In the ideal world, the perfect investment is one that has a high rate of return year after year coupled with a low risk of losing money. Here in the real world, perfect investments don’t exist.
Investments that generate the highest returns, like stocks, also carry the highest risk that you’ll lose the principle you invest. Those that carry the lowest risk, like government bonds, pay the lowest rates of return.
Year-after-year stellar performance also doesn’t exist. The investments that skyrocket one year can plunge the next. We can all look back and say a single asset type did really well in a single year, as stocks have lately. But, it’s impossible to say with certainty which asset class is going to pay the best returns next year.
In short, there’s no one ideal investment. The key to investing success is to spread your investments over a range of assets. Over long periods of time, a portfolio of mixed investments will typically out-earn an investment in any single asset type.
The most common tactic investors use to create a balanced investment portfolio is to spread their money across three classes of assets:
1. Stocks: Rise and fall in value rapidly, offer high returns coupled with high risk.
2. Bonds: U.S. Treasury bonds, notes and bills are low-risk and low-yield, while corporate bonds and private debt funds offer higher yields at higher risk levels.
3. Real estate: Low-risk, high-return investment when held long-term. Real estate hedges against inflation but has a high entry cost and can’t be sold quickly.
Each of those assets plays a different part in balancing an investment portfolio. Stocks can deliver quick bursts of gains or losses — you can make a bundle or lose it all. Bonds deliver steady income and are prized by older investors who don’t have decades to recoup investment losses, as younger investors do. Real estate can be the most challenging investment and for that reason, it’s sometimes overlooked by investors, even though it’s a useful portfolio diversification tool. Real estate offers a slow, predictable rate of return over the long run and can be a great way to build long-term wealth.
Investors who have the money, expertise and time to deal with property maintenance and tenant selection and the capital to cover acquisition costs will find direct investment in real estate makes a great hedge against inflation that can deliver steady income once the mortgage is paid off. A 20-something who buys a rental property with a 30-year mortgage sets up a nice retirement income stream that starts at age 50.
However, direct real estate investment isn’t for everyone. Drawbacks include how hard it is to sell a property compared to stocks or bonds. Plus, it takes quite a bit of capital and countless hours to invest directly by buying and managing rental properties.
Investors who don’t have a long time horizon, such as retirees who won’t be in the market long enough to experience enough appreciation to cover transaction costs, typically don’t benefit from buy-and-hold direct investment in real estate. Those with limited capital may only have enough money to buy low-cost properties. Those rental home can be challenging to manage due to high tenant turnover, low cash flow and scant property value increases.
Leveling The Real Estate Investment Playing Field
One way to get around those challenges is to invest in a professionally managed private mortgage fund (full disclosure: I am the CEO of a private mortgage fund). Private loan funds like this lend money to rehabbers and flippers who buy fixer-uppers, quickly remodel them and then resell the properties. This helps diversify risk, as your investment funds a pool of loans rather than a single transaction. The failure of a single project has a proportionately small influence on the pool compared to the loss you’d sustain if you invested in a single real estate purchase that went south.
The loans in the private mortgage fund are secure debt obligations backed by liens against the properties. Most private loan funds lend no more than 75% of property value, leaving a 25% cushion if the lender ends up foreclosing because the borrower fails to pay — it's conservative when compared to the traditional mortgage market, where homeowners can borrow up to 100% of a property’s value. Private loans are typically repaid in under a year versus the typical mortgage's 15-30 years, helping to guard against the risk that property values will fall while the property is being rehabbed. Private loan fund investors receive monthly earnings, so the income stream looks like that of a bond. But unlike a bond, private mortgage loan yields aren’t influenced by changes in interest rates.
Real estate investment trusts (REITs) offer another avenue for investing indirectly in real estate. REITs purchase all sorts of properties, including office buildings, shopping centers or apartment buildings and then make money by running those properties. REITs come in two flavors: publicly traded and non-exchange traded REITs. You can see the share price of public REITs whereas this is not the case for non-traded REITs. In addition, non-traded REITs are illiquid for longer periods of time.
While perfect investments don’t exist, portfolio balancing can improve the imperfect investments you do hold. By investing across the three asset classes over long periods of time, you increase the likelihood you’ll achieve your long-range investment goals.
