Adding Real Estate to Your Portfolio
By James M. Dahle, MD (aka The White Coat Investor)
Real estate is an asset class worthy of inclusion in most physician retirement portfolios. Modern portfolio theory suggests that adding additional asset classes with a solid return and low correlation with the rest of the portfolio increases the risk-adjusted portfolio return. One of the first asset classes that many investors consider adding to a traditional stock and bond portfolio is real estate. Real estate has many advantages as an asset class, including potential high returns, low correlation with both stocks and bonds, and the ability to use leverage in a safe manner to further boost returns. But there are different ways to invest in real estate, and which way is "the best" is an ongoing matter of debate. In fact, which option is right for you will come down to your willingness to trade time and hassle in order to have more control over your investments. Consider these three ways to add real estate to your portfolio:
Publicly traded REITs
The simplest way to invest in real estate is to purchase Real Estate Investment Trusts, or REITS. These are companies that buy, sell, and manage individual real estate properties for a group of investors in a manner similar to a mutual fund. While privately traded REITs are generally an investment to avoid due to high commissions and low liquidity, publicly traded REITs can be purchased commission-free and can be bought and sold any day the stock market is open. You can buy essentially all of the publicly traded REITs in the world using an index fund at a mutual fund company like Vanguard for less than 0.20% per year. Although an investment in REITs can be extremely volatile (the US Vanguard REIT index fund temporarily lost 78% of its value in the 2008 meltdown,) long term returns have been excellent (about 11% per year over the last 20 years.) The correlations with the US stock market (0.45) and the US bond market (0.54) have historically been relatively low. Remember that a correlation value of 1 is perfectly correlated and a value of 0 is perfectly uncorrelated. One of the best aspects of investing in publicly traded REITs is that it is a “set it and forget it” type investment. REITs aren’t going to call you to fix the toilet. In fact, they’re not going to call you for anything. You can literally buy a few shares and forget about them for decades.
Opponents of investing in REITs deride them as “real estate flavored stock” and point out the tax-inefficiency, the volatility, and the lack of control over investments. The tax issue can be avoided by purchasing them only inside retirement accounts such as 401(k)s or IRAs. The truth about volatility is that the price of all real estate is quite volatile, but only with publicly traded companies is it marked to market on a daily basis. You simply don’t see how volatile the values of your house or investment properties are on a daily basis. However, if you prefer to have more direct control over “hard assets” like individual properties, there are at least two other good ways to invest in real estate.
Syndicated Real Estate Deals
Another common way for physicians to invest in real estate is via syndicated deals. This is a reasonable way to combine the desire for a hands-off investment with a desire for more control over the property. With a syndicated investment, there is a syndicator who does the purchasing, managing, and selling of the property. The investor need only provide money. The investor generally receives an annual distribution and then when the property is sold, typically after 5-7 years, receives his share of the profits (or losses.) The syndicator receives significant fees for his work, but if he does his job well, returns can be quite good even after paying high fees, especially in a booming market. The investment is very illiquid. Unlike a REIT fund which can be sold any day you like, you may not be able to get your money out of a syndicated deal for years. Proponents of this style of investing, however, maintain that you are adequately paid for your illiquidity through higher returns.
Opponents point out that due diligence is required, both of the property and of the syndicator, and that diversification is difficult given that the minimum investment in these deals tends to range from $5,000 to as much as $100,000. If you only wish to invest 10% of your $1 Million portfolio in real estate, you will likely only be able to buy a few properties. Exchanging from one syndicated deal to another, which increases the tax-efficiency of the investment, can also be problematic.
Many physicians are familiar with direct real estate investing, both into commercial and residential properties. Although property managers can be hired, far more time and effort is required to invest this way than by purchasing REITs or syndicated deals. However, control over the investment is also maximized. The return you will see from this investment is directly related to your skill in purchasing, upgrading, managing, and selling the property. If you enjoy this sort of work and are highly skilled at it, returns can be excellent. However, most physicians are far more interested and skilled at seeing patients and will find a better bang for their buck doing that than becoming real estate moguls. Diversification can be difficult, especially given the challenges of long-distance landlording, but direct real estate investors usually prefer to put all their eggs in one basket and then watch that basket closely. The ability to occasionally exchange properties also increases the tax-efficiency of the investment, thanks to the ability to write off property depreciation.
In short, real estate investing gives you the option to be very involved in your investments, or hardly involved at all. Consider the advantages and disadvantages of each, and then consult with your financial advisor to choose the investment strategy that works for you.
Dr. Dahle is not an accountant, attorney, insurance agent, or financial advisor. He blogs as The White Coat Investor and is the author of the best-selling The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.