By: Steve Haskell, Vice President of Kay Properties and Investments, LLC
So, you’ve decided to invest in income-producing real estate as a way to diversify your investment portfolio so all your assets are not correlated to the stock market’s performance. Now how do you plan a real estate portfolio to build wealth and withstand a crisis?
We’ve learned a great deal from analyzing the market through crises including 9/11, 2008-2009, and the current COVID-19 pandemic. There are no guarantees and certainly no real estate is immune from a crisis, but these five tips will greatly enhance the likelihood of having your real estate portfolio hold up even through a severe economic shock like the coronavirus crisis.
Tip #1: Diversify by asset type and geography.
Diversification is a core tenet of building any investment portfolio. Black swan events do take place and can impact any and all investments, crushing some while lifting others. Diversification does not just apply to stocks and bonds. Investors also should diversify their real estate portfolios by asset type, asset class, and geography. An investor can avoid risk of over-concentration by spreading their capital across various asset types such as multifamily, office, medical, self-storage, student housing, and others.
A challenge for many investors is not having the capital required to purchase various properties all over the country on their own. Additionally, many investors do not have the time and energy required to oversee a diversified real estate portfolio. Fractional ownership and direct private placements (DPPs) provide a solution, which is discussed further below.
Tip #2: Avoid asset types that are highly cyclical, volatile, and overexposed to risk.
Crises can impact every real estate sector. However, there are industries more vulnerable than others. These include hospitality, senior care, and oil and gas. Starting in October of 2009, RevPAR (revenue per available hotel room) declined by 16.8 percent over a 12-month period. The recession of 2001 saw a drop in RevPAR over a 12-month period of 10.2 percent in June of 2002. In the top 25 markets, RevPAR declined by 19.1 percent in 2009 and 16.5 percent in 2002. By comparison, CBRE reports that apartment rents declined by only 6.7 percent in 2001 and 7.9 percent in 2009.
Senior care is another high-risk asset class that is particularly vulnerable to crises. Not only has COVID-19 sent the senior-housing sector into a tailspin, but there are innate risks unique to the industry. Senior care has a high exposure to regulatory risk. One infraction can result in a remediation period. If there is a large infraction, the operator’s license can be revoked, which can eventually result in loss of income or even bank foreclosure.
There is a litany of other elements that restrict the assets’ ability to reposition itself in a crisis or economic downturn. Some of these risks are: a heavy exposure to litigation, relatively high operating expenses, high staff turnover, nursing shortages, licensing issues, state regulation risk, and potential complications with clients paying with Medicaid, which can prevent landlords from raising rents and increasing revenue.
Another sector with excessive operational risk and vulnerability to political and economic shifts is oil and gas. These investments have been heavily peddled by private broker-dealers to investors in need of tax write-offs. Due to the heavy capital requirements and intangible drilling costs required to explore in unproven oil fields, investors have the potential to shelter a significant amount of their taxes on the front end of their investment.
However, by nature, these investments are excessively risky. Even if the drilling is successful (which it often is not), something as simple as a dispute between two oil producing countries can send the industry plummeting. The recent dispute between Saudi Arabia and Russia has sent global oil and gas markets down to $20 (WTI) and $27 (Brent). Since then, the coronavirus pandemic decreased the demand, lowering prices for a barrel of oil even further to sub-zero levels.
As we move into a green economy with companies such as Tesla leading the effort to alternative energy, no one can predict how the demand for fossil fuel and natural gas will be impacted. Thus, there is significant operational risk intrinsic to oil and gas, along with its ultra-sensitivity to both demand side and supply side economic and political factors.
Tip #3: Consider direct co-investment opportunities.
Fractional ownership investments (where you are one among multiple investors participating) and direct private placements allow high-net-worth investors with limited cash the opportunity to diversify, generate passive income, and access high quality real estate. The properties are managed by professionals in order to provide the investor with a completely passive investment solution. Potential options include Delaware statutory trusts (DSTs), tenants-in-common (TICs), funds, and non-traded real estate investment trusts (REITs).
