How Should I Allocate My Net Worth as a Passive Investor?
How Should I Allocate My Net Worth as a Passive Investor?
First of all, if I even get a hint that you don’t have every dime invested into multifamily real estate syndications, you’re in trouble. If I catch a whiff of a stock, bond, or commodity on you, so help me, I will pull this blog over.
Just kidding. Of course I don’t expect you to invest every last dime in our multifamily syndications or in anyone’s multifamily syndications. In fact, one of my mentors told me he would smack me if I ever took the last $50,000 an investor had to his name.
But I hope you’re being proactive — or at least thinking — about how you allocate your total net worth … and how much of it you want to invest passively in real estate. How much do you feel comfortable investing in these deals? What percentage squares with your overall investment strategy and risk tolerance?
First Things First … What Is Asset Allocation?
I don’t want to take it for granted that everyone knows what I’m talking about, so a quick primer for the beginners — asset allocation simply means what percentage of your net worth you have invested in what asset, or what type of asset.
For example, if someone has $1,000,000 net worth. They have $300,000 cash in the bank, $400,000 in real estate equity, $200,000 in bonds, and another $100,000 in stocks. That person’s allocation would look like this:
Real Estate: 40%
You can break this down into as many subdivisions as you want. With real estate, for example, you might determine which percentage is invested in which deal; the percentage of single-family vs. commercial; the percentage of multifamily vs. retail vs. industrial, and so on.
For another example, you could break down your stock allocation into blue chips, mid-cap stocks, small-cap stocks, foreign stocks, etc.
But the above example is a kindergarten-level look at what it means to “allocate” your portfolio. Asset allocation answers the question, “What percentage of my net worth is invested where?”
Allocating Based on Risk Profile Instead of Asset Class
Now let’s go deeper. I really don’t care if you’re allocated into stocks, real estate, commodities, or space alien futures.
Okay, I care a little … but let’s think less about allocating to asset classes and more about allocating to risk classes.
Instead of allocating your portfolio to “stocks, real estate, cash, etc.” think about how you want to allocate your portfolio according to “high risk, medium risk, low risk, etc.”
So what … are stocks “high-risk,” and real estate “low-risk?” It’s not nearly that simple. There are high-risk stocks, and there are low-risk stocks. You could buy shares of General Electric, which has been trucking upward for decades; or you could take a flier on a penny stock that you think is going to 10x overnight. Both are “stocks” … but the risk profile is vastly different between the two.
There are also high-risk real estate deals and low-risk real estate deals. Consider the difference in risk profile between buying a rental house and investing in the ground-up development of a highrise. Both are “real estate investments” … but the risk profiles couldn’t be more different.
And, needless to say, the profit potentials are also different. Generally speaking, the more risk you take on, the greater the potential return.
So now let’s look at allocation through this lens. Instead of the following allocation…
Real Estate: 40%
… our hypothetical investor might look at his net-worth allocation this way …
Low Risk: 40%
Medium Risk: 20%
High Risk: 10%
There could be stocks, real estate, commodities, and bonds at all levels of the allocation (except for the “cash” level). The point isn’t the type of asset — it’s the risk profile of the asset, and the role it plays within the portfolio.
The “Diversified Portfolio”
This is probably where you expect me to start talking about a “diversified portfolio,” possibly because you have been pitched by one too many certified financial planners.
Ick … it even tastes gross to say “diversified portfolio.”
I’ll stop being a jerk, though … We give financial advisors a lot of shit around here, and some of it is deserved (the financial planners among you know what I’m talking about). But the idea of a “diversified portfolio” isn’t completely bankrupt. The idea is to spread your wealth around and not put all your eggs in one basket.
Imagine a portfolio that is half volatile stocks, half safe-but-boring treasury bonds. If the stock market is booming, those dumb bonds might start to feel like dead weight holding you back. Why on Earth didn’t you buy more stock?!
