Building a portfolio requires an accurate assessment of your personal financial objectives, but sometimes the biggest challenge is knowing the best questions to ask. While you will need to develop additional questions tailored to your unique situation, and consult your personal professional tax, attorney, and money management team, these 10 questions can provide a framework when determining the best investment types for your portfolio.
1. What holding period works best for me?
Are you looking for an investment over a shorter time frame (1-3 years), or are you able to commit capital to an investment that may take 7-10 years to fully realize its value?
At MLG Capital, over our last 30 years of investing in real estate, we’ve held assets an average of ±6.5 years. Due to this our funds typically target investment asset holding periods of 5-8 years. This time is necessary to acquire a property, take active steps to improve the cash flow/asset value, and eventually exit the property, realizing maximum value for our investors.
2. What Level of Liquidity Do I Need from My Portfolio?
Do you want to generate cash flow for living expenses? Do you have other assets/income streams you can use to finance your lifestyle? Do you need access to your capital in a short timeframe? These are important questions to consider before committing capital to an investment.
Liquidity concerns tie-in with holding period; an asset that requires a longer holding period is typically less liquid than traditional public equity assets. For example, private real estate investments are less liquid than say, the IYR, or iShares U.S. Real Estate Real Estate ETF, which tracks the performance of public REITs. While a private real estate investment is illiquid, in exchange you receive the potential to hit targeted returns that can substantially outperform the public markets (sometimes referred to as a “liquidity premium”), with limited correlation to the public markets.
Many times an illiquid investment will have current cash distributions from operations with appreciation targeted over time.
3. Am I Going at It Alone, Or Am I Partnering with An Experienced Manager?
Say you are a business owner who has just experienced a liquidity event (you sold a business, or idea, you built from the ground up, for example). You’ve translated sweat equity into cold hard cash, and now you want to protect and grow this cash.
Given your prior success, and your entrepreneurship mentality, you may want to jump into new ventures headfirst.
This may be a costly miscalculation. While you may have had the competencies and background to succeed in one industry, entering a new field with minimal experience may not result in the returns you expected. Commercial real estate has a steep learning curve, and may take years of trial and error to fully grasp the intricacies of property acquisitions and performance.
Warren Buffett famously has been quoted saying, “Risk comes from not knowing what you’re doing”
On the other hand, if you realize the difficulties and educational challenges of going it alone, you can capitalize on the expertise of others (such as MLG Capital), and invest in a private real estate syndication. While you will be a passive investor, private real estate funds typically structure their deals to provide a preferred return (for example, 8%) that accrues along the way, with the manager sharing in the upside, or appreciation. Specifically, MLG Capital’s funds accrue an 8% preferred return, and only once the preferred return is paid, plus a return of the full original principal, does MLG share in the upside with investors.
4. What is My Risk Tolerance?
Risk and return are the yin and yang of any investment. While some real estate investment strategies can be considered lower risk (such as a Core strategy), the returns generated from such strategies (example, purchasing a Class A office building in a “Gateway” market such as New York City) are typically on par with a bond-like investment.
On the other end of the spectrum, a more aggressive “Opportunistic Play” (such as investing in the conversion of a vacant office building into a residential multifamily building, or even a hotel) could generate a greater rate of return, but can leave you with greater exposure to risk.
Lastly, leverage creates risk. The larger use of leverage in deals, along with other market risks, leaves more room for the potential of capital loss. Every real estate investment, conservative or aggressive, is different, and requires a competent team of professionals best able to separate the truth from the hype. You should only pull the trigger on deals that provide risk-adjusted targeted returns, with verified support of the overall targeted returns. Afterall, private real estate investing is comprised of deep trust and verification of that trust!
5. Why is Public Market Correlation an Important Consideration?
Although there are numerous investment vehicles for real estate exposure, not all real estate investment vehicles have equal public market correlation.
The IYR (iShares U.S. Real Estate ETF) is heavily correlated with the public markets. Any investment in a public equity (REIT or operating business), will have some market risk, no matter the specific factors affecting the company’s performance.
On the other hand, private real estate investments have typically had a low-correlation to the overall public markets. Their performance has had little correlation with the performance of the stock market.
To build a portfolio with an appropriate level of risk and strong potential for compounding of capital, it’s important to consider alternative investments with a low-correlation to the public market, such as private real estate.
(This chart shows the correlation between the IYR ETF (Public REIT ETF), the S&P 500, and NCREIF (A barometer for private real estate compiled from pension and CRE buyers)
6. What Tax Implications Should I Consider Before Investing?
Real estate serves as one of the most tax-advantaged investment vehicles, with depreciation at its core. Depreciation enables businesses or investors to deduct the cost of tangible assets over time. These deductions can reduce the overall taxable income of a business, which decreases income tax liability.
Other tax advantages may apply to a real estate investment. For example, a 1031 exchange allows for the deferral of gains from the sale of a property.
Any of these strategies require the advice of a tax professional well-versed in sophisticated real-estate tax planning combined with a real estate manager that has a deep bench of tax oriented planning and talent.
MLG Capital views tax planning for our assets and funds in a granular manner. We have several CPAs on staff as well as a tax director. Our opinion is to find the best real estate deals first, and then worry about the tax implications by wrapping exceptional tax planning around the asset.
Always consult a tax professional before making an investment. They’ll have the most up-to-date knowledge, and largest breadth of insight to advise you on your best course of action.
