We talk a lot about stocks and bonds, two of the largest asset classes in the capital markets. But we don’t spend a lot of time on hard assets like commodities or real estate.
While you don’t necessarily want every asset class in your portfolio, some real estate investments might make sense as part of a well-diversified global strategy. That doesn’t mean you should go out and buy just any building. As is always the case with investing, a sound strategy can be tainted by anything from poor decision-making to bad advice. It is important to note that we are excluding your primary residence as a real estate investment for this article, since we view it as a source of shelter, not profits.
Diversification Is Still King
In case you haven’t noticed, we are huge fans of diversification. If diversification was a band, we would have its poster above our bed. And it’s not just for stocks. You can also diversify the number and types of holdings you own with real estate. The reasoning is the same: you’re minimizing your exposure to risk (deadbeat tenants, property damage, crooked property managers, etc.) while still positioning yourself to capture expected returns.
One simple way to achieve diversification in the real estate world is through something called a REIT (Real Estate Investment Trust) fund, or even a combination of multiple REIT funds. These “funds of funds” enable you to own hundreds of properties across a diversified range of domestic and global companies with broad exposure to the world real estate market. Before investing in REITs, perform your due diligence on the fund manager to ensure the strategy is aligned with your goals.
Understand the Unique Risks of Real Estate
While real estate can enhance diversification, it’s essential to be aware of the associated risks:
- Tax Considerations: Real estate investments can be less tax-efficient compared to other assets. It’s crucial to understand the tax implications and consider holding these investments in tax-advantaged accounts when possible.
- Liquidity Issues: Unlike stocks, real estate is not easily bought or sold. This illiquidity can pose challenges if you need quick access to cash.
- Market Volatility: Real estate markets can experience significant fluctuations. Property values can rise and fall due to various factors, including economic conditions and interest rates.
Some investors prefer to own physical property, which is often referred to as a “hard asset.” This could mean buying a rental home, a duplex, or commercial property. There’s something appealing about owning a tangible asset you can see and touch. And in some cases, direct ownership offers more control and the potential for tax benefits that REITs don’t provide. But it also comes with more responsibility. Unlike REITs, direct real estate ownership means you’re in charge of everything: property maintenance, tenants, insurance, taxes, and dealing with vacancies or unexpected repairs.
Allocation Depends on Your Goals
With all these potential returns and known risks in mind, we strongly suggest that stocks and bonds serve as the “meat and potatoes” of your portfolio. Real estate should be “the seasoning” sprinkled around as needed. Beyond a well-balanced meal, your personal circumstances may play a part in determining the proper allocation for you. For instance, if you already own a bunch of buildings (in addition to your primary residence), you might not want to hold as much real estate to offset your existing risks.
While real estate is often a welcome addition to a well-rounded, globally diversified portfolio, the advantages are accompanied by portfolio performance that may deviate from “the norm.” Therefore, it requires a patient, long-term approach to participate in its risks and expected returns, much the same approach we advocate for any other investment. If you don’t have the timeline or risk tolerance to let real estate do its thing, you’re probably better off avoiding it altogether.
Bottom Line
Real estate can absolutely have a place in a well-diversified portfolio. But like any investment, it’s not without trade-offs. REITs can offer access and income with fewer headaches, while owning property directly comes with more control, but also more risk and responsibility. The key is understanding what role real estate plays in your plan and making sure it supports your long-term goals.
And as always, it helps to work with someone who can guide you through the options and make sure your investments reflect your needs and your retirement style.
