37th Parallel Investing Guide: Real Estate Investment Allocation

There may be a million ways to invest your money, but there are a handful of bedrock investing principles that you shouldn’t ignore.

One is diversification, and the other is asset allocation or portfolio construction. Understanding how to create a balanced portfolio is essential to get ahead.

As one of the significant three investments (stocks, bonds, and real estate), you should know how to construct a portfolio that includes real estate investment allocation.

What is Investment Allocation?

Your investment allocation is the amount of money (as a percentage) that you put toward any one asset class. And since everyone’s investing strategy should be personalized to their circumstances, there is no such thing as a universal allocation formula. 

Asset allocation should factor in long-term financial goals, risk tolerance, savings rate, investment horizon, etc. 

After doing all that, how your portfolio is allocated will likely look different than mine. And that’s the way it’s supposed to be.

Understanding the Importance of Investment Allocation

It’s important to understand that risk and reward are inextricably intertwined in investing. The more risk you take, the higher the return can potentially be. Unfortunately, the converse is also true. You’re also more likely to lose significant capital.

Unsystematic risk can also be problematic for those who forgo asset allocation and diversification.

Unsystematic risk is the risk generated in one company or industry that doesn’t necessarily affect other sectors or the broader economy. So, what is an example of unsystematic risk? Let’s say you invest all your money in growing stone fruit in California. 

If California has an unseasonably hot year during a multiyear drought, fruit production could be down significantly. You’ll lose money even though farming in the rest of the country is unaffected and the economy is good. 

Diversification and asset allocation moderate unsystematic risk by spreading your investments across unrelated classes. In the above example, you’d still lose money in that investment, but your other investments have the potential to be productive and reduce the losses with their gains.

Investing in asset categories whose returns move up and down under different market conditions protects you against significant losses. That’s why asset allocation, diversification, and intentional investment portfolio construction are essential. 

Diversifying Your Portfolio with Different Assets

So diversification is a good idea, but what are your options? Below is a list of the major asset classes.

• Stocks (Equities including ETFs, mutual funds, REITs, and individual stocks)
• Bonds (Fixed Income)
• Cash & Cash Equivalents
• Real Estate 
• Commodities
• Alternative Investments (private equity, cryptocurrencies, and other alternative asset classes)

Several investment vehicles can be purchased to gain exposure to these classes. You can buy them individually or in various funds, such as mutual funds and ETFs. 

Benefits of Allocating Investments in Separate Areas

As we discussed earlier, the benefit of allocating investments in separate areas is protection against the downside of any one investment. Diversification buffers against significant losses from any one investment.

As Warren Buffett says, rule #1 is never to lose money. Rule #2 is don’t forget rule #1. There are obvious reasons why you don’t want to lose money, even though sometimes you will. 

Unfortunately, losses hurt more than gains help. The best way I can explain that is by using an example. Suppose you have invested $100,000 and suffer a 20% loss. You’d be left with $80,000 and need a 25% gain to get back to even. 

Using the same example, if you suffered a 50% loss, you’d need a 100% gain to return to your initial investment of $100,000. Losing significant amounts of money can hurt your performance.

Asset Allocation: Balancing Real Estate with Other Investments

It used to be that an asset allocation model with 60% stocks and 40% bonds was considered balanced. This allocation may not be suitable for everyone, but many believed it was a good starting point. And in the 1980s and 1990s, this approach worked for many people. 

Unfortunately, the 60/40 ratio no longer provides the same return level as in the golden age. The failures in the bond market to provide adequate returns have resulted in many investors paring back on their bond holdings while looking for a suitable replacement. 

For many, that replacement has been real estate. What your real estate investing allocation should be is difficult to say. However, when you compare the average investor’s holdings of real estate to that of professional, institutional investors, the average investor typically has a lower percentage. 

Interestingly, professional investors, with their well-funded research departments, choose to invest more of their money in real estate than the average individual investor. 

Reducing Risk

Diversification is more than buying different companies’ stocks. If all you’ve ever held in your investment portfolio was Apple stock, you can’t buy Microsoft and Oracle stock and be diversified. You would still only own stocks in the technology sector.

To truly diversify your portfolio, you need to understand correlation coefficients. Only then will you be able to construct a portfolio that maximizes returns while minimizing risk. Correlation coefficients are a statistical measure that quantifies how two variables (investments) move about each other. 

