Portfolio diversification is the ultimate advantage of reallocating funds into alternative real estate investments. Diversification is the primary factor in modern portfolio theory to reduce risk exposure. Reallocating funds into alternative real estate investments provides a nuanced diversification of the private real estate investor’s portfolio—between corporate equities, debt, and real estate, between liquidity and illiquidity, between correlated assets and uncorrelated, and between soft assets and hard assets for inflation hedge purposes. By investing in an alternative real estate portfolio one can substantially expand the degree of diversification beyond the traditional stock and bond portfolio.
Firstly, alternative real estate provides for multiple opportunities to diversify between offering types—DSTs, QOZs, private REITs (together with UPREITs), and real estate funds. Due to the offering structure, QOZs are better suited for real estate development projects, DST are better suited for more stabilized properties, and real estate funds are best suited for value-add opportunities. Furthermore, some QOZs are structured as funds and others are structured at REITs both with their own advantages and disadvantages. With appropriate planning, the private investor can diversify the risk between development properties with more growth potential, stabilized properties with immediate income potential, and more opportunistic value add properties.
Secondly, the various types of alternative real estate offerings include all the main property types or asset classes. Common asset classes are multifamily, office, triple-net retail, industrial, hospitality, and self-storage. Appendix E provides an important graph that measures the performance data for publicly traded REITs in these investment categories. In addition, alternative real estate investments include more specialized properties such as senior housing, medical office, student housing, manufactured housing, and built-to-rent communities. This smorgasbord of property types provides an outstanding opportunity for the private investor to build an extremely diversified real estate portfolio in high value real estate properties (greater than $100 million) at a low minimum investment of $25,000 (minimum investments in private REITs may be as low as $2,500).
Thirdly, alternative real estate investment properties are located throughout the United States providing an excellent opportunity for geographic diversification. An investor is not limited to investments in properties in one location but is able to invest in properties in different states, alternative coasts, various geographic market corridors such as energy in the southern states and technology in the northern states, cities with high population growth, cities with a large number of employers, or non-income tax states. Therefore, a key to geographic diversification is to allocate investments between varying economies, high growth areas, high household income areas, and more tax advantages jurisdictions.
Lastly, alternative real estate investments are offered to private investors through sponsors with various specializations, management philosophies, and track records. The best strategy is to not be limited to one sponsor. It is important to diversify various sponsors in addition to offering types, asset class, and geographic locations. Many of the alternative real estate offerings will have dozens if not hundreds of properties within a single offering. The private investor is presented with an expansive universe of diversification possibilities with built in safeties against the inherent risks of other markets, thereby, safeguarding invested capital while enjoying greater income potential and growth opportunities.
Strategies for Growing Even Greater Wealth
The strategic plan outlined above positions the alternative investment portfolio well to overcome market volatility, inflation, and taxation. Alternative real estate investments are non-correlated with the volatile securities markets. As we have demonstrated in the earlier chapters, institutional real estate has less volatility than stocks and bonds with only 4 down years over a 45-year period (figure #) and a natural hedge against inflation (figure #). This lack of volatility and hedge against inflation serves well to preserve investor capital. However, the goal of the private investor is not only to preserve capital but to also use these same challenges to the investor’s advantage grow even greater wealth.
Alternative real estate investments generate income on a monthly or quarterly basis. The income or cash flow generated may be sheltered from federal and state taxes and the growth of the net operating income from the property creates value over time and hedges against inflation. This tax-sheltered income is available to the investor to use at their discretion. If desired, any excess disposable income may be reinvested back into the stock and bond markets during periods of inflation and higher interest rates when stock values are lower, and bonds are providing greater yields. According to Benjamin Graham, “The intelligent investor realizes that stocks become riskier, not less, as their prices rise—and less risky, not more, as their prices fall. The intelligent investor dreads a bull market, since it makes stocks more costly to buy. And conversely (so long as you keep enough cash on hand to meet your spending needs), you should welcome a bear market, since it puts stocks back on sale.” Due to the continuous nature of the cash flow over the hold period (monthly and/or quarterly) the reinvestment into the traditional stock market is effectively on a dollar cost averaging method. Alternatively, disposable income may be accumulated and held in interest bearing savings accounts. The additional interest adds to the overall return of the investor’s portfolio and the cash savings may be deployed to reinvest back into the stock market during crisis events that create extreme stock market volatility. This transforms stock market volatility and bear markets into a buying opportunity by taking advantage of lower stock prices and maximizing growth potential. Thus, the traditional and alternative portfolios become a growth cycle that feeds on the other through dollar cost averaging, reinvestment of real estate cash flow into the stock market, and additional reallocations back into alternatives.
In an inflationary environment with higher interest rates promoted by Fed policy, the traditional bond market will experience downward pressure as investors seek higher yields. However, certain types of alternative real estate investments are protected against inflation increasing in value along with inflation. These alternative real estate properties have shorter lease terms and include multifamily with an annual lease, self-storage with a monthly lease, and hospitality with a daily lease. These properties are not only hard assets with intrinsic value that increase in value with the rate of inflation, but they can increase rents at or above inflation rates to not only keep pace with inflation but outperform inflation. The increase in the net operating income through rent growth provides an exit value using current market capitalization (CAP) rates. Please note that this does not include investments in singe family rentals as higher mortgage rates exert downward pressure on home values due to affordability.