This article was originally published on the Forbes website.
Real estate offers investors many benefits. It has little correlation to stocks and bonds since its value rises and falls behind rather than with the same speed as the economy, which makes it a hedge against the stock market. And carefully chosen properties not only appreciate over time; they also yield tax advantages and healthy returns.
But, how much of an investor’s portfolio should be allocated to real estate?
It pays to take a lesson from Yale University’s endowment. With $29.4 billion now under management, the university’s investment strategies have proven productive, stable — and widely imitated. Yale University’s endowment typically allocates 9-11% of its investment portfolio to real estate.
What does this say for the rest of us? Not everyone can build a portfolio on the Yale blueprint, nor should they. But giving a portfolio exposure to real estate and other alternative investments is easier said than done.
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Bulldogs For High-Performance Turn To Real Estate, Private Equity
Yale bears the standard for a high-performing endowment. Its returns consistently cover one-third of the school’s operating expenses, from salaries to scholarships. The Ivy League school “dramatically reduced the Endowment’s dependence” on stocks and bonds 30 years ago, the Yale Investment Office says. When institutional allocation strategies such as absolute return were still in their infancy, portfolio managers took a hard turn toward real estate, natural resources and other alternative investments.
In years when the public markets show strength, the Yale model is inevitably criticized for shunning stocks. Yale’s most recent investment update says that endowments on average invest close to half their assets in public equities, citing investment consultancy Cambridge Associates. Yet in 2017, Yale had 75.1% of its portfolio invested in alternatives at year’s end, while only 3.9% was invested in domestic equities. Alternative investments included not only absolute return instruments but also venture capital, leveraged buyouts, real estate and natural resources.
The model is a clear success. Outside the ivory tower, pension and other fund managers follow the Yale example with broader investment horizons. According to global risk management advisory Willis Towers Watson, pension fund allocations (download) over 20 years have increased for real estate, private equity and infrastructure, from 4% to about 20%.
Savvy Investors Know That Real Estate’s A Long Game
Real estate is a long-term illiquid investment that can be hard to divest, as market conditions change or for investors who depend on regular returns for income. But, it has its upside. Investors who are locked into real estate assets are spared from the temptation of panic selling that ruins so many stock portfolios. Real estate’s role in the Yale portfolio is to hedge against inflation, according to the endowment’s most recent report. It accounted for 10.9% of Yale’s asset allocation in 2017.
For investors who have diverse holdings and can allocate resources to strategies with extended time horizons, real estate allows them to capitalize on market inefficiencies. These can range from situations where sellers don’t recognize a property’s true worth to value-add opportunities where buyers can solve problems that hold back appreciation. But as any cash-poor landlord will tell you, having too much of your assets in real estate can be limiting when life events come calling, like paying for college.
How Much To Allocate To Real Estate
Of course, you don’t have to be rich to buy real estate. Publicly traded real estate investment trusts (REITs) can deliver reliable and good returns. Investors can buy and sell REITs just as they do equities, sharing in in the growth of the real estate market without dealing with management hassles of owing properties directly. But like equities, REITs track the market’s volatility. When the markets go up or down, they do too.
Accredited investors have options beyond REITs and owning properties directly. New fundraising rules put the stakes for private equity real estate within reach for family offices and high-net-worth individuals. For private equity real estate, there are now low-fee alternatives to REITs with funds. (Full disclosure: My company offers this type of investment fund.) These funds invest in multiple institutional grade properties, and by doing so, they limit the risk of any one investment sinking the portfolio. Fund investors don’t have the landlord’s direct choice of where to invest or hands-on control of their asset, so they must research a fund manager’s investment strategy, track record, underwriting practices, team and goals and be comfortable with them. They must also understand the downside — namely, that private real estate investments are a long hold, usually ranging from five to seven years or more.
But using either strategy how much of an investment portfolio should be in real estate? Here’s a general guideline to a real estate asset allocation, based on net worth and time horizon. Every investor will have different timing needs to reach their investment goals, so recommendations are not the final consideration.
| Time Horizon | Net Worth | |||
|---|---|---|---|---|
| $1 – $5M | $5 – $10M | $10 – $25M | $25M+ | |
| Under 5 Years | 5% | 10% | 15% | 20% |
| 5-10 Years | 10% | 15% | 20% | 25% |
| 10-20 Years | 15% | 20% | 25% | 30% |
A diverse portfolio buffers the risks of the public markets, with the potential for building great wealth. There’s no ideal asset allocation for every retirement account or family portfolio. But Yale’s model points to a more productive way to think about investments and their potential for higher returns.
