For some time now, I have been looking at how to diversify my portfolio with an increased real estate investment allocation.

And just a few days ago, I wrote an article questioning whether to use your IRA to buy real estate.

At the time I wrote the article about using your IRA to buy real estate, I was thinking generically about buying a rental property rather than making a specific real estate investment. I had a number of concerns, one of which was the commingling of after-tax funds with IRA funds. Essentially, the IRA needs to be adequately funded to handle maintenance, renovations, vacancies, and any debt service. You can’t supplement the IRA with personal funds. I was also questioning whether you can realistically get a non-recourse mortgage at a decent rate.

Since then, I have come across a specific real estate investment opportunity that may allow me to both diversify my portfolio and use my IRA to buy real estate.

 

Investment Terms

The specific investment that I am evaluating is a private placement with a commercial real estate development company.

The terms of the investment are as follows:

• Use of funds – equity for 5 to 7 real estate development projects to be built over the next 12 months
• Pricing – 10% coupon payable quarterly
• Repayment term – targeted for 5 years but no later than 7 years
• Other – 2 year call protection (guaranteed no early redemption for first two years)

I am pretty familiar with the developer and they have a strong track record of building and fully leasing up similar properties. The one concern I do have is the company has been very active developing new properties over the past few years. I want to make sure they aren’t stretching themselves too thin.

 

Is This a Good Deal?

As I evaluate this investment opportunity, I have prepared the following list of facts, questions, and concerns that are weighing in on my decision:

1. Rate of Return. With the 10-year Treasury trading below 1.8%, this investment pays a multiple greater than 5.5x the risk-free rate. That’s obviously a pretty attractive return in this market and I don’t see too many other options for generating anything close to that.
2. Time Horizon. The closing date for the fund is scheduled for later this year and they are targeting full deployment of the capital within 12 months of the closing date (end of 2017). Payout from the fund is expected within 5 years of deployment with options to extend for another 2 years, putting the total timeline at no more than 7 years (end of 2024) assuming nothing happens between now and then to impact timing of the payout.
3. Call Protection. There is a 2 year call protection feature included. This prevents the fund from calling the note during that period, thereby ensuring that I receive at least two years of coupon payments.
4. What if the issue is undersubscribed? I do not know the answer to this question yet. I do know that this payout is less than payouts the developer has had in the past. As they have grown and built their reputation, they feel that they can raise money without paying as much. I will follow up on this question.
5. Use your IRA to buy real estate. My intention is to convert one of my IRAs from a self-managed account into a self-directed account. This investment appears to be a good fit for an IRA. There will not be a need to add additional capital and as such, there’s little risk of commingling funds. I will not be required to provide any debt guarantees or other commitments. And I’m still young enough that the fund should pay out long before I run into any minimum distribution requirements.

 

What This Would Mean to My Portfolio?

For analysis purposes, I track my investments excluding cash reserves, 529 plans, cash value of life insurance policies, and home equity. Although these are all important, I am not counting on them to pay for living expenses now or in retirement.

With that as background, my investments are heavily weighted in US stocks (40%) and international stocks (35%) with the remaining spread across bonds, REITs, commodities, and cash.

Performance of the portfolio has not been good and it is heavily weighted with expensive mutual funds. I am in the process of making major changes both to get rid of the expensive mutual funds and reduce my exposure to the international markets. I am also looking at beginning to build a portfolio of dividend stocks.

My current real estate exposure is somewhere around 7% of my total portfolio and it consists solely of REITs. Remember I am excluding my home residence from this analysis. This transaction will increase my real estate allocation to around 20% of my investment portfolio.

 

Is a Real Estate Investment the Best Option to Consider?

In addition to this real estate investment transaction, I am also looking at a few direct property purchases. I am evaluating both a buy and flip option as well as a rental property or two. If I proceed with both of these purchases in addition to the above investment, my real estate exposure will increase to around 40% of my total investment portfolio with about half of that in actively managed assets and the other in passive investments.

As I have mentioned before, I am not strongly optimistic about the equity markets over the next few years. To be honest, I am a little skeptical of the housing markets as well, but these are fairly unique circumstances.

But even though I am skeptical of both asset classes, because I am currently very heavily weighted toward stocks – both in the US and internationally – I am thinking that diversification with a real estate investment strategy would make sense. The bigger question is whether this is the best approach.

What do you think? Does this sound reasonable?

 

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