The New Alternatives

Utilizing Real Estate In Retirement Portfolios

The emerging potential of asset-diversity

by David Wieland

Mr. Wieland is CEO of Realized, an advisory focused on real estate & investment property. Visit www.realized1031.com.

At one time, building the right portfolio for retirement meant paying attention to liquid assets like stocks, bonds, mutual funds, ETF’s and cash equivalents. While these are still essential parts of retirement portfolios today, more investors are focusing on alternative investments – like real estate – to help improve portfolio diversification and better manage risk.

Delving down further, investors are filling their portfolios with passive ownership options versus owning real estate outright. To obtain a balanced, risk-based portfolio, they rely on experienced advisors for help.

Defining Alternative Investments

Investors acquire assets or items as investments for various reasons depending on their financial goals and investment objectives. Some investments can generate income or growth. Others might be selected for their appreciation potential.

Delving further into this definition, investments are divided into two categories:

Traditional investments. These are stocks, bonds, mutual funds, ETFs, and cash or cash equivalents commonly traded on public exchanges. 

Other traditional factors are that they:

  • Are easily convertible into cash (they tend to be liquid)
  • Are overseen by regulatory agencies, including the Securities and Exchange Commission (SEC), Federal Reserve Board (FRB) or the Federal Deposit Insurance Corporation (FDIC); note that some alternative investments are also regulated to some degree
  • Available to accredited and non-accredited investors as long as they’re suitable and in the client’s best interest

Alternative investments. Alternative investments are generally those outside the realm of stocks, bonds or cash equivalents. These can include:

  • Private equity, debt or hedge funds
  • Commodities
  • Collectibles
  • Intellectual property
  • Real estate

Alternative investments tend to be more challenging to convert quickly into cash, meaning they tend to be illiquid. They’re also not as heavily regulated as their traditional investment counterparts. They can also be riskier, requiring more due diligence from the investor.

However, alternative investments have the potential to generate higher returns than traditional investments. Many also have a low correlation to market movements. This means they could be helpful when diversifying retirement portfolios while reducing market volatility.

An Overview Of Real Estate Investments

Real estate investments in the United States stretch back to the early 19th century. But real estate as a potential asset for retirement portfolios emerged with the passage of the Employee Retirement Income Security Act of 1974 (ERISA). 

This law encouraged pension fund managers to find ways to increase diversification in the era of high inflation. Real estate proved to be a well-performing asset for many retirement portfolios.

Sixty years after ERISA was signed into law, pension fund managers and investors are using real estate as a diversification tool and inflation hedge in the following ways.

Direct ownership. Through direct ownership, investors physically own buildings and/or the land on which they sit. Investors also have direct involvement with “tenants, toilets and trash,” in other words, the property’s daily operations. They might hire others to manage day-to-day activities but are still directly involved with improving asset value.

Passive ownership. Investors opting for passive ownership pass the day-to-day operations to another entity, which might include the following:

  • Real estate investment trusts. REITs are formed to buy, sell, finance and operate income-producing real estate. Investors can participate in equity or mortgage REITs, which can be traded on public exchanges or privately.
  • Delaware Statutory Trusts. DSTs are legally recognized trusts where each investor owns a “beneficial interest” based on an equity investment. The DST doesn’t need to be in Delaware. Neither is the property (or properties) bought or managed by the trust.

REITs and DSTs are similar in that they pool money from investors to buy income-producing properties. At the same time, investors aren’t involved with buying, selling or operating the real estate. Furthermore, DST and REIT investments can provide portfolio diversity.

Alternative investments have the potential to generate higher returns than traditional investments. Many also have a low correlation to market movements. This means they could be helpful when diversifying retirement portfolios while reducing market volatility....

However, there are multiple differences between these two passive investment structures:

Liquidity. Publicly traded REITs are liquid; REIT shares can be traded on public exchanges and converted into cash. DSTs are long-term investments and are considered illiquid. Additionally, few secondary markets exist if a DST beneficiary needs to cash out.

Minimum investment. A DST carries a minimum investment determined by the sponsor, with the trust available only to accredited investors. Publicly traded REITs generally don’t have minimum investment requirements. They’re also open to accredited and non-accredited investors.

Tax-deferred benefits. Thanks to the IRS Revenue Ruling 2004-86, DST fractional shares can be used in a 1031 exchange. The like-kind exchange means investors can sell direct-owned real estate and use the proceeds to fund the DST with help from a Qualified Intermediary (QI). With this method, the investor could defer capital gain and depreciation recapture taxes from a real estate sale. REITs aren’t eligible for participation in a 1031 exchange.

Cessation of the trust. A DST terminates when its asset or assets are sold, with any proceeds distributed to investors. Its purpose is done. As operating companies, REITs don’t cease operations when they sell assets.

Greater diversity potential. REITs tend to be correlated to market movements; as the markets move in one direction, so might REITs. Real estate-oriented DSTs are less likely to move in the same direction as markets. Because of this, they can provide greater portfolio diversity.

DSTs As A Passive Investment Strategy

Accredited investors may benefit by adding DSTs to their retirement portfolios, like the examples below.

Tax-Advantage Strategies

DSTs can be an essential part of a 1031 exchange strategy. DSTs potentially qualify as like-kind property, meaning that investors could defer paying capital gain and depreciation taxes on the sale of investment real estate.

Potential Portfolio Diversification

Passive real estate investment strategies help with portfolio diversification. As mentioned above, real estate asset performance can be non-correlated with market movements. Furthermore, the fractional purchase allows an accredited investor access to different real estate assets that typically could not be purchased exclusively by the average investor.  For example, many accredited investors might not have the means to buy a $100 million multifamily property or industrial building. But they could acquire fractional shares of a DST that owns such property, potentially benefiting from cash flow, appreciation and other advantages.

Possible Cash Flow And Asset Appreciation

Investors could receive cash flow from their DST involvement depending on the investment type and offering. There is also the chance of generating capital gains when the DST sells its assets.

How Advisors Help

Because DSTs can be complex, working with a Broker-Dealer and RIA like Realized on investing in one or multiple trusts is a good idea. Reputable and knowledgeable advisors can provide the following.

Risk Management And Due Diligence

An advisor specializing in DSTs and real estate can help an investor make informed decisions by conducting an in-depth analysis of the sponsor, DST, and underlying property. Such an analysis can include the following:

  • Asset examination. This might delve into the type of asset considered for purchase and where it might be in the real estate cycle. The process could also consider potential revenue flow and possible capital expenditures.
  • Market/location evaluation. Understanding how well-suited a property’s location is to its use is important. This activity could focus on area competition and regional economic outlooks.
  • Capital and debt assessment. This would study the DST sponsor’s financial profile. As sponsors aren’t allowed to raise additional funds, such an analysis is critical to ensure that the trust has enough capital to reach goals and enough cash flow to pay off debt.

Investor Needs

Along with analyzing DST sponsors and real estate holdings, an advisor will take time to meet with investors. For example, Realized Financial will ask investors about their tolerance to risk and investment goals.

Understanding these and other issues can help ensure investors receive information about offerings to help them compliment or meet their retirement objectives.

Connecting Real Estate With Retirement Portfolios

A well-planned retirement portfolio aims to provide enough returns and cash when it’s time to say goodbye to the workforce. Retirement portfolios once contained stocks and bonds; alternative assets for these portfolios have gained popularity these days.

With the proper due diligence, strategy, and goals, passive real estate investments in the form of DSTs can boost retirement portfolio performance through additional diversification and an increase in depreciation and cash flow. To ensure they receive suitable offerings to match their goals and risk tolerance, investors should partner with an experienced, reputable advisor.