How to Talk to Clients about Investing in Real Estate | Lord Abbett

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Practice Management

The right strategies can make all the difference for advisors.

This Practice Management article is intended for financial advisors only (registered representatives of broker/dealers or associated persons of Registered Investment Advisors).

When it comes to discussing real estate with clients, advisor Michael Martin is able to draw on his own hard-earned experience.

In 2001, Martin, principal and founder of Marius Wealth Management in New York, left a career at Smith Barney to spend what became a decade as a real estate investor, buying, rehabbing, and selling properties in New York and Florida.

“I learned some valuable lessons, I can tell you that,” Martin says. Fortunately for his clients, they are lessons he is now able to impart to them.

The native New Yorker had some home runs renting, buying, and selling properties in the Hamptons, the fashionable beach towns on Long Island.

“I knew what renters and buyers wanted in a house in the Hamptons, and where they wanted to be,” he says. “I knew how far a house could be from the train track, for example. And after seeing a house for the first time during the day and being initially sold on it, I would always go back at night or weekends to uncover any negative surprises, such as crazy neighbors, loud noises, or unpleasant odors from, say, a nearby duck farm.”

But Martin didn’t fare as well in Florida.

In 2005, he overpaid for what appeared to be desirable vacant lots fronting a canal in Coral Gables, Florida. What Martin now owes on his mortgages is more than the fair market value of the lots. His waterfront properties are, in real estate lingo, now underwater.

Martin learned the hard way that “vacant lots do not produce rental income if the numbers turn against you at market highs, especially if you need to derive income while you wait for the market to improve.”

“Don't Have Your Wife on the Mortgage”

"Don’t mortgage vacant lots,” Martin says, “which I did. Don’t have your wife on the mortgage, too, which I did.”

Martin also warns against replicating two other mistakes he says he made: succumbing to FOMO (fear of missing out) and being “persuaded and influenced by a commission-hungry salesman.”

Martin returned to the advisory business in 2012.

“I realized I liked being an advisor better,” he says. “Real estate was ultracompetitive, and it’s easier to differentiate yourself as an advisor.”

After two years at Wells Fargo Advisors, he started his own firm in 2014. When high-net-worth clients say they want to invest in real estate, excluding their primary residence, Martin doesn’t mince words.

“Real estate is not for the faint of heart,” he advises them. “It’s a very fickle market. You can’t be emotionally attached. And the lack of liquidity is a huge issue. You’re married to a property until you’re able to sell it, and the options for liquidity are far less than any other investment.”

Martin and other wealth managers stress the need for a detailed and candid conversation covering asset allocation, risk, tax liability, income needs, and the consequences of owning an illiquid asset.

Advisors generally recommend that high- and ultra-high-net-worth clients allocate anywhere from 5–30% of a portfolio to real estate as an asset class, with many caveats, of course.

Age and income needs are primary considerations. For older clients who will need income, Ross Fox, founding partner at Cardan Capital Partners in Denver, puts “a higher emphasis on cash flow versus total return. We want to have serial liquidity events in investments that mature over time.”

For high-net-worth clients, Fox recommends allocating approximately 5–15% of assets into real estate investments outside their primary residence. For anything exceeding 15%, clients should “have an affinity with the space”—that is, be real estate professionals themselves.

Being caught at the wrong end of an economic cycle is a major risk, cautions Derek Newcomer, director of investment research at Beacon Pointe Advisors, in Newport Beach, California.

Property location is another critical variable. “If you have a real estate asset in Houston, and the energy business takes a dive, you’re left very exposed,” Newcomer explains. One way to mitigate the risk, he advises clients, is to diversify their holdings with multiple assets in different geographic areas.

When Not to Recommend Real Estate

Clients should closely scrutinize maintenance costs, Fox notes. They must analyze tax obligations. And while real estate investments can provide tax relief in some cases, Fox and other advisors say this should not be a primary reason to buy property.

“You can certainly receive favorable tax treatment for some investments, but clients can get too cute by half by trying to [minimize] their taxes,” Fox says.

Lois Basil, principal of the Basil Financial Group in Chicago, says her real estate advice doesn’t vary much, no matter what her client’s tax bracket. “I think there’s a place for real estate in every portfolio, whether mass affluent or high-net-worth,” Basil says. “Leveraged real estate is an excellent hedge against inflation, and [it is] tax efficient. Our goal is to have our clients’ net worth divided [into] one-third interest-earning, one-third equities, and one-third real estate.”

Only after risks have been discussed and understood can the potential benefits of real estate investments be presented to clients, advisors say. Indeed, it’s imperative.

For wealthy clients, real estate is simply “too big to ignore,” says Alex Stimpson, founding partner and co-CIO of Corient Capital Partners, in Newport Beach, California. “Real estate plays an important role as part of overall asset allocation in [wealthy clients’] portfolios,” he says. “It provides risk diversification because it has a low correlation to the stock market.”

Real estate also is a good source of income diversification, he adds. While corporate bonds are yielding around 3%, real estate investors should be rewarded with a higher yield—an additional 2–5%, Stimpson says—in exchange for taking on lower liquidity.

The Illiquidity Premium

This “illiquidity premium” is a key concept when discussing real estate with clients, says Marty Bicknell, chief executive of Leawood, Kansas-based Mariner Wealth Advisors.

Just as clients need to know the risks associated with an investment that isn’t publicly traded, clients “with the patience to ride out economic cycles” also can benefit from illiquidity, Bicknell says, although the premium he seeks is less generous than Stimpson’s.

“The illiquidity premium should be around a 2–3% increase over more liquid alternatives,” he says. “If not, it wouldn’t make sense to tie up the capital.”

A leading way clients can invest in real estate is through publicly traded REITs. But with yields at historical lows (the Vanguard REIT Index Fund yields a little more than 4%), advisors interviewed did not recommend REITs as an optimal real estate strategy.

Direct investments or investments in a private fund were preferred real estate vehicles, and investors can benefit greatly from the capitalization rate, say Stimpson and other wealth managers.

“The cap rate is a powerful predictor of future return and future risks,” Stimpson says. “What you see is usually what you get."

—by Charles Paikert
Charles Paikert is a senior editor at Financial Planning. Follow him on Twitter at @paikert.


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