As more and more investors come to the consensus that a well-crafted real estate investing strategy can help them achieve their financial goals (even the R word itself: Retirement) a fundamental question arises: How should you allocate your real estate holdings within a Blueprint real estate portfolio? Now, the whole notion of “allocation” within a portfolio containing 100% real estate assets may come across as unnecessary. But keep in mind that even in an “all-stock” investment portfolio, there are different types of stocks that bring different returns (and their accompanying risks) to the portfolio. In much the same way, different real estate assets bring different benefits and risks to a real estate portfolio.
These properties are consistent performers and reliable money makers: They are easy to lease and keep leased. Their weakness is that they don’t offer much in the way of property appreciation. Typically they follow the appreciation curve of the overall market or come just under it. These assets offer higher returns for moderate risk. They are recently built (under six years) or new properties located in areas that aren’t yet established to their full potential. Remember, if an area is already popular, it’s already too late for real estate investors. That train has already left the station – prices have risen to the level where price to rent ratios no longer allow for reasonable returns.
Approximate returns for this category of assets: Cash on cash returns of 15%+ and Internal rate of return of 17-18%. Prices range from $100k-$150k
These properties are typically located in established and highly desirable neighborhoods. They offer moderate returns for lower risk when compared to the standard category. There is always high tenant demand for these properties which results in rising rents over time. They tend to be well cared for, older homes (10-20 years old). Their strength is that they offer higher than overall real estate market appreciation so whatever they lack in cashflow returns they tend to make up on value increase over time.
Approximate returns for this category of assets: Cash on cash returns of 10%+ and Internal rate of return of 12-13%. Prices range from $150k-$200k
Note: There are some properties that have no place in a long term real estate investor’s portfolio, regardless of the “outstanding” returns they appear to offer. The reason their “paper returns” are so high is due to the fact that their extremely high risk is “baked into” that return. That risk often takes the form of a property located in a rough neighborhood with high crime rates, low school quality, higher turnover and eviction rates and property damage from defaulting tenants. These assets are the real estate equivalent of penny stocks. Just say no and thank me later.
So back to the big question: What types of assets should be part of your real estate portfolio and how should they be allocated?
If you just purchase 100% standard assets, you will have good cashflow and return on investment but you won’t be able to take advantage of appreciation waves to the extent that you should. If instead, you purchase a portfolio full of premium properties, you would be relying heavily on appreciation to accomplish your goals. Without appreciation, the cashflow produced may not be enough to get you over the finish line within your investment time frame and that just smells a little too much like speculation for my taste.
The optimal solution is to own a combination of the two asset types within your portfolio so you can have the best of both worlds: Solid returns and appreciation. The exact allocation will depend on the goals of the investor, their available time frame for investing and their income level.
- Investors with short time frames to retirement (under 5 years) more than anything else need all the cashflow they can muster during their short capital base growth stage. They don’t have the luxury of time to wait for appreciation. These investors have no other choice but to build a portfolio made up of 100% standard properties.
- Investors with medium time frames to retirement (5-9 years) need a portfolio weighed heavily towards standard assets but should add some premium properties in the mix to take advantage of value appreciation. Exact percentages will vary with each individual investor’s situation but a good rule of thumb in this case would be a 80% standard, 20% premium allocation of assets within their portfolio.
- Last, investors with long timeframes to retirement( 10-15 or more years) do have times on their side so in their situation it makes financial sense for them to add even more premium properties. Generally we advise these investors to adopt a 65% standard, 35% premium allocation of assets within their portfolio.
When I bring up appreciation in a conversation with a client, they always have a conflicted look on their face. After all, I’ve just finished telling them moments ago, that we don’t account for any appreciation in our cashflow analyses for potential acquisitions. So now, why are we even concerned with appreciation?
Appreciation is an elusive and manipulative animal. It’s hard to empirically quantify how much appreciation an area is likely to experience (if any) and when. As such, we cannot build our analysis based on a factor that may or may not come into play. But understand one thing – normal appreciation is an innate characteristic of real estate assets. It’s common sense: The cost of materials and labor to build new homes goes up every year in response to inflation. So the same property will cost more to build in 10 years than it does today. Home builders are in business to make money and they can’t make money unless they sell their homes for more than what it costs to build them. So therefore, the same home should cost more in 10 years than it does today – it’s just plain economics. So why should that matter to a real estate investor? Well, let’s look at the arithmetic. Say you purchase a 125,000 property and you invest 25,000 of your capital as a 20% down payment. If the value of that property appreciates by 10% to 137,500, your return on investment from that appreciation is 50%! That’s due to leverage- since your investment in the property is $25k, a $12.5k increase in value represents a 50% return – in addition to any cashflow returns you might have enjoyed that year. That’s why it’s a big deal and that’s why you should purchase assets that have the potential to capture it in your portfolio if your investing situation allows it.
Are you looking to build a real estate investment portfolio that can get you from where you are to where you want to be in the future? I can help so don’t hesitate to call my cell at 713-922-2702 or if you prefer email head over to our Contact page