Here are some guidelines on maximizing returns and minimizing risks when building your commercial real estate portfolio.
Millions of Americans invest in alternative assets, including real estate. It’s an important step to diversify a portfolio with investments that don’t necessarily correlate with the stock or bond markets.
Here are five tips to help construct a diverse real estate investment portfolio that has the potential to generate income and appreciation. At the end of the day, diversification does not guarantee profits or protect against losses, but it can potentially help!
Step #1: Diversify your investments by property type.
Investors should diversify their real estate portfolios by asset type (also known as asset class) to avoid the risk of over-concentration in one category or class of property, just as you avoid over-concentration in any one stock or single investment. That means investing in multiple types of income property, from multifamily to industrial to net-leased retail to self-storage to medical office.
Step #2: Diversify your investments by geographic location.
Investors should diversify their real estate portfolios across geography to avoid the risk of over-concentration in a particular local or regional market. In other words, make sure your investments are in multiple markets, ideally in different regions around the country to potentially insulate yourself from a single geographic event such as a hurricane, earthquake, sweeping rent control measures or other tenant- friendly laws or regulations that could disrupt investment performance.
Step #3: Avoid higher-risk and volatile property types.
All investment real estate is not created equal. Some asset types have demonstrated they are much higher risk and recession-prone than others. These include hotels and lodging properties, seniors housing in all its forms, and real estate used in the production of oil and gas.
Hospitality, for example, has been hit hard by all three recessions since 2000 and was especially disrupted by the COVID-19 pandemic as travel both for business and pleasure ground to a halt. Senior care is another sore spot, with seniors housing, assisted living, long-term care facilities and nursing homes all subject to regulations that increase the risk of operations and ownership, as well as laws that can greatly affect an asset’s performance. Oil and gas royalties and drilling, likewise, are subject to higher volatility by their very nature. If an oil well doesn’t produce as expected despite due diligence, the underlying asset value can take a serious tumble.
Step #4: Consider the different types of passive real estate investment options.
Unless you want to actively manage your investment properties, passive real estate investments can be the way to go as you are searching for real estate investment opportunities that you don’t have to manage yourself. There are a range of options to choose from, including publicly traded real estate investment trusts (REITs), Delaware Statutory Trusts (DSTs), Tenants-in-Common (TIC) properties, debt-free real estate funds (those that do not have long-term mortgages associated with them, which reduces the risk potential to investors) and private equity funds, including Qualified Opportunity Zone (QOZ) funds.
REITs: The market for publicly traded REITs is well-established, and many people access the market through their retirement plans and stock brokerage accounts. REITs are typically companies that own and operate real estate, so you’re investing in the company, not just the underlying real estate. REITs pay out their income in the form of dividends, which are taxable. The biggest downside to REIT investments (aside from the high correlation to the overall stock market and the volatility it ensues) is the absence of a key tax benefit (see Step #5 below).
DSTs: Most types of real estate can be owned in a DST, including industrial, multifamily, medical office and net lease retail properties. Often, the properties are institutional quality, similar to those owned by an insurance company or pension fund. The asset manager takes care of the property day-to-day and handles all investor reporting and monthly distributions of the properties’ potential cash flow to investors.
TICs: A TIC structure is another way to co-invest in real estate. With a TIC, you receive a pro rata portion of the potential income and appreciation of the real estate. As a TIC investor you will typically be given the opportunity to vote on major issues at the property, such as whether to sign a new lease, refinance the mortgage and sell the property.
QOZ Funds: A fund of this type can invest in real property or operating businesses within a so-called Opportunity Zone, typically a geographic area in the U.S. that has been so designated because it may be underserved or neglected. The time horizon of the fund may be as long as 10 years, which means tying up your capital for that length of time in an illiquid real estate fund.
Step #5: Recognize the potential tax benefits of real estate investing.
Real estate in the form of direct ownership is one of the most tax-advantaged investment classes in the United States. Depreciation deductions are available to all investors, and any real estate investment losses may be deductible against other income, which could potentially reduce your tax bill. Additionally, direct real estate investments qualify for like-kind exchange treatment, otherwise known as a 1031 exchange, which can save investors approximately 40 percent on their tax bills when there are net gains on property sales.
Notably, of the four investment types discussed above, only DSTs and TICs qualify for the highly attractive 1031 exchange tax treatment, regardless of when assets are sold. In contrast, with QOZ Funds, there are some potential tax benefits if the investments are held for the required period of time. With REITs, all gains (if any) are subject to full capital gains taxation.
So, what might a diversified, passive (management-free) investment real estate portfolio looks like? Here’s how one investor could allocate $500,000 into commercial and multifamily real estate to potentially generate passive income and appreciation:
- Invest $100,000 in an industrial warehouse distribution facility with a long-term net lease to a company like Amazon, FedEx, Coca-Cola or Frito-Lay
- Invest $100,000 in a medical dialysis center with a long-term net lease to a company like Fresenius or DaVita
- Invest $100,000 in a multifamily apartment community with 300 units in Texas
- Invest $100,000 in a self-storage facility in Florida
- Invest $100,000 in a debt-free multifamily property with 60 units in Tennessee
With a passive real estate portfolio like this, the investor may be diversified by asset type, tenant base and geography. They’ve avoided more cyclical and highly volatile asset classes such as seniors housing, assisted living and long-term care, hotel and resort properties, and oil and gas royalties and wells. The investor should also prudently consult with their accountant and attorney about the potential risks and tax advantages of real estate investing, including 1031 exchanges that allow the tax on gains to be deferred.
This is a great place to start.