Investors and entrepreneurs today focus on smart allocation strategies that guarantee value creation that withstands market crashes and global economic crises like that of COVID-19. Therefore, besides investing in traditional stocks and bonds and equity spaces, investors are keen on building a real estate portfolio. Reports estimate that over 10% of most entrepreneurs’ global portfolio consists of real estate assets. With higher returns and lesser volatility, asset allocation in real estate through direct investments or Real Estate Investment Trusts (REITs) enables wealth creation in the long-term investing scenario.
In this article, we shall have a walkthrough of the various funds and investment plans regarding asset allocation in real estate.
What is asset allocation?
Asset allocation is an investment technique where seasoned investors divide their money across major investment categories. Therefore the investment portfolio consists of cash, bonds, stocks, equities, and so on. Besides, investors can also choose to invest in alternative assets like real estate and other derivatives.
The whole purpose of asset allocation is to minimize risks and balance its ratio against rewards. Therefore asset allocation focuses on diversifying an investment portfolio according to the investor risk tolerance, investment time bracket, and long-term goals. So, asset allocation determines how much of each asset class an investor must hold in their portfolio to successfully balance the percentage of risk and returns.
Modern portfolio theory provides the most appropriate strategies on how to allocate one’s investment assets. According to this theory, high-risk investments yield higher returns, or conversely lower-risk investments generate lower returns. Hence, spreading one’s investments across diverse asset classes reduces the risks of significant losses.
Real estate assets are the least volatile and have the highest potential for returns. Therefore, retail and institutional investors along with alternative investment models and pension funds, balance their portfolios with a higher proportion of real estate assets.
Asset allocation in real estate: How much is optimal?
Generally, pension funds make passive investments in real estate through Real Estate Investment Trusts or private-equity pools. Asset allocation in retirement is focused on creating a portfolio of real estate assets that withstands market inflation as well as provides equity appreciation.
Most real estate investment trusts make long-term investments in commercial properties. However, pension funds have historically invested more in stocks and bonds and entered real estate relatively recently.
The Global Pension Assets Study by Willis Towers Watson analyses the seven largest pension markets in the world. These are the United States, the United Kingdom, Japan, Australia, Switzerland, Canada, and the Netherlands. Here, the 2019 survey found that an average asset allocation in retirement in these seven countries is now:
- Equities 45%
- Bonds 29%
- Alternatives 23% (real estate)
- Cash 3%
This is a significant improvement from just 6% of asset allocation in Private Equity and Alternatives in 1999.
In 2018, the pension funds of the US allocated 16% of their assets in commercial real estate.
Source: Stock and bond data from Board of Governors of the Federal Reserve, Financial Accounts of the United States, 2018Q4; commercial real estate market size data based on Nareit analysis of CoStar property data and CoStar estimates of Commercial Real Estate Market Size, 2018Q4
The California State Teachers Retirement System is the second-largest US public pension Fund. As of December 31, 2020, their portfolio had its second-largest allocation to real estate behind stocks.
However, different researchers and methodologies have concluded that ideally, pension funds should allocate at least 15 to 20% of their assets to real estate.
Life insurance companies:
Life insurance companies around the world and in the US invest primarily in debt instruments and other fixed-income allocations. However, they have begun investing more in commercial real estate debts and equity. Therefore, commercial real estate investments are the second-largest holding in their portfolio.
Their business plan for grabbing an investment opportunity in real estate minimizes the market risk during inflation.
Source: S&P Global
U.S Educational Endowments:
David Swenson created the Yale model which is an investment strategy used by the Yale endowment. This strategy focuses on investing more money in real estate assets, foreign equity, private equity, and absolute returns strategies.
Endowments make riskier long-term investments in stocks and hedge funds. Therefore, greater diversified allocations in real estate generate higher returns and more stability.
The three largest endowments in the country are Harvard University, Yale University, and Stanford University. Studies show that they hold the majority of their endowments in alternative investments.
As of Q4 2020, Stanford University and University allocated more money to real estate than to bonds and domestic equities. Furthermore, Real Estate comprised the fourth highest allocation amount for Harvard.
What exactly are the retail or individual investors focusing on?
Retail or individual investors are security investors who buy securities and assets in smaller quantities individually. For these investors, the ideal strategy for portfolio construction starts with asset allocation.
The power of different types of real estate to generate passive income or consistent rental income provide greater leverage to real estate investors. Moreover, real estate is inflation-proof and provides numerous tax benefits to investors. Therefore, for an individual investor, real estate portfolio allocation is a great stepping stone toward long-term wealth creation.
Generally, retail investors focus on constructing a moderately liquid portfolio that generates immediate cash flow. Therefore, mutual funds and equity investments take up 65% of an investor’s portfolio. And, real estate investments trail at 15%. This is mainly due to tighter budgets that make real estate investments difficult for an average investor.
However, now, even an average investor can access institutional real estate projects through fractional ownerships and Syndicates. Moreover, REITs and Crowdfunding enable passive investments in real estate with lower investment minimums and no burden of property management.
Read Lilypads’ blog on Real Estate Syndication.
Also, know more about the future of Crowdfunding in the real estate industry post-COVID-19. Read more about it in Lilypads’ blog.
How to build your real estate portfolio?
The bottom line is that there is no hard-and-fast rule to follow to grow your portfolio in real estate. However, these are a few guidelines that can help you get started:
Know your investment goals and determine your investment time horizon. Get clear on your investment strategy- fix and flip, buy and hold or passive investments.
Create a business plan that aligns with your risk tolerance and benefits your short-term goals. Moreover, an investment blueprint enables you to launch your own syndicate and attract limited partners.
Buying the first investment property after evaluating the financial utility of the investment and analyzing the metrics.
Over time, you can keep adding multiple properties that generate more income and keeps risks at bay.
The final and relatively more significant step is :
- Diversifying your investment market
- Diversifying your asset class
- Diversifying your investment strategy
Is asset allocation in real estate still relevant in 2021?
Real estate has always provided higher long-term returns with its appreciative value. Notwithstanding, rising interest rates or inflation, the value of real estate is always on the rise. Therefore, pension funds, endowments, life insurance companies, and even retail investors deem it viable to allocate a chunk of their assets to real estate.
However, every investor has their own budget that requires a custom approach. Hence, it is ideal for an investor to analyze their social security, investment goals, and time horizon. But considering the ever-progressive track record of returns, diversifying your portfolio with real estate investments never loses relevance.