If you’ve ever met with a financial advisor to discuss your investment portfolio, you’ve likely heard the terms “return objectives and investment constraints”. This seems fairly straightforward. You certainly want to know what kind of returns you might receive from certain types of investments. And, it’s a good idea to understand what might be standing in the way of those returns.
While understanding return objectives and investment constraints seems to be common sense for an investor making decisions pertaining to their portfolio of stocks and bonds, surprisingly, these considerations are often overlooked when considering investments in real estate.
Not all real estate is equal. Just as there are differences in “blue chip” stocks versus “growth” stocks or annuities versus bonds, the same is true for different properties and real estate investment options. Additionally, due to the prices of direct real estate, the average individual investor may not have the financial resources to create meaningful diversification1 within the asset class as they would with stocks, for example, by investing in mutual funds. This has the potential to make a real estate investment an expensive financial investment for the average investor.
This major financial decision is perhaps magnified when an investor is investing via a 1031 exchange, where the decision to sell the relinquished property is often due in part to an investor’s shift in lifestyle goals and/or investment objectives. Having a thorough understanding of return objectives and investment constraints is important, so that the investor can effectively communicate with real estate and financial professionals as to their desired profile for a given investment - especially if racing against a 45-day identification period.
Though objectives and constraints are generally linked together, to ensure a deep dive into these topics, we’re presenting the topic in separate blogs. The information below focuses on return objectives. The next blog will discuss investment constraints.
What Can Your Portfolio Do for You?
At first look, the obvious objective of your investment decision is to make money. But, if you’ve read this far, you’ve probably realized that a well-defined investment objective may be a little more complicated than simply making more money. How does this investment fit into the context of your overall portfolio and investment goals? How important is this investment relative to your overall holdings? Do you need current income or are you seeking appreciation? And given that all investments carry a degree of risk – how much risk are you comfortable taking in order to achieve the desired return?
While investment objects may vary between an individual’s specific investments, and while the objective may not fit perfectly “in a box”, four commonly identified investment objectives are:
- Capital Preservation. We’ve written about capital preservation in the past and the reasons for it. The main impetus behind capital preservation is to ensure your wealth doesn’t disappear. When your investment objective involves capital preservation, your investments may place emphasis on down-side protection over potential upside. In other words, you may be willing to forego bigger potential future gains in exchange for less chance of losing your principal investment. In the context of real estate investing, this may mean a preference for properties or investment vehicles focused on a “core” property profile.
- Current Income. Perhaps you are retired and are no longer receiving a regular income. This is where investment income comes into play. As such, your return objective focuses on ensuring a regular income to help with spending needs. Here again, you may be willing to forego potential upside in return for less risk in the income component of your return. With this objective, real estate investments may be focused on a core-plus profile.
- Capital Appreciation. Unlike maintaining your capital, appreciation means your primary focus is growing your wealth. A key distinction between a current income objective and a capital appreciation objective is when in the investment period the bulk of the return is realized. With a capital appreciation objective, an investor may be willing to forego some or all current income and may give up some of the “downside protection” in exchange for higher potential appreciation or gain in value upon exit of the investment. “Value-add” or “opportunistic” property types or investment vehicles may fit into this category.
- Total Return (Growth and Income). If you’re working with a total return objective, you expect many things from your investments. You want to grow your income base and have a degree of capital appreciation. Total return may be classified as a “balanced” objective which considers current income, capital appreciation potential, and depending on the investment, principal reduction. Note that total return objective may be targeted through an individual property or investment, or may be through a portfolio approach of the above investment objectives.
Another investment factor is how much risk you’re willing to accept in order to achieve a particular investment objective. The general adage is, higher potential returns come with higher risk. While some investment objectives are generally lower risk than others – for instance, an investment with a capital preservation objective will typically result in a lower level or risk than an investment with an objective of capital appreciation – it is important to recognize that there are ranges of risk within each investment objective. An investment objective of capital appreciation, for instance, may range from simply exceeding anticipated inflation to “swinging for the fences.” An investor’s risk profile (willingness and capacity to take on risk) may limit available investment choices within their stated investment objective. There are many possible risks when it comes to investing in real estate, please see our blog “Risk in Real Estate Investment” for an in-depth look at some of the most common.
Required or Desired?
Knowledge of risk tolerance, not to mention wise asset allocation decisions, also plays into whether your return is required or desired.
A required return focuses on what you MUST have in your particular situation. Your required return is going to be different if you are retired versus, say, if you have a full-time job and are raising a family. In the first scenario, you might need that return to pay for everyday expenses. In the second situation, you might want your investment to pay for your kids’ college.
A desired return, however, is less quantitative, and tends to be based on outside influences such as personal past experience in investments, or an investment’s historical record. Let’s say, for example, you might be risk-averse, due to the recent history of the financial markets. This, in turn, might lead you to keep your money in a savings account at your local bank. There is nothing wrong with such investments. They may not, however, fit well into a plan which has an investment objective of capital appreciation.
Basically, a required return is more quantitative and based on what you need. A desired return is more qualitative and based on what you want.
In closing, your return objective should be based on more than just rate of return. Factors such as your lifestyle requirements and level of risk tolerance should play into how you build – and maintain – your investment portfolio.
Do you have a well thought out investment plan for your 1031 exchange? The trained Investment Consultants at Realized 1031 can prepare a 1031 Investment Plan to help you understand your individual return objectives and investment constraints, as well as provide insight on certain real estate investments*. With nearly 60 years of collective experience and $5.0 billion of real estate transactions behind us, the Realized team has the expertise and the tools to assist in understanding the risks and returns of real estate investments. Visit our Marketplace to view a variety of tax-efficient, 1031-qualified real estate investment opportunities. Offerings are pre-packaged, allowing accredited investors to efficiently compare multiple opportunities.
*Realized 1031 is not an Investment Adviser and does not provide investment advice. Any information contained in the 1031 Investment Plan or other materials is for illustrative purposes only. Securities on the Realized Marketplace are exclusively offered through WealthForge Securities, LLC, a registered broker/dealer and member of FINRA/SIPC (“WealthForge”). Certain members of Realized are registered representatives of WealthForge.
1 As we’ve written about in previous blogs, there are options available to gain greater potential diversification in real estate investments. Diversification does not guarantee returns and does not protect against loss.
1031 Exchange Guidebook
The 1031 Investor's Guidebook