But if the stock market tanks, you may be glad you have so many bonds, which keep yielding month-in and month-out while your stock portfolio struggles. Your portfolio may have taken a hit, but at least some part of your portfolio is still growing and didn’t take a loss.
Adding real estate to a portfolio makes it even more diversified. While stocks or bonds are underperforming, real estate may be doing fine. Moreover, if you have real estate in different cities, you’re even more diversified. While one town busts, another booms.
Most financial planners instruct their younger clients to take on more risk in pursuit of long-term gains, while they recommend their older clients — presumably closer to retirement — to take on less risk and protect the principal. That way, their portfolio doesn’t get cut in half just when they are on the cusp of retirement.
Here’s the thing, though … “diversified portfolios,” as popularized by the financial planning industry, are designed to help your money grow at one of two speeds — slowly and very slowly.
8% annual return might be healthy for a middle-class earner trying to squirrel away enough for retirement. But it’s not rich people returns. It’s not legacy-builder returns.
Passive investing in multifamily syndications is a rich people investment … which is why you often have to be an accredited investor to do it. It’s what most financial planners — accustomed to mutual funds and modest W2 incomes — would consider ultra-high risk. They find that level of risk hard to bake into a cookie-cutter “diversified portfolio.”
There’s another model for asset allocation out there besides the “diversified portfolio” — one that allows for “rich people returns.” Who’s ready to go to the gym?
Full disclosure — I hate this metaphor. Why? Because the barbell in the metaphor is lopsided, with a lot more weight on one side than the other. If you tried to squat such a barbell, you would immediately tip over and break your neck in the process.
But the analogy has stuck, so we’re stuck with it. Here’s how the analogy works …
Imagine a barbell with a lot of weight on one side and very little weight on the other side. The barbell method of allocation means to allocate the majority of your net worth to low-risk investments (the big end of the barbell), while a small fraction of your net worth goes to ultra-high-risk investments.
Here’s a “barbell” allocation:
Low-Risk Investments: 90%
Ultra-High-Risk Investments: 10%
The low-risk heavy end of the barbell is there to protect the principal. At the high-risk small end of the barbell, the investor has to be willing to lose every dime. But they’re betting on multiple “X’s” — 2x, 3x, even 10x or more — on the light end of the barbell if they pick the right investment.
What’s a “low-risk” investment?
Cash is one option. Yes, cash is currently losing value due to inflation, but we’re going to get to the importance of “dry powder” in a minute. Suffice it to say, many funds and high-net-worth individuals see it as valuable to keep a healthy allocation of cash on hand.
What else might be low-risk? Bonds? CDs? Blue chip stocks? Gold? Energy-focused commodities like oil or uranium? Rental houses in good areas?
For an experienced passive multifamily investor, who knows how to analyze a deal and has great relationships with top-notch deal sponsors, a passive multifamily deal might actually be the lowest-risk asset she owns. The entire “big end” of the barbell in their asset allocation may consist of passive multifamily investments, throwing off cash flow as consistently as the tick of a Rolex watch.
What’s an “ultra-high risk” investment?
Again, it depends on the user. For a new multifamily investor, accustomed to bonds and the S&P 500, a multifamily syndication investment might be the biggest financial risk they have ever taken on. The entire “small end” of their barbell may consist of one multifamily deal. There’s nothing wrong with that.
For other investors, though, multifamily syndication is small potatoes. For them, an ultra-high-risk investment might be a ground-up skyscraper development, an angel investment in a startup.
You may have noticed that the barbell method completely eschews “medium-risk” and even “high-risk” investments. Again, which asset counts as which depends on the user … but why not include these middle-of-the-road risk categories in the barbell? Why are our only options “low risk” and “ultra-high risk?”
Because of the math that goes into the barbell. Let’s do a quick thought experiment to demonstrate this:
Suppose an investor has a net worth of $1 million. She invests $900,000 in a relatively safe asset that she expects to yield 10%. That’s 90% of her net worth — the big end of her barbell.
