The Real Estate Playing Field: Evaluating and Managing the Game

Before including real assets in your portfolio, careful consideration and planning should be key to your playbook.

From the U.S. Trust Specialty Asset Management Group

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The U.S. Trust Specialty Asset Management (SAM) group works with clients on positioning real property, with a focus on asset allocation. This includes incorporating investments such as real estate into investment portfolios when there is little or no such allocation among their holdings, as well as strategically reallocating among existing real estate portfolios when issues like sector or geographic concentrations emerge. “We advise clients to take a comprehensive approach, assessing not just the benefits but also the risks of real estate, along with its suitability for their overall investment strategy,” says Andrew Tanner, national manager, Real Estate Services group at U.S. Trust.

Potential Benefits

Real property can offer a number of advantages. Historically, commercial real estate has delivered consistent cash yields and capital appreciation. Real estate can also offer the potential for tax benefits. Direct investment in real estate tends to be loosely correlated with stock and bond markets. At the same time, real estate can enhance overall portfolio diversification and provide an effective hedge against inflation. Over the long term, commercial, timber and farm properties have performed well, with each possessing distinct investment characteristics in terms of the income, taxation and diversification they potentially offer. “We caution against more speculative types of real estate and guide our clients toward opportunities that complement their investment portfolio with an appropriate level of risk,” Tanner says.

General Risks

One of the biggest risks of direct real property holdings is that real estate can be less liquid — or harder to sell — than other investments. Real estate can also be subject to cycles, making it an asset class more appropriate for long-term investment.

Historically, commercial real estate has delivered consistent cash yields and capital appreciation.

As for indirect investment options, such as real estate investment trusts (REITs) and real estate funds, their liquidity varies widely depending on structure; but they can also facilitate exposure to commercial real estate across a number of properties on a pooled basis. “While providing more diversification across real estate, these structures can exhibit higher correlations with other asset classes, diminishing their diversification and hedging properties,” says David Koletic, investment manager for the Real Estate Services group.

With a large portion of baby boomers reaching retirement age, we’ve been having more conversations with older clients about the ultimate disposition of their real assets,” says Christopher Aiello, national sales executive in the Specialty Asset Management group. For some clients, owning and managing commercial real estate can become their family business and career. That was the case for one couple who had a large real estate portfolio that provided a significant income stream, Aiello says. “They shared with us their hope to pass the real estate on to their two adult children.” But busy with their own careers, both children were reluctant to take over the real estate responsibilities.

With the initial succession plan sidelined, the parents identified their objectives: a desire to lock in an income stream, to generate liquidity for gifting and to complete a philanthropic gift. “Our guidance was to consider a partial 1031 exchange of some properties with tax consequences in mind,” says Andrew Tanner, national manager, Real Estate Services group at U.S. Trust, “and a donation of some highly appreciated land to a favorite charity that would accept real estate.” The parents ultimately moved ahead with this strategy and were glad to have had an important conversation with their children. “In our experience, it usually works out best to discuss a major change in a financial plan with those affected. In this case, the change accommodated the wishes of the next generation,” Tanner notes. “Talking and advance planning are key.”

Considerations on Existing Holdings

Evaluating existing holdings can be difficult, but it is critical to the strategic management of real estate in a portfolio. The process can turn up unforeseen obstacles, including differences of opinion among co-owners, exposure to capital gains taxes on appreciated property, and depreciation recapture on long-term holdings. When multiple properties are held in a single development, it can be difficult to determine which properties to sell and which to retain. A thoughtful approach includes an evaluation of the existing properties through the lens of the client’s current investment objectives and market conditions, along with a thorough review of the tax consequences for each property in light of tax mitigation strategies like a 1031 exchange.

Evaluating existing holdings is critical to the strategic management of real estate in a portfolio.

Such an evaluation can often call for reducing real estate exposure. You might think that shrinking a holding is a simple matter, and often it can be. Yet sometimes a sale can require just as much consideration as a purchase, and include terms and timing issues that can be highly complex.

Investors will have different reasons to reduce the real assets in their portfolios, of course. Many will want to reallocate funds to a different asset class in order to take advantage of potential opportunities. Others may choose to sell part of a concentrated holding, with the goal of increasing diversification. Some may transition from an active posture (apartments) to a more passive one (triple-net leases).

Buying or Selling?

We’ve highlighted why real estate owners and those wishing to invest in real estate need to give considerable thought to potentially complex situations. If you’re considering incorporating or selling your portfolio of real assets, contact your advisor or the SAM team to assist with and execute your game plan.

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities. The information and views contained in this publication are for informational purposes only and do not provide investment advice or take into account your particular investment objectives, financial situations or needs and are not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument or strategy. Neither U.S. Trust, Bank of America Corporation nor any of its affiliates are responsible for this content, and before acting on any information in this material, you should consider whether it is suitable for your particular circumstances, liquidity needs, time horizon and risk tolerance and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice and are only correct as of the stated date of their issue. Projections made may not come to pass due to market conditions and fluctuations. Some of the featured participants are not employees of U.S. Trust. The opinions and conclusions expressed are not necessarily those of U.S. Trust or its personnel. Any of their discussions concerning investments should not be considered a solicitation or recommendation by U.S. Trust and may not be profitable.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust and its representatives nor its advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Nonfinancial Assets Nonfinancial assets, such as closely-held businesses, real estate, oil, gas and mineral properties, and timber, farm and ranch land, are complex in nature and involve risks including total loss of value. Special risk considerations include natural events (for example, earthquakes or fires), complex tax considerations, and lack of liquidity. Nonfinancial assets are not suitable for all investors.

Real Estate Investment Trusts (REITs) Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties, such as rental defaults.

Case Studies Case studies are intended to illustrate products and services available through U.S. Trust. You should not consider these as an endorsement of U.S. Trust or as a testimonial about a client’s experiences with us. Case studies do not necessarily represent the experiences of other clients, nor do they indicate future performance. Investment results may vary. The investment strategies discussed are not appropriate for every investor and should be considered given a person’s investment objectives, financial situation and particular needs. Clients should review with their U.S. Trust advisor the terms, conditions and risks involved with specific products and services.