Diversification/Asset allocation strategy

[Elad Messing]

Hello Everyone!

I was wondering if there is any rule of thumb as to what should be my asset allocation between my $ invested in real estate investments, which include:

1. Single family rentals
2. Syndication deals
3. Loans backed up by real estate

(all of which are in the USA)

And: my $ invested in stocks and bonds. I am currently heavily shifted towards real estate portion and was wondering what is the ratio I should be targeting.

Thank you!

Elad

[Kevin Dean]

Hey @Elad Messing I'm currently taking level 3 of the CFA (Chartered Financial Analyst) program, which focuses on all asset classes with a heavy focus on equities, real estate being a smaller segment of the material. Full disclosure however, I spend 100% of my professional career in Commercial Real Estate, so with those two perspectives pulling me in opposite directions I will try to answer this as unbiasedly as possible.  

There are seven steps you can walk through in order to determine your optimal asset allocation. 

1. Assess your capacity to take risk - Do you have a large financial cushion and a high current income? If yes to both, then you have a higher capacity to take risk. If not to one or both, your capacity to take risk is lower. 

2. Assess your willingness to take risk- Based on your prior investing experiences and personal preferences, are you more risk or less risk averse? If you are risk averse, you will want to focus on higher current yield, less volatile, more liquid investments. If you are not risk averse, you will want to focus on lower current yield, volatility will be less relevant, high growth, less liquid investments. 

3. Determine your liquidity needs - do you need to maintain a certain percentage of your wealth in liquid investments/cash? This will be based on current living expenses, debt covenants and obligations, or for the purpose of having cash on hand in order to be opportunistic and act quickly on an opportunity in the market. If high liquidity needs, use safer, liquid investment vehicles. If you have lower current liquidity needs, you can open yourself up to pursuing illiquid investment opportunities, which often come with a premium due to the illiquidity factor. 

4. Consider your current tax situation - Are you currently in a high tax bracket? If so you may want to increase your allocation to tax deferred investments, which will result in you paying taxes when your tax bracket is lower in the future. Additionally, a high current tax bracket may mean you want to allocate more of your capital in tax shelters such as a LIHTC property, or a value-add multifamily property in which you can use cost segregation to accelerate depreciation, resulting in current losses which will enable you to write down your higher current taxable income. 

5. Project your current income needs - Are you currently living off of your investment income? If so you will need to allocate more capital to income producing assets such as fixed income or real estate. 

6. Set an accurate time horizon - When do you plan to use this capital to fund living expenses? The closer that time horizon is, the more you need to allocate to income producing, liquid assets. If that time horizon is further away, you can tie up more money in growth assets with less cashflow and less liquidity, such as growth stocks, venture capital or real estate development projects. 

7. Consider any special circumstances - Do you or any of your dependents have any serious health considerations? Do you or any of your dependents have any large life expenses coming up that will force you to alter your return goals, liquidity needs, tax considerations, risk budget or current income needs? Do you have any outstanding lawsuits against you? There are a number of things you could throw into this category. Factor how these special circumstances will effect the answers to steps 1 - 6. 

8. Determine your investment goals and set your risk budget - based on your answers to all of the questions above, you will formulate return, cashflow, tax and liquidity goals. You will then need to realistically analyze your capacity for risk and allocate your capital in a way that will meet all of your goals while not exceeding your risk threshold. 

Conclusion: As you can see through the analysis above, everyone's asset allocation should be different. Rules of thumb are set by those who do not want to dig deeper. Age is a very small component of determining an asset allocation and people of the same age can have very different asset allocations depending on their personal circumstances. You know yourself better than anyone else and it looks like you have no fear allocating capital across a range of non-traditional asset classes. I would think through the steps above and allocate your capital in a way that meets all of your personal investment needs.