As we described in our post, “Stop believing that real estate has magic powers,” there are often good reasons to include a measure of real estate in your well-managed, globally diversified investment portfolio. That said, there are better and worse ways to get the job done. Take a “worse way,” and the inherent risks can quickly override the potential benefits.
What approach do we suggest? These days, investors have easy and cost effective access to Real Estate Investment Trust (REIT) funds that offer efficient, low-cost, globally diversified exposure to the asset class being targeted. This is preferred to the more elusive alternatives, where your money is often tightly locked up, and the costs can be both insidious and excessive.
Another advantage to a REIT fund is that you don’t have to personally deal with hassles such as deadbeat tenants, broken pipes in the middle of the night, or unscrupulous property managers.
To participate in the real estate market with informed discipline rather than as a speculative venture, most of the same, essential principles that apply to any other investment apply here too.
Seek global diversification
As with stocks, it’s wise to spread your real estate risks around by diversifying the number and types of holdings you own. By diversifying your holdings across a number of investments and a mixture of property types, you are best positioned to earn the returns that the asset class is expected to deliver, without being blindsided by holding-specific risks.
Understand the risks: liquidity and volatility
Real estate can serve as a stabilizing force and a source of returns in your portfolio but, like any investment, potential rewards are accompanied by notable risks. Real estate investments can become very illiquid, very fast – often just when you need that liquidity the most. Real estate also is a particularly volatile market. Some product providers may try to mask this reality by playing fast and loose with their reporting strategies, but you really should expect a relatively bumpy ride, even if it’s not being reported to you as such.
As reported in “On Shaky Foundations,” we’re currently (summer 2016) seeing these sorts of risks play out in the U.K. “in the shape of a concentrated sell-off of Open Ended Property funds.” Investors in these funds are discovering that the return “smoothing” they thought they were enjoying may have been built on a house of cards. The columnist observed: “Just because risk is not immediately visible, does not mean it isn’t there.”
Select an appropriate allocation
Stocks and bonds are typically the staples in most investors’ portfolios, with real estate acting more as an accent. Beyond this general rule of thumb, your personal circumstances also may influence the allocation that makes sense for you. For example, if you are in the real estate business, or you own a rental property or two, you may want to hold less real estate in your investment portfolio, to offset the real estate risks you’re already taking.
Also, note that you may already be invested in real estate without knowing it. It’s not uncommon for a stock or hybrid fund to include a shifting allocation to real estate. Unless you read the fine print, it’s hard to know just what you hold, in what amounts.
Manage the costs
In addition to turning to a well-managed REIT fund to help manage costs, it’s also a good idea to consider the effect of taxes on your net return. Compared to similarly managed stock funds, REIT funds tend to be relatively tax-inefficient with higher expected income distributions, so it’s best to place them in a tax-sheltered account.
As we mentioned above, real estate investing can entail a bumpy ride, so there are likely to be times when your endurance will be tested. It’s essential to embrace a patient, long-term approach to participating in real estate’s risks and expected returns.
Use REIT funds that complement all of the above
The final ingredient is to select a REIT fund manager who scores well on all of the above, offering transparent, cost-managed exposure to domestic and global real estate markets. Also, by aligning yourself with a fund provider that appeals to disciplined investors like you, your fellow shareholders are less likely to panic and force unnecessary trading during times of market stress.
If an allocation to real estate makes sense for you and your financial goals, adhering to these timeless tenets of evidence-based investing can help you make the most of the opportunities available in this important asset class, while minimizing its greatest risks.