Bank Investment Consultant asked Thomas A. Zgliniec, from LPL, a series of questions about real estate investing and how advisers should approach this asset class. With only a few minor edits for clarity, here are his responses.
For HNW clients who are seeking diversification, is real estate a necessary investment? Or can they easily find diversification in other ways?
While investing in real estate can provide diversification to traditional equity and fixed-income portfolios for HNW clients, the determination of its use in a portfolio includes more than just the benefit of a single quality, such as diversification. Often times, other financial qualities are of greater appeal. These qualities include the generation of tax-sheltered income, ability to execute 1031 exchanges, and control of the use of leverage. While diversification certainly is necessary in most portfolios, nobody can responsibly say that real estate is necessary.
What about mass-affluent clients in the same situation?
Diversification is equally important between mass-affluent and HNW clients. However, the sensitivity to the many forms of risk present with real estate investing is greater with mass-affluent clients. This sensitivity often offsets the diversification desires of mass-affluent investors.
Beyond diversification, what are the main attractions of real estate investments?
There are three primary qualities of investing in real estate that are desirable for HNW clients. These qualities include the creation of tax-efficient income, the ability to execute tax-deferred 1031 exchanges, and control of cash flow through the use of leverage/debt. Here's more detail on each.
● Tax-efficient income: Through the ability to depreciate the value of a property (structures, not land) over a predetermined schedule, investors are able to deduct this calculated value against income that is produced by the property. For HNW clients, tax-sheltered income that is produced by assets other than municipal bonds is greatly appealing.
● Ability to execute a tax-deferred 1031 exchange: Through the ability to execute a tax-deferred 1031 exchange, investors in real estate have the option to “concentrate to create, and diversify to protect.” 1031 exchanges allow investors to delay paying several forms of taxes upon the sale of real estate, and exchange potentially greater and greater amounts of wealth in properties.
● Control of cash flow through the use of leverage/debt: Through proper planning, investors in real estate can control the amount of net income that is produced by the properties they own by the amount of leverage/debt that is used with each property.
For mass-affluent clients who want to begin investing in real estate, what are the top considerations they should bear in mind? Should they restrict themselves of just REITs, or are there other valid ways for them to consider?
Mass-affluent clients should be sensitive to some of the risks that are present with investing in real estate. These risks can be found in the form of illiquidity, loss of income due to vacancy, ability to use variable rate loans, total investment relative to net worth, and the creation of accumulated/dormant equity. Due to this sensitivity, mass-affluent investors often times can benefit from an access point that is professionally managed, or has an established long-term tenant in place.
In addition to REITs, mass-affluent clients could consider “triple net lease” properties, which are arrangements where tenants are responsible for certain costs such as property taxes, insurance, and maintenance during the term of the lease.
For the clients who want to simply invest in REITs, what are the main considerations they need to bear in mind?
Purchasing real estate can be a cyclical investment that is influenced by many factors. In addition to the obvious considerations such as interest rates and market/economic cycles, here is a list of additional considerations:
● Cyclical nature of the type of properties in the REIT (hospitality vs. distribution/storage)
● Financial health of tenant
● Aggressiveness of assumptions made in the REIT offering pro forma
● Reputation and stability of sponsoring firm
For clients who are interested in direct real estate investing, what areas are drawing the most attention now? What are the biggest considerations for them to bear in mind?
The recent popularity of television shows that seemingly make real estate “flipping” look easy has created interest in this form of short-term real estate activity. However, many would say that real estate flipping should carry the same warning labels that accompany day trading of stocks.
Short-term ownership of real estate is not given the same tax advantages as long-term investors. These disadvantages come in the form of short vs. long-term capital gains rates, the inability to execute a 1031 exchange, and the potential IRS classification of a “dealer” rather than an investor.
In what types of markets do real estate investments generally make the most sense?
Low interest rates and expansion periods in economic cycles.
Tell us something else important for clients to consider when investing in real estate.
Prior to making an investment in real estate, prudence should be examined from both a financial as well as non-financial sense. Along with directly-held and managed real estate comes the joys of the “three-Ts,” which are toilets, tenants, and trash. The opportunity cost of dealing with these aspects of ownership should be understood and embraced prior to investing.