Sometimes, investors can confuse these opportunities with the more common and accessible publicly traded REITs. Publicly traded REITs may be a suitable option for part of some investors’ real estate portfolios. However, performance of public REITs is more closely correlated to the overall stock market, and more vulnerable to the volatility of the stock market.
A few institutional investors who pull capital out of the market can send the shares of REITs plummeting, even if the underlying real estate is performing well. In the last recession, REIT performance was approximately in line with the stock market with 37.7 percent negative returns, which included dividends, in 2008.
There are other potential benefits unique to DPPs and fractional ownership that REITs do not provide. This form of real estate ownership may also offer tax efficiencies through depreciation, which can provide a significant tax benefit to some investors.
Additionally, options such as Delaware statutory trusts and tenant-in-common structures provide investors the opportunity to 1031 exchange in and out of their investment, potentially saving up to 40 percent in taxes. However, those who invest in these types of assets must plan on holding them for at least 5-10 years. These are illiquid assets and there is currently no public market for their trading. As with all real estate, there are risks and investors can lose money including their principal, which is why diversifying while avoiding the most risky asset classes is important.
Tip #4: Focus on the fundamentals.
When it is all said and done, real estate investing comes down to buying property that makes sense for a reasonable price, and enjoying its potential cash flow benefits as well as the potential asset appreciation. Instead of always looking for home runs, portfolios positioned to withstand a crisis typically shoot for singles and doubles — consistent performance over time.
When considering a location resilient in a crisis, search for a city with a younger, growing population and multiple economic drivers. In contrast, purchasing a building in a town completely dependent on the local power plant may provide a nice yield, but leaves the investor unreasonably dependent on the success of that sole employer.
Proper research is critical. This research includes collecting appraisals, environmental reports, lease audits, inspection reports, surveys of demographic and population data, and title reports, and performing cash flow analysis and financial stress tests on the property.
This part of real estate investing can be boring, but making time or effort to undertake the research is critical to find good deals. Overlooking a sewage spill captured on the environmental survey that took place on the property 15 years ago may significantly impact the selling price down the road.
If an investor does not have the time or experience to conduct this level of due diligence, they can potentially pay an advisor to assist or choose an alternative real estate investment where much of the due diligence has already been performed and packaged for the investor.
Another example: when considering a commercial property, the tenant is very important. A publicly traded tenant with a strong credit rating significantly decreases the likelihood of tenant bankruptcy. During a crisis, it is important that the lease on the property is backed by a strong balance sheet. This doesn’t assure that the tenant can make good in a crisis, but significantly increases the odds.
Tip #5: Avoid leveraged investments if possible.
There are many potential benefits of using debt to buy real estate. However, if the goal is to survive a crisis, avoid leveraged investments if possible. The greatest element of risk in a real estate investment is often the debt. Not only can the debt expense force the property into a cash flow crisis, other bank requirements built into the loan can restrict flexibility and resilience.
Banks often incorporate mechanisms that mitigate their own risk but place the property owner in precarious positions. These challenges include prepayment penalties, defeasance, balloon loans, re-tenanting restrictions, and sinister stipulations built into the loan that could result in cash flow sweeps if a tenant leaves the property or restructures its balance sheet … even if they never miss a rent payment!
As a property owner attempts to navigate an economic crisis, these elements can act like landmines waiting to blow up the deal. An unleveraged property does not face a restricting debt obligation or balloon payment. It is free to wait out economic cycles, tenant bankruptcy, or random black swan events.
As noted, there are no guarantees in real estate. Crises have the potential to impact all asset classes. But adhering to these five tips can greatly enhance the wealth preservation and wealth building power of a real estate portfolio while mitigating potential loss.
Steve Haskell is vice president of Kay Properties and Investments LLC, which operates a 1031 exchange property marketplace. Steve works with 1031 exchange and direct investment clients throughout the U.S. He is based in San Diego.