Many individual investors don’t own any real estate in their investment portfolio. Usually this is not by design. Rather, it reflects the lack of attractive options for investing in real estate, and a bias towards stocks and bonds because they are readily available and easier to research. If you use a robo-advisor to allocate your portfolio, real estate is not even part of the equation. But if you are a pension fund, an insurance company, or a very wealthy individual, real estate is an important component of your portfolio.


Allocation to Real Estate by Different Investor Types

Source: Cornell Baker Program in Real Estate/Hodes Weill & Associates, and Knight Frank.


For pension funds and other institutional size investors, real estate is a critical component of maximizing returns and diversifying portfolios. In addition, real estate is relatively stable and has a low correlation to the stock market. You only have to look at the wild gyrations in stock markets in the beginning of 2016 to appreciate this key benefit. These considerations also hold true for individuals whose time horizon may not be as long as a pension fund. North American High Net Worth investors allocate 24% of their investment portfolios to real estate, according to Knight Frank’s 2015 Wealth Report. Globally, the allocation to real estate is even higher, at 32%.


Value of $100 Invested in Core Real Estate, Stocks, and REITs

Of course, the right allocation depends on an individual’s specific situation. Most real estate investments are not very liquid and require an investment horizon of 5 years or longer. Let’s address some specific issues related to allocation.


1. Where does real estate fit in to the portfolio?

The old rule of thumb is that 100 minus your age equals the percentage of your assets that should be invested in stocks, and the remainder should be invested in bonds. More sophisticated approaches modify this based on an individual’s risk tolerance and life circumstances. The underlying principal is that stocks constitute the long-term portion of the portfolio because they have higher returns than bonds, but they are more volatile. Real estate may be less volatile than stocks, but it is also less liquid. Therefore, it should be part of the long-term component of the portfolio.


2. How liquid is real estate?

This depends on the form of the investment. The most liquid real estate investments, such as REIT stocks, are typically highly correlated to the stock market. It can be argued that traded REITs are really a component of your stock allocation, not of your real estate allocation. Real estate funds have varying levels of liquidity, depending on their structure. Some are completely locked up for the term of the fund while others allow redemptions, subject to certain limits. These redemption features can be helpful when you need liquidity due to personal circumstances, but they are unlikely to help you if everyone is heading for the exits at the same time. The best approach is to assume that money invested in a fund will not be available until the fund is liquidated, generally in 5 to 10 years.


3. What about current income?

Current income provides partial liquidity. Investments in stabilized operating properties can throw off attractive current returns. Opportunistic investments generate their returns from capital appreciation, so they generally don’t generate much current income.


4. Does my personal property count towards my real estate allocation?

Your primary residence should not be included because it is not disposable. You may realize a nice capital gain when you sell it, but you will need to reinvest this gain in a new home to maintain the same standard of living. A vacation home is trickier to evaluate. If it is an important part of your family’s lifestyle, you should treat it like a primary residence. If it doubles as an investment property and you don’t have much emotional attachment to it, then it can legitimately count as part of your investment portfolio.


5. So, how much should I allocate to real estate?

This is where a good advisor can really add value. The right range could be anywhere from 5% to 30% of the investment portfolio. Picking the right point in that range requires a good understanding of the individual’s personal circumstances, risk tolerance, and need for liquidity.


6. What is the best form of investment?

Again, a good advisor can help to select the form of investment that best fits an individual, and to avoid investments that are poorly structured or have onerously high fees. The choices are addressed in detail in our blog post “What Options do Accredited Investors have for Investing in Real Estate?”.

Here is a brief summary of our conclusions:

Pros Cons
Listed REITS High liquidity and low transaction costs Volatility and correlation to stock market
Non-Traded REITs Low volatility Very high fees and poor historical performance, limited liquidity
Direct Ownership Control over asset and no management fees Requires lots of time, expertise, and capital; limited diversification and liquidity
Real Estate Crowdfunding Efficient format and ability to select individual deals Non-institutional deals and sponsors, limited diversification and liquidity
Real Estate Funds Professional management and diversification, institutional quality properties Historically difficult for individuals to access, limited liquidity


Summary

If some of the world’s most sophisticated investors allocate meaningful proportions of their portfolios to real estate, why should individuals be different? With the investment landscape changing through globalization, technological advances and central bank interventions, the long term outlook for stock market returns looks uncertain. Many commentators call this the “new normal” – lower future returns and increased volatility. In this environment, the benefits of diversifying through real estate investing look even more compelling.