These coefficients are measured on a scale from -1 to +1. The definition of strong, moderate, and weak correlation can be debated, but as a general guide, correlation coefficients can be interpreted as follows:

+1.00 perfect positive correlation

+0.99 – +0.85 robust positive correlation

+0.84 – +0.70 strong positive correlation

+0.69 – +0.40 moderate positive correlation

+0.39 – +0.10 weak positive correlation

+0.09 – +0.01 negligible positive correlation

0.00 no relationship between two variables (uncorrelated)

-0.01 – -0.09 negligible negative correlation

-0.10 – -0.39 weak negative correlation

-0.40 – -0.69 moderate negative correlation

-0.70 – -0.84 strong negative correlation

-0.85 – -0.99 robust negative correlation

-1.00 perfect negative correlation

A perfect positive correlation (+1.00) is the strongest positive correlation, meaning that two securities move in tandem, producing identical results. A perfect negative correlation (-1.00) means that two variables move identically opposite and cancel each other out. Uncorrelated assets (0.00) have no relationship with each other and, therefore, move independently of one another.

While correlation coefficients vary over time, you’d expect stocks within the tech sector to have a very high positive correlation to one another. For example, at the time of this writing, Apple stock has a +0.97 correlation coefficient to Microsoft and a +0.91 correlation coefficient to Oracle. This powerful correlation would concentrate a portfolio, not diversify it.

Generating More Success Over Time

So, instead of accumulating multiple highly correlated assets, focusing on ones with low correlation is better.

Nuveen, a TIAA company, looked at thirty years (1991-2021) of correlation coefficients between U.S. stocks, bonds, and private real estate. They found that the private real estate correlation coefficient to U.S. stocks was +0.18 and -0.25 for U.S. bonds.

That means private real estate has only been weakly correlated to stocks and bonds for the last thirty years. This makes it ideally positioned to diversify a portfolio of stocks and bonds. 

And since multifamily real estate has enjoyed decades of high returns and low volatility, additional research has shown that adding rental properties to a stock/bond portfolio increases returns while decreasing risk.

So, if you aren’t a real estate investor and want to generate more success, you should consider adding multifamily properties to your portfolio.

Strategies for Effective Real Estate Investments

It’s important to understand that I’m not discussing your home when discussing real estate investment allocation. There are many great reasons to own a home, but I don’t consider it an investment, and I recommend that you don’t either. 

There are several ways to invest in real estate. To narrow down the right approach, consider these options: active or passive and commercial or residential.

Active investors are their properties’ asset managers and often act as property managers. 

That means that they have the expertise and experience to choose markets, vet rental properties, execute purchase and sales agreements, negotiate terms, manage rental properties, draft a business plan, implement capital improvements, collect rents, drive appreciation, oversee move-outs and make-readies, manage cash flow and successfully liquidate a property. 

If you don’t have the experience and expertise to do these things, passive real estate investing is likely better suited for you. Active management is a full-time job; you could be setting yourself up for failure without the time and experience needed to succeed. 

Passive investing is when you partner with professionals in the industry to do those things for you. Their experience and expertise should maximize returns, and you don’t have to become a landlord to invest in real estate. 

The second question you should focus on is whether you will invest in residential real estate (1-4 units), multifamily properties, or some other type of commercial real estate. We’ll explore these options further in a later section. 

Geographic Allocation: Diversifying Across Locations

If you’re going to invest in real estate, it’s a good idea to diversify your holdings. One of the best ways to do that is to invest in a private real estate fund with holdings in multiple markets.

For those who actively manage, all their properties in the same market can be necessary. However, concentrating holdings in one area can increase risk, as other investments do. Diversification across submarkets, markets, and states can mitigate some risks.

Property Type Allocation: Exploring Multifamily, Residential, Commercial and Industrial Properties

Resident-occupied real estate encompasses residential and multifamily real estate, sometimes called commercial multifamily real estate. Differentiating residential from multifamily comes down to unit count.

Residential real estate is one to four units. It’s single-family homes, duplexes, triplexes, and quads. Anything above four units is considered multifamily. When I refer to multifamily, I talk about more significant apartment buildings or complexes with 100 units or more.

Other types of commercial real estate outside of multifamily are retail, office, industrial, hospitality, etc. Investing in different real estate types can be another way to diversify your portfolio. However, it’s essential to understand that research shows that, over any long-term investment timeframe, multifamily has outperformed other real estate types. 

So, if real estate investing is in your future, consider multifamily real estate.

How Much Should Investors Allocate Towards Real Estate Investments?

As I said earlier, individual investors’ asset allocations, risk tolerance, time horizons, and investment objectives are specific to them. So, no number is suitable for every investor.

That said, most investors are underallocated when it comes to real estate. Perhaps that’s because some mistakenly believe their primary residence is an investment, while others invest in the stock market with REITs (Real Estate Investment Trusts) and think it’s the same as investing directly into the real estate market. 

