By Dr. Jim Dahle, WCI Founder
Once you have decided to invest in real estate, at least outside of publicly traded REITs, you will quickly discover one of the biggest dilemmas in this space—the minimum investment vs. diversification dilemma.
It basically looks like this. Consider a doctor five years out of residency who has now paid off student loans and is living in a “doctor house.” This doc makes $300,000 a year and saves $60,000 a year. Perhaps the investment portfolio is sitting at $400,000 right now. The doc decides to invest 25% of the portfolio into real estate. Twenty-five percent of $400,000 is $100,000.
Depending on how the doctor prefers to invest, the minimum investment problem will quickly rear its ugly head. Consider the minimum investments of some common real estate investments (including those in my portfolio and those provided by some sponsors of The White Coat Investor).
Now, don't take everything in this table for gospel. Minimum investments and the number of properties in a fund frequently change, but this gives you a pretty good sampling of what is out there. Note also that not all properties are the same size. For example, the DLP Housing Fund might only have 28 properties, but that represents close to 15,000 doors in 15 different states. Obviously, those are pretty large properties.
2 Schools of Thought
There are two schools of thought when it comes to diversification. The classic one is that you don't want to put all of your eggs in one basket. That way, if any given investment does poorly, it won't hurt the overall portfolio much. This is a very real concern. I have had one individual syndication and one property inside a private fund go to zero. That would be devastating if either had been a large chunk of our portfolio.
The other school of thought is often attributed to Warren Buffett and basically says, “Put all of your eggs in one basket and then watch that basket very closely.” For Warren, that means being on the controlling board of the investment. For a real estate investor, that should probably mean you're the primary owner of a direct real estate investment. Once you're investing in syndications, funds, and REITs, you no longer can watch that basket closely and you need to diversify.
More information here:
Diversification Always Matters (My Syndicated Investment Goes to Zero)
A Private Real Estate Investment Update: My CityVest DLP Access Fund Goes Round Trip
A Diversification Rule of Thumb
How much diversification is enough? Only you can be the judge. I think a reasonable rule of thumb when it comes to passive real estate is that you need at least three different operators/managers and that you should not have more than 5% of your money in any given property. This level of diversification is easily achieved with publicly traded REITs and private REITs. As long as you own three of them, the private funds are also relatively easy to diversify. However, if you're buying individual syndications, you're going to need at least 20 of them. That's $200,000-$500,000 if you're buying them on crowdfunding platforms with low minimums. When you go directly to operators, that's more like $1 million-$2 million. That's a much harder target to hit for most white coat investors, especially when you consider that $1 million-$2 million is only a portion of their portfolio (since they also usually own some stocks and bonds).
When it comes to private funds, the high minimum investment is going to require you to have at least $150,000 invested in real estate across three funds to reach that minimum diversification level. With 25% of your portfolio in real estate, that suggests a portfolio of at least $600,000.
None of that sounds too bad at first glance, but it can be tricky when you are building a portfolio from scratch. Let's go back to the example of the doctor who has a $400,000 portfolio and wants to invest $100,000 of it into real estate. Sure, that doc may like a fund manager like DLP or 37th Parallel, but if the doc invests there, they will have to contribute the entire real estate portfolio into a single investment. And forget individual syndications. The doctor will need to choose from the REITs and funds with lower minimums or endure a period of multiple years before having adequate diversification in this portion of the portfolio—especially when you consider that the doctor is only investing $15,000 a year into real estate. It takes a long time to get to a $100,000 minimum investment like that.
More information here:
A Tale of 2 Sponsors: How My Real Estate Investments Have Had Vastly Different Results
The 60+ Worst Mistakes You Can Make in Real Estate Investing
The Hassle Factor
Perhaps a bigger issue than diversification is the hassle factor of keeping track of so many investments, especially when it comes time to file taxes. I love the simplicity of our Vanguard taxable mutual fund portfolio with a handful of funds that all reported on a single 1099 received in January each year. Compare that to somebody who owns 20 syndications across a dozen states. That person will receive 20 K-1s between March and August, and they will likely have to file taxes in a half dozen states every year.
Investing in private funds increases diversification and cuts down on the number of K-1s, but it is not uncommon for a single fund to invest in a dozen states and require you to file in many of them. Sticking with the REITs (which send out 1099s instead of K-1s and don't require multiple state tax filings) can eliminate many of those hassles.
