How to position real estate in the portfolio

Reader alert: This is Part 3 of a series. Read Part 1 and Part 2.

As mentioned in Part 2 of this series, the addition of real estate investments can enhance the diversification of a portfolio. But introducing a new asset class to the mix takes some finesse to avoid overwhelming investors with too many products. It also requires some “know how” to find the right investment.

For Doug MacDonald, RFP, Vancouver-based Macdonald Shymko & Co., the primary job of a financial advisor is to help investors maintain discipline, and to do this the portfolio needs to be kept simple. In the process of determining how much real estate investment should be included in the equity portion of the client’s mix, he remains focused on keeping the portfolio simple with only a few funds to meet the clients investment need and comfort level.

“The industry makes life so complicated, whereas we strive to make it simple for the client so that they understand what they’re doing and why they’re doing it.”

Keep it simple

For MacDonald, once the asset mix is determined, it’s about deciding how much real estate should be added to the equity portion of the mix, so that if the investor has an allocation of 50% equities, 10% of that may be allocated to real estate. And, as investors draw closer and deeper into their retirement, the mix would be adjusted to reflect a larger portion of real estate investments because inflation protection and cash flow are a greater concern to retired investors than investors in their thirties with employment income.

MacDonald typically uses the “core and explore” approach to asset allocation, so he’ll often start clients with a REIT index to harvest the core return and then depending on investor’s comfort level, he’ll add actively managed funds to give the portfolio a personal tilt. But the point is that using REITs to start keeps the portfolio simple and provides investors with the desired market exposure.

It’s all about the team

According to Carey Escoffery, real estate financial analyst and advisor at DCL Equity Partners Inc., the key to finding a good real estate investment is getting the right team of experts who have expertise not only in the financial aspect, but also knowledge of the local market and understanding of building structure. But most important, the team should include a visionary—someone who can see how a building’s current function can be converted to reach its highest value in the future.

“The visionary, with their understanding of the market, will see that the warehouse has the potential to be converted to a multi-family residential unit,” says Esoffery.

Understanding the metrics is just one part of the piece in finding good real estate, but it requires expertise from the ground to give the data fuller meaning. Take the capitalization rate (cap rate) for example. This value provides a general indication of the property’s rate of return based on the expected income and is often used as the baseline to valuing property.

Generally a high capitalization rate, often the result of lower property prices, signals potential for high return. But with a higher cap rate there’s also the risk/reward tradeoff as higher cap rates may be the result of political instability in the area and this may be the reason for the depressed property values. Conversely, a low cap rate may not necessarily be indicative of poor investment. For example, despite the low cap rates in the U.S., institutional investors have been scooping up commercial real estate property there.

“Of course the metrics would include more than the cap rate. But the point here is that the metrics do not tell the full story,” says Escoffery. “You also need experts on the ground to review the property and the local market.”

On the ground, a host of other factors can affect the property’s investment return.

“Other factors such as views, corner locations, architectural appeal, building functionality, and walkability to public transit, retail, restaurants, lodging, entertainment, and landmarks can differentiate one building from another,” says says Joe Rodriguez, senior portfolio manager, Invesco Global Real Estate Fund.