At a recent seminar on real estate investing as part of a family’s asset allocation, presenters and participants categorized real estate as an alternative investment to publicly traded common stocks and bonds. This statement assumes that common stocks and bonds are the primary asset classes that serve as the core positions in a diversified portfolio. 

The word “alternative” implies that something has similar result possibilities while achieving them with different risk characteristics than the primary or generally used options. If that’s the definition one uses for asset classes other than stocks and bonds, then real estate would fall into the alternative category. However, if we consider the qualifications of a long-term investment, it becomes apparent that real estate isn’t an alternative investment, but rather a primary one, from which other asset classes should be judged.


Long-term Investment

Before determining the role of investment real estate in a diversified portfolio, investors should identify the qualifications of a long-term investment. Doing so will allow investors to determine what asset classes should be included and the allocation breakdown among them.  

To understand what these qualifications should be, it’s essential to establish clear and concise goals for the portfolio. Such goals could be as simple as “a portfolio constructed so as to have a low probability of permanent capital destruction that generates income and real growth necessary to meet desired or required distributions.” It’s from the fulfillment of this simple statement of investment objectives that the decisions as to what should be invested in are made.

Based on the investment objectives stated above, real estate should be viewed as a core holding commensurate with publicly traded stocks, bonds and cash equivalents. In addition to the core holdings, real estate investments should also play some role in the more opportunistic portion of a portfolio. Consequently, in garnering portfolio allotment positions in both the core and opportunistic allocation, real estate investments could collectively reach 20 percent to 25 percent of the total portfolio. This is especially true in multigenerational investment entities, such as generation-skipping trusts and family investment companies.

So, the question that needs to now be answered is, “How do we access this asset class to participate in the full scope of benefits available?”


Property Types

The first step is to explore the various property types and requirements for participating. These requirements could be minimum size, costs and the liquidity available to acquire the properties. At any given time, there are sectors within the real estate market that are in and out of favor. As with the ownership of operating businesses that have a myriad of specialties, real estate may also be acquired having specific uses. These various categories are also called sectors, just as in the stock market. They include such uses as pre-development land, office buildings, warehouses, retail centers, build-to-suit single tenant specific needs buildings and multi-family residential properties, to name a few. Real estate can be held in concentrated geographic areas or broadly diversified, both domestically and internationally. In addition to the real estate sectors, there are two basic categories to consider when evaluating the role that real estate should play in a portfolio asset allocation: core holdings and opportunistic investments. 

Core holdings. These are properties acquired based on solid fundamentals. Families should look for characteristics such as the quality of the location, tenant lists and lease agreements in a core asset. The property’s ability to provide sustainable and reasonably predicable cash flow and value appreciation to meet the constant impact of annual inflation on the real value of the property are key points to determine. Generally, such core positions don’t provide the proverbial short-term big pop in value often seen in more opportunistic purchases. They’re holdings that are reliable sources of steady returns. Core real estate holdings, on an aggregate basis, should be expected to provide returns that meet or exceed other equity asset classes within the portfolio.

Opportunistic investments. These investments will vary in return results as markets go in and out of favor.  Such investments are made available when markets go through normal or even extreme ebb and flow in performance.  

These descriptions, core and opportunistic, are similar to those that would apply to investing in publicly traded common stocks. A core position is likely to be comprised of companies that have solid financial fundamentals, are leaders in their product markets, have a history of long-term operating results that keep earnings consistent with adjustments for annual inflation and provide rising cash flows to investors in the form of dividends. Opportunistic investing in publicly traded stocks that have declined due to general market conditions versus changes in their fundamentals may offer the same big pop as found in other depressed price assets when normal valuations return.


Range of Structures

The range of options for real estate investments come in the same structures as those used to purchase stocks and bonds. Families can purchase properties directly, and those properties will comprise a diversified group of holdings just like a private individual stock portfolio. Or, families may acquire properties through a commingled entity, such as a partnership or real estate investment trust (REIT). Various commingled entities often offer diversification over a wide range of geographical locations, as well as among the various specific sectors. Again, the commingled options for real estate investing are similar to the many opportunities to build such diversification in public stock or bond asset classes. As with any commingled investment option, families should explore the manager’s financial participation with the endeavor and the conflicts of interest that may be present before making a final decision.

