How Much of Your Investment Portfolio Should Be in Private Real Estate?

Private real estate can build wealth as a hedge against the stock market because it has a low correlation to stocks and bonds, rising and falling well behind the economy. Well-chosen properties not only tend to keep pace with inflation and hold their value, they also offer investors tremendous benefits, from high returns to tax advantages.

But with the prospect of adding private real estate to a portfolio brings about an important question: how much to own?

Yale University’s endowment — considered a global gold standard for its exceptional performance — has grown from $5.8 billion to $27.2 billion over the last 20 years and produced a 12.1% return with help from substantial investments in private real estate. Yale’s endowment allocated 10% of its portfolio to real estate in the fiscal year ending June 2017, but its allotment reached 20% in 2013, notes Lazard Asset Management.

A recent Tiger 21 survey cited by Bloomberg showed that high-net-worth investors representing $51 billion in assets had an average of 33% of their portfolios in private real estate investments. And a report from Urdang Securities Management cites a study by Stephen Lee, of the Cass Business School in London, which concluded that: “Optimally investors would include a 26% allocation to private real estate, but actual allocations are much lower, due to perceived risks and illiquidity.

Lee brings up a good point: One thing investors must keep in mind when allocating to private real estate is the fact that it’s illiquid, which means an investor’s capital may take months or years to unlock. So real estate is not an ideal investment for those who need capital in the short-term for living expenses or college tuitions. The ideal allocation truly depends on each individual investor’s situation, which is a combination of their net worth and time horizon.

For example, a family office worth $300 million may be fine with more than 50% of its investable capital in illiquid assets, while an accredited investor with $1 million in investable capital may not feel comfortable having any capital in illiquid assets. On the flipside, an investor may be perfectly comfortable with a large illiquid position in their retirement account, but not in their personal savings account, which they may need to tap at a moment’s notice. Illiquidity is something that has to be managed appropriately.

The question to ask is how much liquidity should be reserved for an emergency?

The illiquidity that comes from private real estate investing isn’t necessarily a bad thing, as long as an investor has enough savings to use for emergencies. One of the most common bad investing decisions is precipitated by panic when the market turns south. The pain of a stock market crash is so great that investors flee at the bottom, which is precisely the time they should stick with it.

Solid evidence substantiates this point. In “Why Smart People Make Big Money Mistakes and How to Correct Them,” co-authors Gary Belsky and Thomas Gilovich pointed out that “by pulling your money out in short-term stock market drops, you run the risk of missing the productive days.” And those productive days add up. They did the math: “If you missed the 90 best-performing days of the stock market from 1963 to 2004, your average annual return would have dropped from almost 11%… to slightly more than 3%.”

It turns out that amounts to big bucks. According to the co-authors calculations, “on a $1,000 investment, those different rates of return translate into the difference between having $74,000 after four-decades and having about $3,200.” It brings to mind another benefit of real estate investment: illiquidity can stave off knee-jerk decisions brought on by panic.

The matrix below helps guide a potential private real estate investment allocation, based on net worth and time horizon. Bottom line, a mix of stocks, bonds and private real estate investment can yield a higher risk-adjusted return and lower volatility. But determining how much to allocate to longer-term private real estate is a personal decision each investor must make based on their short- and long-term goals and needs.