The author argues that advisors should grasp the benefits that Modern Portfolio Theory should bring to commercial real estate investments – and give their businesses an edge.

Here’s another guest article that comments on the real estate market from David Wieland, founder and CEO of Realized. (See his previous article here.) He applies what is called “modern portfolio theory” (in fact, it is now quite old) to the bricks-and-mortar world. It’s an example of how we try to get deep into the details of investment stories and get beyond the superficialities. 

The usual editorial disclaimers apply to guest articles. The editors are very pleased to share these insights and invite replies. Email tom.burroughes@wealthbriefing.com

Nobel prize winner Harry Markowitz once said that becoming an economist was not a childhood dream of his. But in 1952, he introduced a ground-breaking strategy that revolutionized the way we invest – modern portfolio theory (MPT). 

As a result of his research and forward thinking, Markowitz deduced that the performance of an individual stock was not as vital as the composition and success of an investor’s overall portfolio. And even though MPT didn’t take off until the 1960s, the concept is now the gold standard for financial advisors. Nobel laureate Paul Samuelson said of the investment strategy and its developer: “Wall Street stands on the shoulders of Harry Markowitz.” 

Yet oddly enough, MPT isn’t something investors typically apply to real estate investment the way they do stocks and bonds. Doing so, however, could reduce investment risk in real estate while also building a more diversified portfolio.

The risks of traditional CRE investment 
Conventional wisdom holds that real estate is typically a less volatile investment than stocks. That’s because real estate investment has different types of returns and risk profiles than traditional asset classes. And while alternative investments aren’t a good fit for clients seeking short-term rewards since they don’t offer easy liquidity, an investor with a five- to 10-year investment horizon will find commercial real estate (CRE) has the potential to provide solid returns. 

Investing in CRE helps investors increase the diversity of their portfolios. And financial advisors can help clients take this diversification even further by applying MPT to real estate investments, expanding an investor's CRE portfolio to help manage risk in a similar way to traditional portfolios. 

Let’s say an investor owns one retail property that houses one tenant. Should the tenant decide to close his business, the property could be vacant for quite some time before the owner-investor secures a new lessee. However, if a client invested those same assets in multiple properties or property types, they could spread the risk, and that’s one of the key potential benefits of MPT.

But many investors don't have the funds to invest in multiple properties, so it’s hard for them to apply MPT to real estate investments. Instead of investing in multiple types of properties, say, a combination of student housing and retail, CRE investors may often only be able to invest in one property type. This can leave them vulnerable. 

Applying MPT in CRE
If a client only has $500,000 to invest, how can they diversify and purchase several commercial properties? One option is through a Delaware Statutory Trust (DST), which is a legal entity that allows multiple investors to pool their resources, so they can own a fractional interest in several commercial property types, such as multifamily residential, hospitality, or retail, as well as in several geographic locations. 

DSTs also allow for 1031 exchange transactions and their pass-through advantages, such as capital gains tax deferment, for passive investments. Owning a share in a DST allows investors to apply the ideas of MPT to property ownership, diversifying their CRE assets.

DSTs also provide an Umbrella Partnership Real Estate Investment Trust (UPREIT) option, which is especially attractive if your client already owns a property but wants to reduce or eliminate the management of it. An UPREIT is a partnership between the owner of an appreciated property and a Real Estate Investment Trust (REIT). The REIT is a company that owns, finances, or invests in real estate or real-estate-related assets, providing individual investors the opportunity to invest in a portfolio of larger properties. In exchange for transferring their property to the trust, the property owner receives operating partnership units through a tax-deferred exchange comparable to a 1031. Property owners can continue to defer those capital gains until they sell their shares or convert their units to REIT shares. 

DSTs and DSTs with an UPREIT option are vehicles to help investors diversify their CRE portfolio and potentially decrease their tax obligations.

Determining a client’s risk appetite
Investors may turn to DSTs because they’re transitioning from owning and operating real estate to more passive investing, especially if they’re close to retirement or looking to maintain generational wealth.

When it comes to traditional portfolio management, advisors must evaluate a client’s risk tolerance as well as their goals and timeline. Then they can use MPT to create a suitable investment plan. The same applies to CRE. The goal is to diversify those real estate holdings. 

Many experienced advisors say approximately 10 per cent of an investor’s portfolio should be in real estate, though most people hold more than that. If a significant amount of a client’s worth consists of CRE investments, advisors can struggle to provide an accurate, comprehensive wealth management plan and miss out on significant revenue since real estate, which is not typically a forte for advisors, makes up such a substantial part of a high net worth client’s portfolio. 

If 40 per cent of a client’s real estate worth is in one or two types of properties that can be risky. With a DST, a client can invest in five to 10 different types of properties that also differ in things like location, property tax, and strategy, potentially increasing their return and further managing risk.

DSTs also open the doors to a whole new quality of real estate. Most clients can’t buy an Amazon distribution facility outright, but they can fractionally own one through a DST. For example, a client can invest $200,000 to $300,000 in a quality property or properties through a DST. However, they’d need half a million or more to purchase a property on their own. And that’s not including the time it takes to manage the property, find and retain tenants, or potentially hire someone to complete these tasks. 

Building out wealth management services
Applying MPT to CRE can be tricky for the individual investor. On one side, they’re dealing with a real estate broker who is incentivized by selling a piece of property and, as a result, is encouraging the purchase. On the other side is their financial advisor, who may not have a lot of experience in real estate and can’t properly advise the investor as to whether or not a property purchase will be lucrative. 

That’s where companies like Realized® come in – seeking to bridge the gap between traditional portfolio diversification and the inclusion of strategic CRE investment. Realized helps financial advisors apply a widely accepted form of wealth management to real estate so they can offer to manage this often sizable portion of a client’s portfolio. 

This can not only strengthen the advisor’s business, but it may also provide their clients with a more comprehensive wealth management plan. That includes striving to ensure that a client has a well-rounded balance of gains and losses to potentially reduce tax liability.

CRE investments can present a large capital gains liability, too, when investors want to liquidate. A DST can reduce that via the 1031 exchange option while also providing a client with passive income potential.

Advisors who understand the benefits of applying MPT to CRE have an increased ability to help their clients experience greater investment success. It also allows advisors to establish a competitive advantage by more fully rounding out their services arsenal. 

Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.