Modern Portfolio Theory: The Cliff Notes Version
Modern portfolio theory suggests that a diversified portfolio is central to maximizing returns and minimizing risk. Within this approach, a 10 – 20% allocation into hard assets is an effective strategy to minimize risk to the overall portfolio. It assumes that the greater the risk, the greater chance at market reward. The theory then weighs this against an “efficient frontier” of diversity with an individual’s investment portfolio. My wife, Lisa, can understand dense economic and investment theories with ease. Her RE MBA and experience at the Fed has made her better at abstract theory than I. She approves of this description.
Multifamily real estate is an attractive alternative investment. The benefits include the wealth building power of principal paydown as well as one of the few remaining tax-advantaged investment vehicles. Real estate looks more and more like the smart play for yield.
Beyond the initial 10 – 20% of the total portfolio allocation, the theory takes it one additional step: taking that 10 – 20% and diversifying further within the real estate approach.
Creating Your Unique Strategy
Initially an examination of your investment appetite and ultimate goals is paramount. Investors tend to be lured into selecting the opportunities that offer the highest stated returns. Makes sense – but does that opportunity take into account your desire for safety or steady cash flow?
This discussion is one that we have with our high net worth partners immediately. We work backward: from ultimate goals, then a specific path to get there. This is how we match up the right project to the right investor. Here are two different approaches to the same end with their associated characteristics:
Physical/ Repositioning Value Add Deals
- Little to no cash flow initially
- High cash flow post repositioning
- Value creation allowing for both short or long term exit options
Minor Value Add/Stabilized Deals
- Consistent cash flow right away
- Typically, 5- 10 year hold periods
- Less variables and potential for unknowns than the heavy repositioning deals
Many of our investors look to have more than one type of deal simultaneously, so that they are maximizing both steady passive income and equity build up with the more labor intensive deals. The power of having multiple type of apartment deals in your portfolio provides diversity, even within your real estate strategy.