Commercial real estate investing could be an option for adding alternative assets and balance to your retirement portfolio. Let’s explore why.
The current financial landscape may have individuals confused as to what’s next for their investments. Stock market volatility, climbing interest rates, stubborn inflation rates that keep persisting and a maxed-out debt ceiling — it’s enough to worry any investor.
But for those investors approaching retirement, this uncertainty can be compounded as they head into a period where they attempt to rely on the wealth they’ve accumulated for decades.
As an investor shifts from wealth accumulation to wealth distribution, what are the questions he or she should be asking when they evaluate their retirement portfolio?
The traditional 60/40 portfolio of stocks and bonds may not be the ideal investment mix for someone looking to manage risk with their investments. That’s why I’ve been a longtime advocate for creating a diversified portfolio that follows the tenets of Modern Portfolio Theory, or MPT.
Commercial Real Estate Investing Helps With Diversification
MPT is an investment strategy that allows investors to use diversification to manage portfolio risk while seeking increased returns. Using the principles of MPT, an investor’s portfolio contains stocks, bonds and alternatives such as real estate to create a more sophisticated mix of different investment classes. With a more diversified portfolio, the higher the level of risk you’re willing to take, the higher the potential you can receive better returns.
At Realized, we believe a balanced portfolio that contains alternative assets can help investors improve returns while managing risk. However, only 15% of workers have real estate included in their retirement portfolios.
Let’s explore why real estate, specifically commercial real estate, could be an option for an alternative asset in your retirement portfolio.
Why Alternative Assets?
Alternative assets, such as real estate, hedge funds and NFTs, were previously only of interest to institutional and high-net-worth (HNW) individuals. While they have become more mainstream in recent years, they can be considered somewhat riskier as they don’t have a very long track record and may not be as regulated (see the recent woes of the cryptocurrency market).
MPT principles suggest diversified portfolios should contain between 10% and 20% of alternative assets, but most individuals are falling short of that threshold. Institutional investors such as pension funds and endowments, typically have 30% to 50% invested in alternative assets, whereas most individual investors have only 5% of their portfolio dedicated to alternatives such as hedge funds, private equity and real estate.
Why Have Real Estate in Your Retirement Portfolio?
According to data from Griffin Capital, the average return in a portfolio of 60/40 stocks and bonds is around 6.86%, while a portfolio that has 55/35/10 of stocks/bonds/real estate has slightly higher average returns of 7.06%. An additional potential benefit of adding real estate to a portfolio is the volatility between the two portfolios decreased from 9.90% to 9.15%, respectively.
Many of our clients have used direct real estate as a way to diversify their portfolios and accumulate wealth over the years. However, the hassle of managing tenants and the risk of geographic concentration are factors to take into consideration when evaluating retirement goals and planning.
For investors who want to keep real estate in their portfolio without the daily responsibilities, transitioning into passive real estate ownership may be an option for them. By executing a 1031 exchange when they decide to sell their direct real estate, an investor can defer the capital gains taxes and invest their proceeds into another “like-kind” investment property, keeping more of their wealth working for them.
The like-kind property can either be another direct investment property or fractional ownership of a commercial property. Commercial real estate can be an option for investors who want the potential long-term benefits of investing in real estate without the hassle associated with tenant management.
Investors have the ability to invest in commercial properties such as industrial facilities or multifamily properties by using investment vehicles like REITs (real estate investment trusts) or Delaware Statutory Trusts (DSTs). These investments are professionally managed commercial real estate properties that pool real estate and financial resources from a group of investors. The investors receive the benefit of passive real estate ownership without the work of direct property management.
Let’s take a closer look at both of these options.
Delaware Statutory Trusts. DSTs give investors access to fractional ownership of commercial real estate properties like apartment complexes, retail centers and industrial facilities. They are established by sponsors who secure the funding, find a property management company and manage the day-to-day operations and decisions associated with the property.
Accredited investors are able to invest as little as $100,000 into a DST, and they can purchase fractional interests in these properties even if they do not live close to the property. Additionally, any debt acquired in creating the DST is held by the trust and not the individual investors.
With high inflation levels throughout most of 2022, investment property owners also likely saw the increase in operating costs cutting into their net profits if they owned traditional rental properties. With a DST, that financial obligation falls to the sponsor instead of the investor directly, which can help investors pursue a steady income stream throughout the investment’s holding period – a consideration for investors who are in the income-harvesting mindset instead of income-generating mindset.
Additionally, certain types of commercial real estate, such as apartment complexes, student housing and hotels, offer more potential for rate increases and adjustments than direct properties. The volume of tenants each building can hold, the number of lease renewals for apartment buildings and the daily rate updates possible with hotels provide owners with more opportunities to keep pace with market fluctuations.
REITs. A REIT is a company that owns, invests or finances real estate or real estate-related assets. REITs give investors the ability to invest into a larger portfolio of real estate, similar to how investors are able to invest in stocks. Similar to DSTs, they also offer passive investment, as the REIT’s underlying real estate is professionally managed by a third party and not the investor. There are several different structures of REITs, as well as different kinds of investments within the REITs themselves. The two most well-known forms of REITs are public REITs and private REITs.
Public REITs are registered with the SEC, and their shares are listed and priced on a national securities exchange. Shareholders can sell REIT shares at market price whenever they would like, but they are subject to a taxable event. There is no minimum investment amount to invest in a public REIT, and all management and operations decisions are made by the trust.
Private REITs are available only to institutional or accredited investors. Shares are not traded on public exchanges. Share redemption programs vary by company and may be limited or only allowed within a specified period of time. Private REITs usually have a higher minimum investment threshold of $1,000 to $25,000, as they are designed for accredited or institutional investors.
Whether an investor is building their retirement portfolio or assessing their investments before entering into retirement, there are opportunities and options available to them within commercial real estate. Consult with a financial or tax professional to learn more about the types of investments that best suit an individual’s income needs, risk appetite and investment objectives.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
David Wieland, is CEO and co-founder of Realized Holdings, a company that helps people manage their investment property wealth. He has architected more than $3 billion of institutional real estate and capital markets transactions. David leads Realized Holdings’ vision to help investors maximize their after-tax returns and create custom investment portfolios tailored to each investor's risk tolerance, long-term objectives and income needs.
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