Just as the natural world around us comes from the elements found in the periodic table of elements, capital markets are made up of asset classes, broadly organized into stocks, bonds, and hard assets like commodities and real estate.
As elemental as asset classes are to investing, it often makes sense to include some real estate investments in your globally diversified portfolio. That said, as with any investment, there are better and worse ways to go about implementing an otherwise sound strategy … with a lot of misleading misinformation out there to add to the confusion.
If you intend to invest in the market’s risks and potential rewards with informed discipline rather than as a speculative venture, most of the same principles apply, whether it’s for real estate or any other asset class. To help you avoid hanging out with the wrong elements (so to speak), let’s review those essential guides.
As with stocks, it’s wise to spread your real estate risks around by diversifying the number and types of holdings you own. By diversifying your holdings across a number of investments and a mixture of property types, you are best positioned to earn the returns that the asset class is expected to deliver, without being blindsided by holding-specific risks such as property damage, deadbeat tenants or unscrupulous property managers.
One way to achieve diversification is through a well-managed, low-cost Real Estate Investment Trust (REIT) fund, or a “fund of funds” combination of multiple REIT funds. As one REIT fund prospectus describes, this enables you to own hundreds of properties across a diversified range of domestic and global companies “whose principal activities include ownership, management, development, construction, or sale of residential, commercial or industrial real estate.”
Why bother with real estate? The magic word is “correlation.” As in 2013, “It’s really nice in times of volatile markets like now to have an asset class that may zig when traditional stocks and bonds zag. An asset with low correlation to others in your holdings can both reduce risk at the portfolio level and increase returns.”
In his July 2016 column, “,” Reformed Broker Josh Brown observes that, “Going back to the year 2000, REITs are the best performing asset class in the market, according to JP Morgan, up 12% on an average annual basis. … [I]t’s weird that people generally don’t focus on them.”
So, real estate can serve as a stabilizing force and a source of returns in your portfolio. But, like any investment, potential rewards are accompanied by notable risks.
Real estate investing tends to be relatively tax-inefficient. Domestic and international tax codes vary and change, with different treatments required for different kinds of real estate investments. Due to potentially unfavorable tax treatments on distributions, they are best located in your tax-sheltered accounts, lest the taxes incurred exceed the benefits.
Unlike publicly traded stocks, which can usually be traded with relative ease in busy markets, real estate ventures can be relatively illiquid investments that don’t always lend themselves to being bought and sold on a dime. This can be tricky for an individual investor purchasing them directly. It also can impact a fund investor. If the fund manager is forced to place ill-timed trades to meet popular demand, the trades can be costly for all shareholders.
Although an allocation to real estate can contribute to decreased volatility in your overall portfolio, the asset class itself typically exhibits a wide range of performance along the way. Some providers may try to mask this reality by playing fast and loose with their reporting strategies, but you really should expect a relatively bumpy course with your real estate holdings, whether or not it’s being reported to you as such.
Investors discovered these risks in 2007–2009 when generated a global credit crisis. Investors had been treating any and all real estate prices as sure bets, despite the underlying risks involved. As reported in “,” we’re seeing these risks play out again in the U.K., “in the shape of a concentrated sell-off of Open-Ended Property funds.” Investors in these funds are discovering that the return “smoothing” they thought they were enjoying may have been built on a house of cards. The columnist observed: “Just because a risk is not immediately visible, does not mean it isn’t there.”
In light of its potential returns and known risks, evidence-based investment strategy suggests that stocks and bonds are typically the staples in most investors’ portfolios, with real estate acting more as a flavor-enhancing ingredient.
Beyond this general rule of thumb, your personal circumstances also may influence the allocation that makes sense for you. For example, if you are a real estate broker, or you own a rental property or two as a side business, you may want to hold less real estate in your investment portfolio, to offset the real estate risks that you’re already exposed to elsewhere.
Incidentally, we suggest you avoid treating your home as a real estate investment. If it happens to appreciate over the years, that’s great. But don’t forget that its highest purpose is to provide you and your family with a dependable roof over your heads. This is one of several reasons your home is best thought of as a consumable expense rather than a reliable source of investment returns. For a heart-wrenching tale of what can happen otherwise, consider this powerful piece by Behavior Gap’s Carl Richards, “How a Financial Pro Lost His House.”
As always, the less you spend on your investments, the more returns you get to keep. Given that there are well-managed REIT funds that offer relatively cost-effective and efficient exposure to the asset class being targeted … why would you choose a more complicated alternative where the costs may be both insidious and excessive?
While it can often make sense to include real estate in your globally diversified portfolio, the advantages are accompanied by portfolio performance that may often deviate from “the norm.” That’s by design, to help you achieve your own financial goals, not some arbitrary norm. Given these practical realities, it’s essential to embrace a patient, long-term approach to participating in real estate’s risks and expected returns. If your time horizon or risk tolerance isn’t in line with such an approach, you may be better off without the allocation, to begin with.
If an allocation to real estate makes sense for you and your financial goals, the final ingredient to successful application is to select a fund manager whose strategies align with yours. Look for a fund that clearly discloses the investments held, the approach taken, the risks realized, and the costs incurred. Consider a provider who scores well on all of these counts; offers diversified exposure to domestic and global markets; and appeals to disciplined investors like yourself, who are less likely to panic and force unnecessary trading during times of stress.
Also, note that you may already be invested in real estate without knowing it. It’s not uncommon for a stock or hybrid fund to include a shifting allocation to real estate. Unless you read the fine print in the prospectus, it’s hard to know just what you hold, in what amounts.
Is real estate investing right for you? If it is, how much should you invest in, which holdings make sense for you, which account(s) should hold which assets, and how can you maintain control over your target allocations? These are the kinds of questions we cover when helping investors with their real estate investments, embracing each family’s highest interests as our personalized guide. Please be in touch if we can help you with the same.
Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.
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