Planner Rich Arzaga has a complex relationship with real estate. Under the right circumstances - if a client has the right properties, the right cash flow and the right diversification - the CFP loves it. "Directly held real estate investment is definitely the forgotten asset class in the financial planning world," he says.

But those circumstances aren't always right, he points out. Just take Arzaga's own luxury home in San Ramon, Calif., which the founder and CEO of Cornerstone Wealth Management bought in 2005 for $1.8 million. Today it has a fair market value of $1.6 million - and carries what Arzaga calls the "negative cost structure" of home ownership.

Arzaga says he loves his home, but is skeptical about it as an investment: "Our family can afford to own a home because of our other investments," he explains.

As a specialist in (and advocate for) directly held real estate investing, Arzaga is an anomaly in the financial planning industry. His clientele include real estate investors, business owners, sole proprietors, business executives and affluent families.

He and two colleagues (one advisor and one support staff) offer comprehensive financial planning to 55 clients - 80% of whose net worth is in real estate and closely held businesses not reflected in Cornerstone's $50 million in assets under management. The firm operates under a hybrid RIA, as a registered representative with LPL Financial for securities transactions and as a separate RIA, Cornerstone, for financial planning services.

"My clients have a passion for real estate," he explains. "They just need counsel on how to best execute that passion."



That execution, he explains, often boils down to a cash flow calculation. One problem, says Arzaga, is that clients fail to fully understand all the ramifications of their real property holdings. The real challenge of most residential real estate, he says, is the total cost of acquiring, maintaining, improving and operating this property.

"Most clients do not properly understand the cash flow," he laments.

Consider one of Arzaga's clients, a 54-year-old single woman who intends to retire at age 66 and currently owns her own residence. Conservatively assuming a life expectancy of 100, Arzaga asked his client to consider what would happen if she sold her home in 2016 and rented a similar home in the same neighborhood.

If she were to sell her home at an estimated future value of $892,000 in 2016, her $392,000 mortgage would be retired and her net proceeds from the sale would be $491,000, after adjusting for incidentals. Her annual homeowner's expenses - taxes, homeowners insurance, repairs and maintenance, capital improvements, some utilities, and landscaping - would be reduced by $17,000 a year.

Yet she would have to add $30,000 a year (before inflation) for rental costs. All other facts remain the same, including an investment portfolio assets of $2 million (before the proposed sale).

According to Arzaga's cash flow analysis, if his client sells her home in 2016, she would die with portfolio assets of about $1.5 million. If she keeps her home, she runs out of cash at age 95 - although whatever equity she has in her home would be passed on to her heirs.

That's not a great outcome, Arzaga notes: The first objective of most clients is to not outlive their money.

The same cash flow crunch haunts residential investment properties. Arzaga examined 300 single-family and condo/townhouse residential investment properties around the United States to study the impact of these investments on one client's goals for financial independence.

The surprising results: The client was better off selling the investment rental, paying capital gains taxes and placing the balance in a conservative investment in 100% of the cases. Once again, the cost of ownership buried the performance of these smaller properties.



Clients seeking counsel in the directly held real estate arena are hard pressed to find advisors knowledgeable or willing to help them, Arzaga says. "About one-third of this nation's wealth is in real estate and the topic is barely mentioned in the CFP curriculum," he says.

Arzaga attributes this neglect to three factors. First, financial planners do not see a sustainable revenue-model in real estate consulting. Arzaga says he has pieced together a nice living by charging a fixed fee for financial planning and complex real estate work, a sliding-scale percentage on non-real estate AUM, and commissions on the sale of life, disability and long-term care policies.

Personal bias is also a "huge issue," he says: "Too often, advisors ... either love or hate real estate."

Additionally, real estate is simply a confusing asset class - requiring both data analysis and subjective judgment - that many advisors prefer to steer clear of. A savvy real estate consultant needs expertise in capital gains reduction tax strategies, such as different types of 1031 tax-deferred exchanges, qualified oil and gas drilling programs, and the use of charitable remainder trusts with wealth replacement trusts.

Arzaga believes the right real estate can be a cash cow for the properly motivated investor. He just doesn't believe residential real estate is the answer. And don't get him started on home ownership. "It is the 'American Dream' to own a home," says Arzaga, who advocates renting in most cases. "But whoever said that did not analyze the numbers."

On average, homes in U.S. metropolitan areas appreciated less than 2% a year from 1950 to 2000, according to a study by Todd Sinai, an associate professor of real estate at the University of Pennsylvania's Wharton School. As a result, Arzaga argues, it is difficult for owners to grow their way out of the high carrying costs of home ownership.

Rather, Arzaga advocates investments in cash-flow real estate - a type of commercial real estate distinct from land development (which, he points out, has no cash flow) and "opportunistic" real estate (which involves high-risk renovation of rundown property).

The five main categories of cash-flow real estate include retail (anything from a strip mall to a stand-alone Walgreens); industrial, such as warehouses; small-town office buildings and office space in larger cities; multi-family apartment buildings (with five units or more); and specialty real estate, like churches, schools, hotels and nursing homes.



For new clients with no interest or investments in real estate, he might recommend no more than 15% to 25% of their portfolio in these types of real estate investments. For the remainder of the portfolio, Arzaga favors a multi-asset balanced portfolio such as the 7Twelve model (developed by Financial Planning contributing writer Craig Israelsen).

Clients who come to Arzaga with existing holdings, he says, are usually too heavy in the real estate asset class - and not well diversified within it. At the very least, he advises these clients to move into commercial real estate and to diversify their holdings geographically and by property type.

Arzaga likes commercial real estate because, he says, its rate of return is competitive with other major asset classes like equities and commodities. All three classes have returned in the neighborhood of 9.5% to 11% from 1970-2009 - and commercial real estate does not correlate over the long haul with equities and commodities.

There's another advantage. Clients like holding tangible assets, he says: "Real estate is simply more interesting than equities."



Jim Grote, CFP, is a Financial Planning contributing writer in Louisville, Ky.



Rich Arzaga

Cornerstone Wealth Management, San Ramon, Calif.

Credentials: B.A., San Jose State; graduate studies at Northwestern University's Kellogg School of Management; CFP, CCIM, CLTC, CDFA

Experience: Founded Cornerstone in 2003. Adjunct professor in UC Berkeley's personal financial planning program since 2006.

AUM: $50 million (does not include real estate investments)

How I see it: "About one-third of this nation's wealth is in real estate and the topic is barely mentioned in the CFP curriculum."

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