Real estate also uniquely protects a portfolio from two permanent destroyers of wealth: (1) government tax and economic policy; and (2) investor market timing decisions. Real estate provides characteristics that uniquely equip it to meet these two distinct challenges.   


Tax and Economic Policy 

Real estate is subject to the impact of tax policy on both the earnings from property rents and the capital gains on the sale of the property. Direct ownership of real estate offers the ability to take advantage of depreciation of the property values against some or all of the ordinary income earned. On the negative side, unlike marketable securities, direct ownership real estate is subject to property taxes from the local government. Such taxes, however, are typically deductible from income subject to federal income tax.  

When assets pass from one owner to another via gift, versus sale at fair market value, the Tax Code requires a gift tax to be paid. While there’s a generous personal lifetime exemption value, currently $5.12 million plus the annual gift exclusion amount of $13,000 to as many individuals as desired, the tax on transfers above either of those exemptions is now at 35 percent. If gifts are made that skip one generation to provide benefit to another, there’s a generation-skipping transfer tax.  

Real estate investments are treated favorably when determining transfer tax liability. Since, other than publicly traded REITs, an appraisal is required to determine the tax valuation, there’s room for negotiation with the Internal Revenue Service as to what those values were on the date of the transfer. In many instances, significant discounts to a timely liquidation value are provided, thus reducing the amount of tax due. Such reduction in values subject to tax helps protect the family wealth from non-market destruction in value. By including real estate as a major portion of a family wealth portfolio, liquidity is available from the daily market-priced securities, and discounts to liquidation value on the real estate provide a lower overall tax burden as the assets pass down generational lines.  

Claims can be made that structuring publicly traded stocks in a family limited partnership may provide similar discounts to net asset values. However, there’s been pressure to eliminate such discounts on partnerships that exclusively hold publicly traded securities. Including real estate positions along with publicly traded securities helps substantiate why such discounts should continue to apply.

Regardless of what tax liabilities are imposed on income or the transfer of assets, real estate investments will most likely continue to provide more benefits than other more liquid, daily priced securities. Such benefits add to the bottom-line total return without adding additional market risk. For family wealth preservation, these additions to net returns are very beneficial.

Another government-influenced source of wealth destruction is the impact of annualized inflation on real estate values. Real estate offers a very positive result when there’s long-term inflation in the economy. At a time when interest rates are low on debt instruments, such as bonds, income from high credit quality income real estate provides an extra yield, plus a safeguard against future inflation. Structuring portfolios with a significant allocation to asset classes, such as real estate, which will generally pass through the impact of long-term inflationary pressures, is critical to preserving the real value of family wealth.


Market Timing

One of the major, and perhaps the most prolific, destroyers of wealth is a poorly thought out or emotionally driven investor decision. One such activity is deciding when to enter or exit an asset class based on a perceived information advantage over others who are making similar investment decisions.  

It’s all too common for an investor to act on media coverage surrounding macro economic or geopolitical events. Such information will cause a nervous investor to flee the markets for cash. Typically, such a decision, when made by the majority of investors, constitutes the bottom of the market. The difficulty they then face is when to redeploy their assets. Unfortunately, while out of the market, the after-tax real returns are generally negative. Sustaining a loss in the portfolio going forward becomes certain. As previously stated, the next challenge is to determine when to go back in the markets. History shows that most investors enter and exit the markets at the wrong time.

“Impact of Market Timing,” p. 53, illustrates the impact on long-term portfolio values of market timing, providing a contrast between buy and hold returns for various asset categories and those achieved by the average investor. It’s clear that the average investor was making decisions during this measured period that impacted the investor’s long-term results.  

