By Dr. James M. Dahle, WCI Founder
Too many real estate investors (and, really, investors of all types) approach investing as a collector rather than using a well-thought-out (and written) plan. They end up with a portfolio full of shiny baubles that introduce all kinds of unnecessary risk and that may even prevent them from reaching their goals. When it comes to the real estate portion of your portfolio, consider using the four-quadrant approach to analyze your holdings.
The Four Quadrants of Real Estate
The four quadrants divide real estate into four categories, using public vs. private and equity vs. debt.
Public vs. Private
Public real estate is traded on an exchange. These typically take the form of Real Estate Investment Trusts (REITs) or mortgage-backed securities of some form. These investments can typically be bought and sold on the open market every weekday. Private real estate is not bought and sold every day, and it can be very illiquid. The primary benefit of public real estate is liquidity, but there are often secondary benefits of easy diversification and access to passive management techniques. The primary benefit of private real estate is stability, although there are often secondary benefits of higher returns (from an illiquidity premium) and the opportunity to add value (or subtract it) through savvy active management in an inefficient market.
Equity vs. Debt
Just like with the stock and bond markets, the equity side focuses on growth and the debt side focuses on income. While there can be some overlap, equity tends to be more volatile and uncertain but provides higher returns. Debt tends to provide less volatile, more certain, fixed, and lower returns. The equity side also tends to be much more tax-efficient than the debt side.
If you plot these two spectrums against one another, it looks like this:
If you start in the upper left quadrant, you will find Private Equity. The primary benefits here are high returns, stability, control, and tax efficiency. This category includes the house down the street and other directly owned real estate. It also includes syndications, private funds, and private REITs. If it is equity and is not traded on the public markets, it goes in this box. This is actually the largest box in the quadrant by market capitalization, as most real estate is not publicly traded. Traditionally, smaller properties are also far more common in this box than in the public equity box, providing exposure to an important risk factor.
The biggest downside of private equity real estate is its illiquidity. It takes time to get into these investments and time to get out of them. Transaction costs can be substantial. However, it is one place that an investor with the capability and willingness to be illiquid can add stability and potentially additional return to the portfolio. These investments are also much more likely to be actively managed, introducing additional manager risk but also the potential to add alpha through smart management. There is some debate whether the illiquidity premium is eaten up by fees and active management missteps, but there is no doubt that private equity investments can add stability to your portfolio. While the markets are going haywire, your tenants will likely just keep paying the rent each month.
If you move to the lower left quadrant, you will find Public Equity. The primary benefits here are high returns with liquidity. While there is substantial debate (and no good data) whether private or public equity provides the highest pre-tax returns, there is no doubt that public equity provides far more liquidity than private equity. Public securities also generally require less time, hassle, and expertise from investors.
The main downside here is a lack of stability. Publicly traded real estate companies, including REITs, tend to rise and fall with the stock market on a minute-to-minute basis. This is the price of liquidity, but it can manifest with some impressive volatility such as the 78% drop in the value of publicly traded REITs in the 2008-2009 bear market. Publicly traded REITs are also among the least tax-effective of stocks, despite the ability to take advantage of the 199A deduction. Yields are also usually substantially lower than similar underlying assets found on the private market. Compared to the private market, it can also be more difficult to go further out on the risk spectrum, away from core and core-plus properties into value-add and opportunistic properties.
Moving to the right over to the lower right quadrant, you will find Public Debt. This quadrant provides the highest liquidity of any real estate investment, although substantially less in a crisis than securities—such as a money market fund, savings account, or treasury bonds. It also provides significant yield and much lower volatility than on the equity side. Public debt is easy to diversify. Public securities also generally require less time, hassle, and expertise from investors.
The main downsides of public debt are low returns and tax inefficiency.
If you now move up to the upper right quadrant, you will find Private Debt. This quadrant provides the highest yield of any real estate investment. This quadrant includes individually held mortgages (such as when you sell a rental property and take back the mortgage), but most savvy investors diversify here by using private debt funds. Yields tend to be higher (sometimes much higher) than in the public debt quadrant, and prices are more volatile—although part or all of that may be a reflection of the fact that private investments are not marked to market daily. Private debt is also often shorter term than public debt, reducing interest rate risk. Manager skill (or lack thereof) also plays a more significant part here.
The primary downsides of this quadrant are tax inefficiency and illiquidity. Essentially the entire return in this quadrant is paid out in yield, taxable at ordinary income tax rates each year, making this the least tax-efficient quadrant. While substantially less liquid than public debt, private debt is generally much more liquid than private equity, as most of the debt is of short duration. Even funds tend to provide liquidity after just a few months or a year. The biggest risk with a private debt fund is that it becomes a private equity fund should real estate values collapse and the fund has to foreclose on the properties in the portfolio.
Building a Portfolio
Stability and liquidity. Growth and income. Whether real estate makes up 10% or 80% of your portfolio, you'll need to decide how to divide your assets between the four quadrants of real estate investing. There is no rule that requires you to use all four quadrants, much less split your assets evenly between them. You can decide what ratio you want to use in your portfolio according to your needs for high returns, liquidity, stability, and income.
In my case, real estate makes up 20% of my portfolio. I have 10% in private equity, 5% in public equity, and 5% in private debt. This provides me with a nice blend of what I'm looking for—high returns, stability, and liquidity in that order. (Notice how my lack of need for additional income explains why 3/4 of my real estate is on the equity side).
Your mix may look entirely different from mine, and that's OK.
Proper asset location can add significantly to your after-tax return. Some quadrants do better in retirement and other tax-protected accounts than others. As the least tax-efficient quadrant, private debt is an obvious candidate for tax-protected accounts. Unfortunately, these investments are not available in very many of them. If you have access to a self-directed traditional or Roth IRA or a self-directed 401(k), private debt is probably the first asset class that should be placed in there.
If you do not have self-directed retirement accounts and wish to put real estate into retirement accounts, you will likely need to put public debt and/or public equity into those accounts. The tax inefficiency of public debt argues to place it first into tax-protected accounts, but the higher expected returns of public equity probably outweigh that factor when yields are low.
Private equity is not only the most difficult to put into retirement accounts, but as the most tax-efficient of the quadrants, it is the best one to hold in a taxable account. Only the most diehard real estate investors with the highest ratio of real estate to other assets in their portfolios will consider putting private equity real estate investments into their tax-protected accounts. Otherwise, taking advantage of depreciation, 1031 exchanges, opportunity zone funds, the step-up in basis at death, and Real Estate Professional Status (REPS) can allow the private equity real estate investor to invest surprisingly tax efficiently.
Understanding the four quadrants of real estate investing will allow you to optimize and personalize your portfolio according to your needs for high returns, income, stability, and liquidity.
If you are interested in real estate investing, sign up for our free monthly real estate newsletter. If you are interested in learning more about private real estate investments, you can check out our current real estate partners, most of which I have invested with personally.
What do you think? What is your mix of investments in each of the quadrants and why? Comment below!
Featured Real Estate Partners
Self-Storage / Mobile Homes
Fund / Syndication