Financial advisors tell clients to maintain a diverse investment portfolio. This tactic helps reduce risk. In the context of securities, diversification may be as simple as buying several different stocks or investing in a fund that holds many stocks.
Diversification in real estate works much the same way.
Investors can help diversify their real estate portfolios by:
A common reason people buy rental real estate on their own is to maintain full control over the investment. They can make independent decisions about leasing, operations, capital improvements, financing and disposition. This is particularly important if you need liquidity for your investment. Sole ownership also allows you to choose your asset class and location, as well as the degree of risk. For example, a stabilized property with a long-term tenant under a net lease will be less risky than a ground-up development or a property with substantial vacancies. Owning a property on your own presents both benefits and disadvantages.
As a sole owner, property management will be among your most important operational choices.
You will have to do your own due diligence to assess what type of work, if any, will be needed during your intended holding period. You can also decide whether to make capital improvements to the property. These are improvements to a building’s structure that will extend the useful life of the building, such as a roof replacement; potentially raise the value of the property, such as upgrading kitchen or bathroom cabinetry; or make the property more desirable for a tenant, such as adding or removing interior walls. You will decide when to do them and how to pay for those improvements.
If you want to use leverage (mortgage debt), you will be able to select your lender, and also adjust the loan amount and terms, which include:
Note that if you take out a mortgage loan, you usually need to provide some type of personal guarantee for the debt. This may be in the form of non-recourse “bad boy” carve-outs (covering your own actions with respect to property ownership), environmental indemnities, or full personal recourse (lender can recover loan deficiencies from your outside personal assets). The extent of the guarantee required depends on the borrower’s experience, credit, and relationship with the lender, as well as the credit and stability of the tenant.
The most significant trade-off for the freedom of sole ownership is tying up your capital in one project.
You can diversify your investment by buying a mixed-use asset (i.e., a storefront with offices or residential spaces) or a multi-tenant commercial asset. This strategy helps mitigate risks associated with a single tenant or industry. However, your investment is still limited to a single location in one market. If that market declines for any reason, or expenses significantly increase, you won’t have as much return on your investment, or you may have difficulty selling the property profitably.
One alternative to avoid having all of your proverbial eggs in one basket is to invest in a professionally-managed real estate fund. Funds can take many forms, including public or private REITs or private placements.
A REIT is a real estate investment trust—a business entity that owns and operates a portfolio of real estate. Rather than buying real estate directly, you will acquire shares of a fund that owns the real estate. Investors receive periodic distributions of income and financial reporting based on the number of REIT shares they purchase.
Real estate funds also allow investors to buy a share of a larger portfolio or asset. In addition to distributing income and providing reports, these investments typically pass through to investors the tax attributes relating to the real estate. This includes both income tax obligations and depreciation deductions.
A REIT will have investment guidelines identifying the type of properties that it may own. The guidelines may be broad, such as industrial properties, or narrow, such as grocery stores. REIT holdings can include both real estate and mortgage loans. These trusts need to distribute 90% of their taxable income to their investors as dividends.
Publicly-traded REITs are traded on stock exchanges, so they provide easy liquidity. Like mutual funds, they make disclosures and public filings as required by the SEC. There are also private REITs whose shares are not traded; those investments are illiquid.
REITs are professionally managed. The properties they buy are vetted by people with experience in the real estate industry. The REIT’s professionals will also assess the physical structures, the locations and their tenants. Underlying investors have no voice in how the properties are operated, financed, or sold. REITs often get funding from institutional investors, so the credit and quality of the underlying assets tend to be high. Reporting is provided on a prescribed basis, and financial results are usually audited by a reputable, national accounting firm.
If the REIT is publicly-held, you will be able to liquidate your investment by trading your stock at any time.
Besides REITS, there are also privately-held real estate investment funds. Like REITs, these investments are professionally managed. They may be offered by a financial institution or a private real estate company. The managers acquire, operate and dispose of properties on behalf of their investors. Such funds work like private REITs, but without a legal obligation to distribute a specific percentage of income to investors. However, the fund is likely to be structured in a way that allows investors to benefit from certain tax advantages of direct real estate ownership. This is especially important for Qualified Opportunity Funds that are structured to shelter capital gains through investments in properties located in designated Qualified Opportunity Zones.
Before investing in either a REIT or a real estate fund, you will receive an offering memorandum that states the following:
Among the cons is a lack of control on the part of individual investors, and fees charged compared to those earned through sole ownership. Depending on the size and nature of the fund, assets may be bought or sold after you invest. This makes it harder to know exactly what properties are part of the portfolio at any point in time.
Fees may include:
These types of investments are likely to engage professionals in larger firms with national reputations.
Another alternative to diversify your real estate holdings is to invest in a private real estate syndication. Syndications are a type of investment where many unrelated parties put their funds together to acquire a property or a group of properties sharing such characteristics such as a similar location or tenant. Syndications are put together by professional sponsors who enter into contracts to do the following:
Most syndications state which properties they own or will acquire before accepting investor funds. You will also receive information and disclosures similar to what is provided for investors in REITs and larger real estate funds.
Syndicated investments are usually structured as limited liability companies (LLCs) or limited partnerships. There are also Delaware Statutory Trusts (DST) syndications that are structured to qualify as replacement property for tax-deferred “like kind” exchanges (1031 exchanges). Investors acquire interests in the entity that owns the property, rather than holding title in their own names.
Unlike REITS, interests in syndications are not traded on public exchanges. These interests are historically illiquid. However, Crowdfunding sites are emerging as a market for fractional interests in existing syndications as well as new investment opportunities. Investments in syndications often have restrictions on transfers, such as prior sponsor or lender approval.
Like real estate funds, syndications are not legally bound to distribute a certain percentage of their income to investors. While this may seem like a disadvantage from a cash flow standpoint, it gives the sponsor flexibility to maintain reserves or to pay for major expenses out of cash flow instead of making a capital call or diluting investor ownership percentages by bringing in additional investors.
Syndications will also have fees that are borne by investors, including up-front costs, ongoing fees for administration and operations, and disposition fees or “promotes”. However, typical returns for syndications are higher than yields on a REIT investment. Individual investors may communicate directly with sponsors about property operations depending on:
Sponsors have more control over the timing and nature of the investment’s disposition strategy than an REIT or fund because there is no fixed fund liquidation date.
There are many alternatives to help with real estate investment portfolio diversity. All real estate investments involve risk. You need to consider the level of experience and integrity of people acquiring, managing and selling the assets.
The party could be you or outside professionals. In any case, it is important for you to do your own due diligence to understand the risks, costs, and potential rewards of your investment. In addition, a truly diverse investment portfolio will include a variety of asset types, including cash, securities, fixed-income assets (e.g., bonds) and hard assets (e.g., real estate).
©All Rights Reserved. May, 2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM
Tracy is a Principal at Syndicated Equities where she helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas…
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