Another observation of the 20-year asset class compounded returns is that all categories provided a positive real return. All categories offered the ability to the wealth owner to preserve the family wealth, when adjusted for the 2.5 percent annual inflation rate, plus provide real growth. In the case of the S&P 500 index, that real growth was 5.3 percent per year. (To calculate the annual real return, simply subtract the annual inflation rate of 2.5 percent from the nominal compounded annual return of 7.8 percent.)    

Another market timing challenge occurs during speculative periods of the market. When things are going strong in the market as a whole or in a sector of the market (for example, the tech sector), the challenge to protecting wealth comes in the form of group think.  As in the case of a declining market, when investor fear sets in, it’s not uncommon to see a mass exit to cash. The opposite timing experience happens when speculation bubbles occur. Here, the fear isn’t losing wealth, but rather, being left out during its creation.    

Old economy stocks were perceived as doomed during the tech bubble. Investors at the highest levels were in lock-step with the popular conclusions. “This time it’s different,” was the rallying cry.  Well, it was different. The destruction in value for tech sector investors was devastating and, in many cases, permanent.

Whether it’s group fear or group euphoria, all such decision traps can cause a destruction of wealth. It’s very difficult to be wrong, but it’s human nature when wrong to not want to be alone. Justifying an inquiry from family members of “Why didn’t you see it coming, everyone else did?” is a difficult position for most to find themselves in. Consequently, investors, including professional money managers, often make herd-based decisions.

Real estate, due to its lack of liquidity and high costs of converting to cash, provides a buffer against group decisionmaking. Avoiding the wildly popular strategies of the moment provides portfolio stability and reduces the chances of investor error. Since there’s little investors can do with core real estate holdings to meet short-term reactions to popular thoughts or fears, the assets continue their long-term strategy without interruption. Thus, they generally outperform the average investor portfolio. On the other hand, investors making opportunistic real estate allocations may be enticed to chase riskier deals or increase the leverage on the properties. Both can have significant wealth destruction exposure.


Zero Sum Strategies

Another form of investor decisionmaking that can destroy family wealth is that of a high allocation of the portfolio to investing in zero sum strategies. Zero sum strategies are likened to gambling, which is an “I win, you lose” game. There’s no creation of wealth, only a transfer of it from one individual to another. There are certainly some opportunities in trading assets under a zero sum scenario that make sense and should be part of the opportunistic allocation portion of a portfolio. Nonetheless, it’s not core investing and shouldn’t be confused as such. The ownership of productive or real assets creates wealth as the economy grows over time. Under a core investment structure, holding high quality assets doesn’t require the gain by one investor to result in a loss by someone else in order to work. Real estate, purchased at reasonable prices and held over a time, offers a format and resale characteristic that discourage zero sum trading. Marketable securities having high levels of liquidity present temptations to actively trade them. While some do well with a zero sum trading strategy, most don’t. Day trading, speculation in short-term price movements and using information that gives an advantage is typically a formula for destroying family wealth. The lack of liquidity of real estate is a blessing in taking that portion of the asset allocation off the gaming table.  


Additional Wealth Benefits 

Owning properties directly requires active management. It requires rents to be collected, roofs repaired, insurance purchased and tenant problems solved. Most real estate portfolios employ leverage to add to returns on the capital investment. This is both a positive and negative feature of real estate. Regardless of how leverage is employed, management of bank and non-bank lending relations is ongoing and requires special efforts and skill sets. 

A portfolio of individual properties offers the family an opportunity to be in the real estate business. In many instances, this, in turn, provides opportunities for rising members of the family to participate in the management experience, including mowing the lawns or other maintenance or administrative activities. These seemingly basic work activities provide family members an opportunity to participate in the family real estate business. For some family members, such involvement won’t work. They’re busy in their own lives, have little or no interest in doing so or are concerned about their lack of understanding of how to handle the assets within the portfolio and, thus, require professional assistance. For others, the family real estate holdings may offer personal opportunities for growth and meaningful engagement. Regardless, real estate owned and managed within a family system extends potential benefits well beyond return on capital. When family members are interested in pursuing participation in the assets of the portfolio, real estate provides significant training and future management options, unlike other, more passive, assets.