When you look at professional institutional investors, you’ll notice that the most prominent real estate investors are insurance companies, endowments, and pension funds. These institutional investors research their investments thoroughly and leverage the power of real estate to achieve their investment goals. 

Is A Real Estate Investment Strategy Worth It?

Studies show that adding real estate to one’s portfolio increases returns and decreases risk compared to a portfolio with just stocks and bonds. So, adding real estate is worth it if you do it right. It’s essential to have experience or expertise or invest with someone who does. 

Stocks are known for producing high returns over the long term. However, they are unpredictable and can be highly volatile in the short term. Historically, investors have balanced that risk with bonds. Bonds offer fixed income, stability, and low correlation in a lower-return investment. 

However, as bond returns have declined to untenable levels, investors have sought viable alternatives. Real estate, particularly multifamily, has the potential for stable income, stability, and diversification while providing a much higher return ceiling than bonds. 

So, making a real estate allocation by cutting your percentage of bonds can make a lot of sense. Interestingly, research also shows that whether you allocate to real estate by cutting bonds, stocks, or both, your overall portfolio would yield increased returns and added stability (over the last twenty years).

Another thing to consider is that the government offers various tax incentives, such as 1031 exchanges, bonus depreciation, and ways to reduce your taxable income. You should review these tax benefits and see if any of them can contribute to your financial goals.

What is the 5% Rule?

I want to be clear that being an active real estate investor requires experience and expertise for success. Unless you possess that, you should use a passive approach to investing in real estate. More significant properties have economies of scale that are unavailable with smaller properties. 

Despite those warnings, there are always people who want to get their hands dirty and become landlords. Often, they start with single-family homes. 

For those people, they came up with the 5% rule. 

The 5% rule was derived initially to help people determine whether renting or buying in a particular area is better. This rule can help investors decide if buying rentals in a specific market is good. 

Please realize that the 5% rule is a quick and dirty preliminary look at a market. In no way is it a substitute for thorough due diligence. 

Using this rule, you multiply 5% by the cost of a house. So, let’s say the houses in a market cost $500,000. When you multiply $500K by 5%, you get $25,000. Next, you divide that number by 12. $25K divided by 12 equals $2,083. Are single-family homes renting for less than $2,083 in this area? If so, then it’s better to rent. If not, it’s better to buy. 

As an investor, you want to be in areas where it’s more affordable to rent than to buy in the local real estate market. But never forget: affordability is just one metric of dozens that professional investors and portfolio management companies consider before entering a market. 

Other Investment Allocation Tips

If you’ve determined that multifamily real estate is right for you and you want to make a real estate investment allocation, then the best advice I can give you is to get started. To do that, you need two things. 

First, educate yourself on the subject because educated investors make better investment decisions. Three top resources you can consume as a new investor are:

• Evidence Based Investing
• Introduction to Multifamily Real Estate
• Private Real Estate Evaluation Framework

Once you’re educated, finding a private real estate investment company that matches your goals is essential. Once you find that, then invest. 

Education is essential, but analysis paralysis is accurate, and sitting on cash consumed by inflation is unwise. 

Hire a Professional to Help You Navigate Allocation

If you’re less comfortable making investment decisions, it might be a good idea to hire a professional financial advisor to discuss your investment strategy and personal finances. However, be aware that financial advisors frequently have conflicts of interest. 

Many have agreements that pay them commissions for putting investors in certain mutual funds. Also, many are less familiar with the real estate market, so that they won’t recommend it. 

Just remember that finding someone who acts in your best interest as a fiduciary and discloses any affiliations, commissions, or conflicts of interest is essential. And if they are unfamiliar with the power of real estate, then they likely aren’t right for you.

37th Parallel is a Trusted Partner for Real Estate Investing

37th Parallel Properties is a private real estate acquisition and asset management company specializing in multifamily properties. 

We’ve been in business since 2008 and have maintained a 100% profitable track record over more than a billion dollars in transaction volume. 

We’ve made our investors money in good times and bad, in bull and bear markets, and across multiple recessions. That’s because we know what works and put our investors first.

We write articles and helpful guides like this one because it is crucial to help educate current and potential investors about the more nuanced aspects of real estate investing.

Evidence-Based Investing Funds with a Focus on Real Estate

Just as doctors follow evidence-based medicine to do what is best for their patients, we practice evidence-based investing for the benefit of our clients. A balanced portfolio often includes stocks and bonds, but there is also room for real estate.

After all, the research is clear. Over the last twenty years, a portfolio made up of stocks and bonds did not perform as well as one that included real estate. And with multifamily properties being the best long-term real estate category, it’s undeniable that most people should take a long, hard look at investing in apartments. 

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