As a small business owner, you devote most of your financial resources and energy to growing your company. It is not uncommon for a business owner’s net worth to be comprised of 70, 80, or even 90% of their principal business interest.
Over time, diversifying a small portion of your assets away from your business equity can help to reduce financial pressure on the business, provide essential investment diversification, and create more options for succession planning down the road.
In today’s blog, we will discuss the why, the how, and the benefits and risks, of using real estate investing to diversify your portfolio, as well as the ramifications of using debt as part of your strategy.
Let’s dig in.
Real Estate Investments as a Diversifier
One of the most common investment diversifiers is real estate holdings.
Many business owners feel comfortable investing in real estate due to its tangible nature, relatively steady return profile, and control they hold over these investments. Real estate is also generally an income-producing asset, providing a stream of cash flow as its main source of returns.
Using Debt as a Strategic Tool
When debt (mortgage or loans) is used as part of a real estate investment strategy, it can enhance the cash-on-cash return of the asset, due to it raising the risk profile of the investment overall. As a quick refresher on terminology, a cash-on-cash return is the annual cash flow you earn from a property divided by the actual cash you invested out of pocket.
Investors need to decide whether investing all cash or using financing is the most viable strategy for them. Using financing can increase cash-on-cash returns, but it is more likely to do so in favorable interest rate environments and/or favorable lending terms.
3 Investment Approaches – Most Common types
Now that we’ve discussed the why and some strategic information above, let’s dig into the how. Investment approaches must align with your overall portfolio goals as well as your appetite for risk, and there are several ways to approach that.
1. Owner-Occupied Property
Purchasing the building where your business operates allows you to turn rent expenses into equity. It also provides potential tax advantages, such as depreciation and deductible interest.
This is one of the most efficient forms of real estate investment and also provides control over the business property long-term.
2. Income-Producing Properties
Residential or commercial rental properties can create ongoing cash flow while appreciating in value over time. Many owners begin with smaller properties and gradually expand their portfolios.
The downside to these properties is the management that comes along with it. This either takes time away from the business owner or reduces the return on the investment due to paying an outside management company. Typically, multi-tenant properties (residential or commercial) can provide a stronger return profile due to lessened vacancy risk.
3. Partnerships and Syndications
For those who prefer a more passive role, participating in a real estate partnership or syndication offers exposure to larger-scale properties with professional management in place.
However, there are many downsides to this approach, as the investor loses the control benefit, can lose some of the tax benefits (though not always), and is paying higher fees which can reduce return. The illiquid nature of these investments can also pose a risk to the investor.
In general, we typically advise away from syndicated investments in favor of direct residential or commercial investments that maintain many of the benefits of real estate investing.
Benefits and Risks to Your Financial Plan
Overall, real estate investing can be a positive addition to a business owner’s portfolio, however, it does carry one significant downside, illiquidity.
Most business owners struggle with liquidity, and real estate is not nearly as liquid as publicly traded investments or cash.
It is important that business owners work to balance their liquidity profile with their business interests and real estate holdings. That helps maintain flexibility and provide an emergency liquid bucket when business/real estate investments have rough patches or need further reinvestment.
Conclusion
Every real estate investment needs to be evaluated on its own merits. When making a tangible, cash-flow based investment, it can be tempting to look at these opportunities without breaking down the numbers and properly evaluating the risks within the context of your overall financial plan.
At Master’s, we partner with our clients to evaluate these opportunities one-by-one, while also making sure these investments are aligned with your goals and objectives.
Contact us today to learn more!
