If you invest right, real estate can offer asymmetric returns: high potential returns with relatively low risk. Sure, it requires a degree of skill, but by investing alongside others in an investment club, you can instantly draw on others’ experience.
Skill aside, traditional real estate investments come with another challenge: the money required to invest.
If you buy a rental property, you’ll likely need $50,000 to $100,000 between the down payment, closing costs, cash reserves, and any initial repairs.
If you invest in a real estate syndication, you’ll likely need $50,000 to $100,000 as a minimum investment mandated by the operator.
That makes it hard for the average investor to diversify. It begs the question: How much of your net worth should each real estate investment make up?
In the beginning, it should be small, under 1%. As you gain confidence and expertise, it can grow.
“But in the beginning, I don’t have a high net worth, so investing in real estate will require a high percentage of it!” Not if you can start by investing $500 or $5,000 at a time. But we’re getting ahead of ourselves.
Control Group: Standard Investment Advisors
If we grabbed an average investment advisor off the street and asked them about asset allocation, they’d probably talk only about stocks and bonds.
They might say something like, “Follow the Rule of 100: Subtract your age from 100, and put that percentage of your portfolio in stocks and the rest in bonds.” If they were particularly aggressive, they might bump that to 120 or propose holding 5% to 10% of your portfolio in REITs.
Yawn.
I literally chatted last night with a close friend of mine who’s an investment advisor. I asked her point-blank: “For your high asset management fee, does your team beat the stock market at large?”
Her response: “No, and we’re not trying to beat the market either. Our clients are mostly wealthy people who want to minimize risk so they don’t run out of money before dying.”
Not only does her advisory team not beat the S&P 500, they significantly underperform it, especially after adding in their 1% to 2% advisory fees each year.
It’s hardly a plot twist when I tell you that I invest differently.
My Asset Allocation
I aim for around 50% of my net worth in stocks and the other 50% in real estate. I don’t bother with bonds at all, as a 40-something.
“But Brian, how do you protect against risk?!”
First, I’m not retired, so stock market corrections don’t scare me. Second, bonds aren’t as low risk as you might think. They’re susceptible to inflation risk, for starters. Rewind the clock just two years to when inflation hit 9.1%, and ask someone holding a 2% Treasury bond how they felt about losing 7.1% in real dollars.
Then, there’s interest rate risk, which causes the value of existing bonds to bounce up or down. The Morningstar US Core Bond Index fell 12.1% that year.
Instead of bonds, I invest in real estate. And I expect my real estate investments to earn twice as much as my stocks, with half the risk.
Speaking of stocks, I invest in a mix of ETFs that give me broad exposure to the entire world: small-cap, mid-cap, large-cap, all sectors, all geographical regions, you name it. If you don’t know anything about stocks, try investing in just two funds: VTI (the Vanguard Total Stock Market Index Fund) and VEU (the Vanguard FTSE All-World ex-US ETF).
But how do I manage the risk in my real estate investments?
Concentration Risk Among Real Estate Investments
Imagine you have a net worth of $100,000 as a young investor. If you go the traditional route and invest $50,000 to $100,000 in a real estate investment, it will take up 50% to 100% of your net worth. If that investment goes poorly, it could cripple your finances for the foreseeable future.
You wouldn’t put 100% of your stock investments in one company. Why would you do the same thing in real estate?
Now imagine you put $100 toward loans on Groundfloor (0.1% of your net worth). Then, you put $100 into real estate funds on Fundrise. Then you buy a fractional share of a rental property on Arrived for another $100.
If Fundrise does poorly, like it did in 2022 and 2023, it won’t break you.
After dipping your toe in passive real estate investing with a few crowdfunding platforms, you discover private real estate investments. You start wrapping your head around private partnerships, real estate syndications, and equity funds. You start experimenting with private notes and debt funds for monthly income.
In SparkRental’s Co-Investing Club, I invest $5,000 at a time in these types of passive investments. Yes, that’s higher than the $100 to $1,000 that you can invest in some crowdfunding platforms. But we also aim for higher returns and lower risk than crowdfunding investments.
This is because crowdfunding investments, REITs, stocks, and bonds all share one thing in common: They’re open to the public at large. By definition, you’ll earn average market returns because you’re paying market pricing for public investments.
You can do better—if you’re willing to leave the well-trodden path that the herd follows.
How Your Real Estate Allocation Should Change Over Time
When I first started investing passively in real estate, I aimed for no single investment to take up more than 1% to 3% of my net worth.
Over time, I’ve evolved as an investor. I know more, and so does the investment club of other investors that I vet deals with together. Collectively, we’ve developed deep expertise. It’s almost a “hive mind” as we get together each month to vet investments.
I also have firsthand experience with over 25 operators by now. I feel extremely confident in some of them after having invested with them on multiple investments and seeing their communication style, how they handle hiccups, and so forth.
Today, I feel comfortable investing 5% to 10% of my net worth with some of those operators. I started small and have scaled up some of my real estate investments over time.
That’s the beauty of passive investing: You can invest a little with one operator, see how they do, and then invest more with them if you like them.
The risk is never zero, of course. The principal could die in a plane crash, or a major war could come along and disrupt your real estate and other investments. But I’m comfortable that the risk is low compared to other investments—especially given the high returns.
Start Small, Then Expand
It’s a lot easier to invest small amounts in passive real estate investments than active ones. Despite all those gurus trying to sell you on “zero money down!” real estate investing strategies, most of them require deep expertise if you hope to execute on them without enormous risk.
I mentioned that I aim for twice the returns on real estate with half the risk. That doesn’t start with a $50,000 or $100,000 investment in a single property with an operator you don’t know. It starts with $500 or $5,000, followed by a probation period where you see how that operator performs. In our Co-Investing Club, for example, we aim not to invest with the same operator within one year of our first investment with them.
Small-dollar investing lets you build confidence, trust, and expertise over time before betting on the farm. From there, you can scale up to investing $50,000 with an operator or more.
If you want to keep your risk low and your average returns high, start low and go slow.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.