With the last $100,000, she invests in something risky that could go to zero … but if it takes off, it could 10x in value.
How does the math play out?
If her high-risk investment doesn’t pan out, she loses the whole $100,000 … but the $900,000 has yielded 10%, leaving her with $990,000. She took a risky bet, but only lost 1% of her net worth. Nothing to cry about.
But what if her risky investment pays off and 10x’s like she calculated? That $100,000 is now worth $1 million … and she still has the $90k yield from the big end of her barbell. Her net worth is now more than 2x in a relatively short period of time.
And look at it this way — ”high-risk” doesn’t mean a blind crapshoot. As our investor becomes more educated and experienced, she will tend to make better and better bets on the light end of the barbell. Her “high-risk” investments may start to pay off more often than not, substantially accelerating her net worth.
This is why lower risk profiles don’t really have a place in the barbell strategy. The goal is to protect the principal on one end and shoot for the stars on the other end. There isn’t really any need for weight in the middle … which I guess is why the stupid analogy came to be in the first place.
The Importance of “Dry Powder”
Why do so many of these strategies emphasize the importance of keeping cash on hand? We’ve all seen the inflation numbers. The dollar is losing purchasing power at a scary clip. Shouldn’t you buy as many appreciating assets as possible to stop the bleeding?
Not necessarily. For investors, especially in the barbell strategy, cash isn’t just a “safe” investment — it’s dry powder, so named for the lose, clean snow on the ground after fresh snowfall that’s easy to ski over.
Suppose an amazing investment opportunity comes up — a can’t-miss real estate syndication or private equity opportunity for example. You won’t be able to participate if all your net worth is tied up in illiquid assets like real estate. If cash is dry powder, real estate is “hard-packed snow,” too slippery to grasp and impossible to dislodge.
In other words, keeping a healthy stash of cash (or low-risk and highly-liquid assets) on the big side of your barbell gives you means to act on an opportunity to load up the small side of your barbell — which are your real money-makers.
Bringing It All Together — How Much Should I Allocate to Real Estate Passive Investment?
The answer is going to be different for everyone, but whether you resonate more with the “diversified portfolio” or the “barbell,” passive multifamily real estate investment can sit within many positions of the portfolio.
To use the barbell as an example, suppose an investor is inexperienced and hasn’t evaluated or participated in many deals. But he trusts the deal sponsor and takes the plunge. His real estate passive investments might make up the entire small end of his barbell — 10%, maybe 20% max of his total net worth.
On the other hand, suppose another investor is an experienced multifamily passive investor, comfortable with the asset class with access to consistent deal sponsors. This investor might put most of the big end of his barbell into passive multifamily investments — say 60-70% of their total net worth, with the rest left over for dry powder to jump on new real estate or private equity opportunities for the small end of the barbell.
Don’t Put All Your Eggs in One Basket
The “eggs in the basket” metaphor from the diversified portfolio conversation applies here too. Even if you’re comfortable having most of your net worth in passive multifamily real estate, that doesn’t mean you should invest all your dry powder into one deal.
If an investor has $500,000 to allocate to multifamily real estate, I would much rather see her buy a $50,000 position in ten deals, rather than invest all $500k into one deal. The latter situation would be easier on me as a deal sponsor (fewer investors to coordinate with), but the former situation is safer for her as an investor. That way, if one deal underperforms, she has the other nine to offset it, preserving the stability of the heavy side of her barbell.
Ultimately, asset allocation is a personal choice, based on your net worth, long-term goals, education level, and risk tolerance.
But it’s not a choice you have to make alone. If you’re on the fence about how much of your net worth to allocate to passive multifamily investment, give us a call. Whatever your situation, other investors we’ve worked with have been in that same situation. We’re happy to go over the numbers and share unbiased opinions.
We don’t want any investor to allocate more to our type of deal than they are comfortable with … and we can help you decide how much that is.
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All the Best,