Investments in income generating real estate are much more prevalent at the institutional investor level than they are at the individual, or retail, investor level. Part of this is likely due to capital constraints and illiquidity but could also be a result of real estate not fitting neatly into modern portfolio theory’s asset optimization approach to portfolio construction.

A recent post on the CFA Institute blog got me thinking about portfolio construction techniques. Specifically, asset optimization versus a liability-driven investment approach. In an asset optimization approach, we seek to maximize our return for every unit of risk we incur while in a liability-driven approach we strive to ensure we have enough cashflow to fund our obligations, whatever and whenever they may be.

While modern portfolio theory has been a large driver of portfolio construction for individual investors over the past 65 years, it might not be as practical in the current world we live in with longer lifespans and a higher cost of living in retirement.

In a liability-driven investment approach, specific expenses such as housing, healthcare and education are identified over a specified time horizon. The investment portfolio is constructed with assets that are expected to generate sufficient returns to provide the necessary cashflow to fund the identified expenses when they are anticipated to occur. There is obviously a margin of error associated with estimating the timing and amount of future expenses, but a conservative approach and regular updating as circumstances change should more than account for the inexact nature of forecasts.

Income generating real estate is one of the better suited assets for a liability-driven investment approach. Some of the advantages of income generating real estate are:

1. It offers a stable income stream similar to a coupon payment from a bond but often times at a higher yield. In retirement, this income stream is quite attractive as it can be used to match fund specific expenses.
2. It provides attractive diversification benefits to traditional stock and bond investments. The general stability of these investments helps to offset the volatility of stocks, bonds and commodities. Without the daily price fluctuations that stocks and bonds are exposed to, an investor may be better equipped to avoid behavior induced mistakes.

Some of the disadvantages of real estate include:

1. The illiquid nature of real estate poses some obvious challenges. Not being able to sell with the click of a mouse can result in an uncomfortable financial situation if the investor is cash-strapped and in need of the funds allocated to real estate. In such a situation, the investor could be forced to accept a less than favorable selling price. However, with proper planning and enough foresight the illiquidity risk can be largely mitigated.
2. High transaction costs relative to traditional stock and bond investments. In a world of shrinking transaction costs for stocks and bonds, real estate expenses still remain fairly high. As a result, real estate investments should be approached with a long-term perspective to help offset the higher costs of investing.

Income generating real estate investments should be a part of nearly every investors’ asset allocation. Whether you are 20 years away from retiring or approaching retirement, an income generating real estate investment can provide valuable income and diversification benefits to help you meet your financial objectives.