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Alternative investments: Real estate as a portfolio diversifier

April 21, 2020 / 9 min read

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.

For the right investor, real estate can be a good way to generate passive income and create long-term returns. And with the equity and bond markets facing alarming levels of volatility, it can also be a good diversifier in a managed portfolio — when stocks or bonds take a downward turn, directly owned real estate doesn’t necessarily drop with it, thanks to its low correlation with those markets.

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.

Portfolio considerations

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, although a professional asset manager can assist with these responsibilities. 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:

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:

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:

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. 

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