7. What Do I Do with Excess Capital?
For high net worth investors, excess capital typically comes in two forms. Either it comes from a liquidity event (sale of a business), or from ongoing cash flow (either from a business or highly paid profession).
If you’re considering an investment of excess capital, you may be interested in considering a balanced portfolio with lower risk tolerance. Effectively, this means prioritizing capital preservation over capital growth, ideally having vehicles that fuel both objectives!
Private real estate may be the best opportunity to pursue this strategy for your excess capital as it typically has cash flow distributions along the way, and appreciation over time. Seeking an experienced manager with an investor advantageous business model can help achieve both of these objectives.
8. How Much Volatility Can I Tolerate?
When considering your overall portfolio picture, it’s important to understand your volatility tolerance. For example, if you have most of your assets tied to the public markets and the markets enter a severe recession, how do you protect yourself?
Historically, private real estate investments (as tracked by the NCREIF index) have had lower volatility relative to public market indices such as the S&P 500 and IYR (iShares U.S. Real Estate ETF).
A diversified approach to combining lower-volatility focused investments (such as private real estate) can create long-term compounded returns exceeding those of a higher volatility portfolio (such as a public REIT or individual stock investments).
9. What Level of Diversification Will This Investment Provide?
Diversification can happen on many different levels when building a portfolio. Along with diversification among asset classes, it’s desirable to also diversify within an asset class.
For the real estate portion of your portfolio, it may be beneficial to diversify your property investments. MLG Capital’s funds, for example, enable you to meet substantial geographic, asset class, and asset vintage diversification, all in one place, with an experienced manager.
Historically, private real estate investing occurs on a local basis based on a big concentration of what and who you know within one or two metropolitan areas. MLG Capital invests in multiple markets. We also invest in multiple property types, including multifamily housing, industrial, retail, and office space, in order of preference
MLG’s funds typically target an investment into 20-25 properties per fund, spanning multiple markets and multiple asset types. This level of diversification can better serve your investment objectives when considering diversification.
10. How Will Interest Rates Affect My Investment?
Though other uncertainties (political changes, natural disaster, tax policy changes, changes in insurance costs, and climate change) can affect performance, interest rates may play the biggest macro role in a real estate investment.
Real estate has historically outperformed stocks and bonds in inflationary/rising rate cycles. In a market environment where the PE ratio of the S&P 500 is 24, this looks can appear to be a likely scenario.
Ironically, in uncertain times, interest rates are typically driven lower to spur economic demand. This interest rate drop increases the value of hard assets such as real estate.
Times of market euphoria can lead to increases in interest rates, impacting real estate valuations. This correction is a counter to the higher demand and higher operating incomes generated in frothy markets.
Cap rate changes are not proportional, but are correlated, to interest rate changes.. If interest rates and cap rates go up, it is likely due to a stronger economy. A stronger economy allows for increases in rents/cash flow from a property.
MLG Capital understands the inflationary cycle’s role in real estate investing. By taking active steps (property improvements, leasing, leverage) steps to grow operating income, we can do a lot to offset a worsening in valuations (cap rates) caused by higher interest rates (Underwriting conservatively on an exit).
Here’s an example of how rents can increase in a strong market experiencing increased interest rates:
- If a multifamily property had an NOI of $1 million at acquisition, and cap rates grow from 5.46% to 6.3% during the hold period, to retain the value of the equity, the NOI must grow by 15.4%.
- Such growth would require gross rental revenue growth of 7.7% during the holding period (or 1.55%/year).
- There is also the impact of inflation to consider: however, as multifamily leases are typically short-term, rents can be raised to counter increases in operating costs.
A strong understanding of the inflationary cycle requires optimal use of leverage. Examples including using short-term financing (allowing for refinancing once rates come down), as well as using interest-only financing (which removes the principal pay-down element). Removing the principal pay-down element improves the cash-on-cash return.
Here’s an example of how we may approach the use of leverage taking into account the inflationary cycle:
- A Class B or Class C multifamily property is purchased using 40% equity and 60% debt. The debt is interest-only, and matures in 10 years.
- Class B and C assets currently trade in the 5.5% to 6% cap rate range.
- If the 10-year treasury is at 4%, and the interest-only debt employed in the deal is at 5.25%, the investment will achieve a 7.125% cash yield on a 6% cap rate asset.
Now compare a 7.125% yield buying a Class B low levered apartment property (60%) to the risk-free yield of 4% of US Treasuries. We think there is a worthwhile opportunity at this yield difference.
Despite these cap rate changes, the market finds a way to do deals. Higher cap rates (8% range) have not been seen since the early-to-mid 1990s. Highly leveraged central banks requires low interest rates. Assuming the financial condition of the United States does not change, 10-year treasuries will continue to generate lower yields (1.75%-4%) for the coming decades (opinion).
This creates difficulties in modeling for higher interest rates. An interest rate spike will cause economic damage, which again could result in lower rates.
The impact of the inflationary cycle on investment returns makes it an important factor to consider when determining the fit of any investment opportunity.
(you’ll notice that in inflationary cycles private real estate outperforms even gold, because of current income from rents. After all, if there is an inflationary cycle it is common that wages will also rise, causing increases in rental rates)
While these 10 questions are only the starting point when determining the best investment type for you, they provide an outline in generating additional questions more specific to your needs. MLG Capital is not recommending a portfolio structure or advocating for any certain investment. As always, contact your planning professionals for consideration on your unique personal situation.