As we discussed in a previous blog, understanding of personal return objectives and investment constraints is often overlooked in real estate investing, although the same principles should apply as with any financial investment. In that blog, we focused on return objectives, what they are, and how they might impact your decision-making when it comes to investments. Also discussed was risk tolerance, which, when paired with return objectives, are used to determine the best investment “fit” for an investor.
Another factor that needs to be determined are financial constraints, or investment constraints. An investor has a finite amount of funds available to invest, and must weigh current investment options with short-term and long-term needs and wants. However, investment constraints go beyond just how much money is available for investment. Although investment constraints are specific to the individual investor, common constraints include:
- Liquidity Requirements. Liquidity requirements means that the investor is setting aside a certain amount of money for other purposes, and isn’t available to invest. For example, if you want to buy a house, and the down payment is $20,000, that money needs to be set aside, and is unavailable. Here’s another rule of thumb: The more liquidity you need, the less investment risk you’re likely to take.
Here at Realized, we help investors to understand their options when evaluating a potential 1031 exchange. The sale of an investment property is often a conflicting time for investors wishing to gain a degree of liquidity. On one hand, there may be substantial equity in the property they just sold and would like to access part of that equity. On the other hand, in order to fully defer taxes upon sale, investors must reinvest all of their proceeds. Thus, an investor may have to make a difficult choice between fully deferring taxes and gaining liquidity. Fortunately, there are several options available, that, depending on an investor’s specific situation, may make that decision less difficult. Examples include a Partial exchange, a “cash out” exchange, investment in 1031 into a REIT program or investment in a Qualified Opportunity Zone fund.
- Time Horizons. Your time horizon can also be a constraint, as it impacts your ability to accept risk. If you have a longer time horizon, you might be willing to accept more investment risk; your time period is longer to make up any losses. A shorter time horizon offers the opposite impact; there is less time to make up any losses meaning you, the investor, might not be willing to accept risky investments for your portfolio. As such, an individual in his 20s might have a longer time horizon than one in her 60s or 70s, depending on return objectives.
- Taxes. At Realized 1031, a good portion of our business centers around capital gain taxes and how to defer them. Taxes are also considered an investment constraint. Many investments generate income that can be taxed, especially if you’re in a higher income bracket. In this situation, rather than investing in something with potentially more risk in order to generate a higher after-tax return, an investor may instead place more emphasis on assets that provide tax-sheltered income or even tax deferral.
For example, an investor may compare two investments. Say that Investment A is expected to generate an 8.0% pre-tax return while Investment B is expected to only generate a 5.0% pre-tax return. However, if Investment A has no income tax shelters, and the investor is in a high income tax bracket, the after-tax return may be 5.0%. By contrast, if Investment B is fully sheltered from income taxes, it may also yield a 5.0% after-tax return. All else being equal, Investment B may present a significantly higher risk-adjusted return.
- Legal and Regulatory. There can be all kinds of rules and regulations when it comes to your portfolio. Here at Realized, we frequently work with investors concerned with estate planning issues who are making investments through various types of Trusts. Depending on the structure of the Trust, there may be certain legal requirements, such as limit on the amount of distributions to its beneficiaries in a given year or the types of investments it may make. No matter how much its beneficiaries fight it, they may may legally bound by the rules of that trust.
A regulatory constraint we frequently encounter is with potential investors considering reinvesting 1031 exchange proceeds in a Delaware Statutory Trust (DST). Most DSTs require all investors to meet the definition of an Accredited Investor. Thus, even if the concept of a DST investment is of high interest to a potential investor, they may not have the option to invest in them due to regulatory constraints.
- Unique Circumstances. This final category is a catch-all for constraints not listed above. Perhaps your particular beliefs mean you’re not likely to invest in tobacco companies, even if those investments do offer higher rates of return. Or, it might be difficult for your investment advisor to approve putting money into diamond mines that use child labor. Then there could be regulations against investments that aren’t necessarily covered in the Legal and Regulatory constraint area.
As a real world example of 1031 exchange investing, we sometimes see investors who sold or are selling a property with a relatively high degree of leverage. In order to fully defer taxes via 1031 exchange, investors generally must reinvest all net equity proceeds but also must acquire equal or greater property value than what they just sold - from a practical perspective, this typically means replacing the debt. For investors in such a situation, they may need to utilize highly leveraged “zero coupon” DSTs and/or contribute additional equity to the exchange in order to fully defer taxes.
Another common example may be personal preference and past experience. For instance, an investor who has significant experience in multifamily real estate may wish to continue investing in multifamily, or, if they are feel they have a high exposure to multifamily, they may be seeking diversification by investing in a different property type. And investors seeking a socially conscious investment (while still defer taxes) may consider investment in a Qualified Opportunity Zone Fund.
When it comes to developing an effective portfolio, a thorough understanding of investment constraints is just as important as knowing your return objectives. As such, taking the time to understand such constraints can help ensure a more effective asset allocation, as well as return on investment.Need help figuring out potential investment constraints? The experts at Realized 1031 will be happy to work with you on constraints, as well as return objectives. Learn more by logging onto https://www.realized1031.com.