the market? What will need to be done to maintain that level of return or increase it over time? What are the biggest risks to achieving expected returns? Consider these key categories:
- Revenue: Who are the tenants? What is their credit quality? What are the lease terms? Are there contractual rent increases in the lease that will raise returns over time? How easy will it be to backfill space at current rents? Are the market rents higher or lower than those of existing tenants?
- Occupancy: Can occupancy levels be maintained or improved, or are they at risk to decrease?
- Expenses: Has the property been managed well? Are expenses in line with the market? How do the projected expenses and expense growth rates compare with historical expenses at the property?
- Capital: Are there any capital improvements that will need to be made immediately? What capital improvements will be required over the lifespan of the investment? For example, if it’s a class A property with an investment period of 10 years, it’s important to consider which capital investments will be needed to maintain that class A level during the entire investment period.
- Management fees: What are the management fees at the fund level and the property management level? Fees can vary greatly and have a significant impact on the investor’s net returns and viability of the investment.
- Leverage: One of the areas a manager may try and increase investment returns is through the use of leverage. Is the amount of debt appropriate for the investment? Is the type of debt flexible enough for the risks associated with the investments? How does the maturity date of the debt line up with other major milestones in the project, such as a major tenant lease expiration? Beyond a senior loan, what other forms of debt or equity have priority before the investors’ position in the capital stack?
These are the questions investors should expect their advisors to ask when doing diligence on a real estate fund. We have a cross-disciplinary team of investment, underwriting, real estate, and tax professionals who work together to evaluate fund managers and underlying assets to ensure clients make informed decisions before deploying capital.
Plante Moran investment advisory team
Taking a top-down approach to real estate investing whereby identifying investments that fit within your overall investment portfolio as well as your real estate strategy and objectives, will aid in developing an ideal real estate portfolio for you. Given the complexity and potential risks associated with real estate investing, it’s a huge advantage to have a multidisciplinary team of real estate, tax, and investment advisors evaluating and structuring opportunities. We have the advantage of pulling in resources from anywhere within the firm to help provide attractive investment opportunities that fit within your overall plan.
To find out more about real estate as an alternative investment, give us a call.