Personally, my individual investments get larger and larger, not only because I have more capital to deploy as time goes on but because it takes a certain amount of investment return/income to be worth the hassle and cost of keeping track of multiple investments and filing in multiple states. This is also why I prefer open-ended funds; I can contribute more to the same investment rather than doing the paperwork for a brand new one as occurs with the firms that run a series of close-ended funds.
If you decide you want to add real estate to your portfolio, consider how you will maintain diversification and minimize hassle as you select investments.
If you are interested in private real estate investing opportunities, start your due diligence with those who support The White Coat Investor site:
Featured Real Estate Partners
What do you think? Is this a problem you've had in real estate investing? How did you resolve the minimum investment/diversification dilemma?
Here’s another issue for those who might add this: If the $600K portfolio, or the $4 million portfolio, WCI decides to move to 25% real estate there will be a good bit of taxes paid to move from (presumably) stock and bond holdings to free up that big chunk for initial real estate investment. Or a decision to slowly move such holdings, or forego new investments in anything but ‘cash’, for a few years; to put into real estate once enough is amassed to make those moves. An inheritance or say sale resulting in a large cash inflow such as selling a practice or some other property would avoid this tax / slow build up issue, as would doing all real estate investing in tax deferred or tax free accounts such as IRAs if permitted by the plan.
Good post. In addition to the diversification / risk angle I have a questino about returns as I attempt to gauge what an outlook would be to compare with public markets.
If you’ve written about this before what do you estimate your returns on real estate will be? And what have they been historically?
It’s difficult to compare the returns from these private funds to public market returns.
1. The projected returns from these funds come from the sponsor and are just that, projections. Some sponsors will be conservative with their estimates, others will be aggressive. And there’s no way you can aggregate them all. It will be less reliable than projections for the public markets, which itself is kind of a guess, as well.
2. These funds are levered, in that there is debt (and more risk). It’s not comparing apples to apples to compare the two. And different sponsors will use different amounts of debt.
3. Historical returns have the same issue, leverage. And a relatively short track record (especially compared to stocks).
1. I’m not sure the projections are any worse for private than for publics, might even be better, but either way, I agree that short term projected returns are close to useless. I got an email this week from Origin with their income plus fund which included this data about past returns:
Jan-May 2024: 1.2%
2023: 4.5%
2022: 9.5%
2021: 21.9%
2020 (Apr-Dec): 4.6%
Their updates include comparisons to two benchmarks (please excuse cut and paste formatting but I think you can figure it out):
Benchmark
YTD
Trailing 1-Year
Trailing 3-Year
Non-Traded REITs2
0.3%
-2.1%
7.0%
FTSE NAREIT U.S. Real Estate Index – All REITs
-4.3%
9.4%
-5.2%
Origin IncomePlus Fund
1.2%
2.6%
10.3%
Disclosures
Total returns reflected are net of fund fees and assume monthly reinvestment of distributions. Returns are not guaranteed. Past performance is no guarantee of future results. All investments involve a degree of risk, including the risk of loss.
Non-traded REITs reflect four of the industry’s largest non-traded REITs that provide publicly available performance reporting. The non-traded REIT returns presented above represent a simple average of the four constituents. Origin has not separately verified accuracy of the performance data with each third-party issuer. Actual individual investor performance may differ based on share class.
On the equity side I see little reason to be chasing private investments for single digit returns when expected long term returns on public REITs are probably in the 10% range. With that additional risk and leverage I really think I ought to be compensated in the 11-15% range. If they can beat that great, but I am certainly not counting on that.
On the debt side it’s easy to see what my returns have been (9.25%) and I see no reason for that to really change much in the long run. 7-11% is my expectation there. The main downside is debt real estate returns are super tax-inefficient.
Any thoughts on private non-traded REITs like BREIT, SREIT?
It seems like one major issue with these evergreen funds is that they might have to sell cheap to fulfill redemptions.
And those redemption requests come at the worst time, when the markets are slumping. Basically what we saw in 2023.
There is a risk there. I haven’t spent a lot of time looking at them. If they’re so large that they’re investing in the same stuff the public REITs are I’m not sure there’s much of an advantage there in being private.