June 01, 2014

Should Commercial Real Estate Be Part of Your Investment Portfolio? An Interview with Ron Kaufman

Bruce A. Mann

Most financial advisors tell you to diversify your investment portfolio by investing in a number of types of assets, one of which is real estate. Many people consider home ownership to be their principle real estate investment. However, unless you are planning to sell your home to help finance your retirement, it is not part of your “investment portfolio.” Should you invest in real estate to add diversification to your investment portfolio, and how can you do it? For answers to these questions, I interviewed Ron Kaufman, CEO of The Ron Kaufman Companies, a San Francisco-based company that has specialized for more than 50 years in the investment, development, and rental or sale of commercial real estate for private investors.

Let’s start out with whether investment in commercial real estate should be part of everyone’s investment portfolio.

Not necessarily. Because there are many variables and each retirement plan and type of investment asset is different, I think it’s difficult to give universal advice. However, there are questions investors should ask themselves and think about before deciding whether to invest in commercial real estate.

And these questions are?

First and foremost, the investor must look at real estate as a long-term investment. Thus, the investor’s age and future need for liquidity should be considered.

Second, how much equity capital does the investor want to commit? Direct investment in quality real estate requires very substantial capital, which means that the investor must have a substantial net worth to compete for quality properties with the “army” of other investors seeking them.

Diversification is also important. I wouldn’t recommend that anyone put all his or her eggs in a single basket. So, if you’re going to invest directly in commercial real estate, you should have millions of dollars of liquidity to be able to make deposits and lock in loan commitments.

 Let’s start out with whether investment in commercial real estate should be part of everyoIf you don’t have millions of dollars to invest, what about borrowing much of the purchase price?
ne’s investment portfolio.

Debt on a property and its impact on your return on investment is a key consideration, so it’s critical to work on a loan at an early stage, either with a loan broker or your bank. Maintaining good banking relationships is very important, and one’s liquidity and loyalty will help. For most retirement plan investments, I’d recommend a very low loan-to-value ratio, not to exceed 50 percent.

That sounds like direct investment in commercial real estate is out of the question for most of us, even if we’re currently in high-paying jobs rather than being retired or semi-retired. Are there alternatives that we can use to fill our real estate investment bucket?

There are several, including real estate investment trusts (REITs), master limited partnerships (MLPs), the equity securities of companies that invest in real estate, and private partnerships formed by real estate professionals and sold to a limited number of sophisticated investors.

Let’s start with publicly traded REITs, MLPs, and real estate investment companies. What do you advise?

These investment vehicles are generally designed to provide a steady return from a portfolio of many large holdings. They are professionally managed, and you can’t possibly evaluate individual properties in their portfolios. For these investments, I’d look at the track record of the company and its executives and pay attention to the views of the professional investment research analysts who focus on real estate and make recommendations to their or their firms’ clients.

Okay, what about investment in individual properties syndicated by real estate professionals?

When an individual is part of a private group, the due diligence process needed is the same one needed for buying an individual property. For the experienced real estate investor, that means following a checklist that includes valuation, structure, quality of the tenant, a review of the leases with a fine-tooth comb, review of title, local or national location, environmental study, etc. Unless you are an experienced real estate investor and want to do this yourself, you should hire a professional to look at what is being offered and to do your due diligence for you.

What do you mean by “a professional”?

To start with, even if you are comfortable evaluating the investment potential of the property, you’ll need a real estate lawyer who can advise you on the title, the leases, and other legal documents. This is all time consuming and expensive, but it should be part of your pre-investment budget. You should also consult with your lawyer or accountant as to the form of ownership entity and how it fits into your investment plan. Is it an asset your retirement plan can invest in? Is it structured as a “pass-through” entity that will have annual tax consequences for you, rather than simply a gain or loss when the investment is sold or liquidated?

 

What about relying on the promoter or syndicator to provide these services?

You can do that, but before doing so, you should evaluate the promoter’s own track record. I also think you should focus on how the promoter makes money. Is the promoter investing side-by-side with you? Does the promoter have a carried interest and, if so, do you have to get a reasonable return before the promoter starts to share? Is the promoter getting a fee for syndicating the investment or putting it together? If so, how does this compare to his or her investment in or potential gain from the property? If the syndicator/developer is taking a substantial upfront fee, an investor should be very, very cautious. That might mean that the syndicator/developer is getting a lot up front, and the investor might receive a much lower return even if the project goes very well.

Do I still need professional involvement once the investment has been made?

Even after the investment is made, you’ll have to depend on professional management to manage the property on an ongoing basis and decide whether it should be held, sold, or exchanged for another property in a “Section 1031 exchange.” This is all part of the cost of direct real estate investment.

This all sounds very complicated.

It is. Individual investors really are ill-suited for doing this. The real estate scene is dominated by larger, institutional buyers. Unless you have substantial assets to devote to investment in specific properties without making those investments a major part of your retirement portfolio, my advice would be to avoid individually syndicated properties and use publicly traded REITs, MLPs, and professionally managed real estate investment companies as your vehicle for including real estate as part of your investment portfolio.

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