Should High Net Worth Individuals Consider Real Estate
Should High Net Worth Individuals Consider Real Estate

High Net Worth Individuals are considering real estate as part of their portfolio more frequently now than in the past.  They are looking for hard assets that can also provide a decent yield (income replacement) with less daily volatility than the stock market. Dividend producing companies are being pressured lower in many industries and the forecasts for increased volatility is starting to force these individuals to look at alternatives.  There is a lot of cash and Net Worth chasing a smaller pot of ‘income replacement’ stocks and bonds, pushing yields lower and lower and real estate seems to be the current choice for a portion of that cash. However, this approach can be quite dangerous unless knowledge of the investment type is considered.

We have witnessed High Net Worth people, and baby Boomer looking for income replacement, jump into real estate with both feet, only to discover that investing in real estate is a different ball game than the industry or investment vehicle they used to create their wealth. Which means they are putting themselves at higher risk than they need to.

What Should High Net Worth Investors Consider Before Adding Real Estate To Their Portfolio?

Real Estate is too broad of a brush to paint investment choices. It is important to note that there are many ways in which to invest in real estate as part of a portfolio, each with its own strengths and weaknesses. From the complete ‘hands-off’ approach of owning shares in a REIT or ‘private placement fund’ across the full spectrum to hands-on ownership and management of physical property.

Hands On Ownership of Actual Property: Unlike other investments, hand-on property, is not a passive investment. Available time, and desire to fill it, must be considered before buying a physical income property. By the way, real life buying, renovating and owning real estate is not like those 30 minute edited real estate TV shows (we all wish it were). High Net Worth Individuals can create tremendous R.O.I. and long-term yield by owning a well chosen piece or two of revenue property, but it comes at a cost of time and attention.  Owning a piece of revenue real estate is the same as owning a small business – in a small business you either have created a job for yourself (i.e. you are the “doer” or the manager) or you have hired a manager, whom you still have to manage.  That means even if they decide to not manage the property on their own they must (and I mean MUST) take time to manage the managers of the property.  You either spend time managing the property/tenants/repairs or you hire and mange someone who will. Higher R.O.I. and yield but at the cost of hassle and time.

Hands-Off Ownership Options: On the more passive side of real estate, the options are more like the mutual fund market where you pool your capital with others and pay a management fee for the operations of that pool.  In these cases, you give up some of the returns you can achieve with hands-on ownership, but the ‘hassle factor’ drops tremendously. However, there are hidden risks in this passiveness which can be reduced by completing detail due diligence on the type and location of properties purchased in the pool and more importantly the quality and track-record of the management team. Which means doing some detailed homework before writing the cheque. “He/She is a nice person” is NOT due diligence.

It is true we are witnessing some great successes of High Net Worth individuals in real estate, with an increasing number entering the industry. But the successful ones know that a little extra homework at the beginning can greatly reduce the risks.  The next question often is…

What Is The Optimum Percentage of a Portfolio Should Be In Real Estate?

Well, in the perfect world based on text-books or models you could state a clear percentage. However, in real life, there is no “perfect formula.”  As with any quality investment analysis many factors must be considered. At a minimum:  Age of the investor, knowledge of investing, source of net worth, risk tolerance, liquidity requirements and where the geographic target area is in the Real Estate Cycle all play a role in deciding what percentage (if any).  We have some clients who put 10% of net worth in real estate (as they are company owners and majority of their wealth is in their own company shares) while other high net worth investors are verging on 80% of their portfolio in multiple types of real estate investments and are using strategic real estate as their main wealth preservation and income replacement tool.

Considerations of Risk Reality

Real estate should never be considered a ‘get-rich-quick’ investment tool nor a passive investment.  In fact, due to its limited liquidity in many market conditions, it is more buy & hold than would be many stocks or mutual funds.  Anyone can analyze a property for its potential income or capital cost and if you stop your analysis at that level you will often be buying a risky investment.  As proof, we witnessed many rookies buy properties during past downturns not because of their potential, or the strength of the area’s potential. Nope, they bought because the property was much cheaper than at peak.

Similar to those buying Nortel stock on its way down.  The price was much lower than peak, but the underlying economics, if analysis was done, still did not support future stock strength.  Real estate is not about ‘Buying on sale” it is about buying in markets with strong underlying economics today (or projected). Knowledge of a region is more important than knowledge of a particular property. Same goes for ‘financial’ investments in real estate (such as REITs), if they are investing in areas that do not have strong economic growth potential then they are at risk of “Nortelling.” (new verb)

That is why gaining knowledge on how to analyze a market’s underlying economic fundamentals from a real estate demand potential is so very important. Plan to be in that market, through ups and downs, for a decade or more.  If the High Net Worth investor is buying a physical piece of property the higher financial returns only start to hit in year 3, when mortgage paydown is accelerating (due to amortization schedule), capital values begin to increase and income is stabilized and beginning to rise.  High Net Worth investors are targets and must be extra diligent to avoid being caught buying on an idea, a reputation or high-profile personality.

“Some People” have been saying, for the last 3 decades, that Canadian housing markets are overheated. Sadly, following their advice, many have missed out in large income and capital gain opportunities. But even during these last great times, people made bad real estate decisions and lost money.  A lesson that proves that as with any investment it is important not to simplify the analysis of real estate or real estate markets.  The value of the property plays less of a role to a strategic investor than does the R.O.I. .  Take the complex Vancouver market as an example. It looks quite overheated and over-priced if you look at it with a cursory view, however, with a more strategic eye you find that in some segments it is definitely over-heated, while in others it is not. (here is some more detailed analysis on residential portion of the Vancouver market: http://www.donrcampbell.com/vancouver-housing-market-peeling-the-onion).

Suffice it to say, investing in real estate takes some work and if the High Net Worth individual is not willing to do the work required (or have one of their people do the work) to investigate not just the property but the underlying economics, it would be better if they invested in a more liquid financial asset like a REIT.

Conclusion is, if done correctly, High Net Worth investors can do extremely well adding quality, well researched real estate in their long-term hold portion of their portfolio. But the opposite is true, buying under-researched real estate is a risk not to be taken, not matter what your net worth is.

That is why it is, especially for high net worth individuals, important for them to choose a strong market with a future – sadly too many get caught into buying in regions that have high-profile’ or are ‘close to home’ both of which can lead to diminished returns and higher risks.

A great way to understand the Canadian real estate cycle and how it plays in an investment decision, pick up a copy of my “Canadian real Estate Cycle” book from Amazon at the link below and PLEASE make a commitment not to buy investment real estate without informing yourself of the risks, rewards and strategies in advance.

Should High Net Worth Individuals Consider Real Estate was last modified: February 23rd, 2016 by Don R. Campbell
 

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