Investment Analysis

Wealth Management

Learn strategies for advising high net worth investors.

During the last several years, America’s high net worth investors have both discreetly weathered the most bearish of conditions and abundantly flourished through the bullish upswings across all market sectors. Now, in an effort to even out the impact that market swings have on their portfolios, more Americans — particularly affluent ones — are looking to investment options such as commercial real estate, currencies, and hedge funds. As a result, financial advisers are playing an increasingly important role in managing and protecting these assets.

To provide affluent clients with comprehensive wealth management services, advisers must understand how to manage risk and add growth opportunities while minimizing the volatility of the stock market. Because each client’s investment strategy must fit their specific short- and long-range goals and assess their risk tolerance, there is no magic number for determining the percentage of assets that should be invested in real estate. However, investing in some form of real estate should be on all financial advisers’ radars despite today’s market.

In turn, real estate advisers who guide high net worth investors can better steer their clients and improve their services by understanding how financial advisers view real estate and the role it plays in overall wealth management.

Investment Allocation

There are two aspects of working with financial advisory firms that commercial real estate professionals should consider. First, real estate pros should have a detailed understanding of the varying elements, risks, and rewards of each investment they present. Second and equally important, they should understand the way investment advisers think about real estate and how it fits into their clients’ investment portfolios.

All firms are not alike in how they allocate their clients’ funds. The best approach is to simply ask how a company makes its client allocation decisions regarding real estate.
Most Securities and Exchange Commission Registered Investment Advisor firms allocate funds across asset classes utilizing some sort of forecasting methodology. Some firms use a mean/variance optimization methodology that examines the correlation between different asset classes with respect to standard deviation (risk) and expected return.

Other companies use a Monte Carlo simulation analysis, also known as stochastic optimization, which examines a myriad of potential return outcomes and creates a probability graph. The highest probability for a given return dictates the allocation. Both of these methods are based upon the idea that there is a most-efficient portfolio for all identifiable risk/return objectives.

Finally, some firms use an economic forecasting methodology to determine asset allocation. This methodology examines the cycles of different investment classes to determine which asset classes are likely to be in favor in the current and near-term future and which are out of favor and have risk above their historical levels. This is a timing methodology and has its own inherent risks. High net worth investors’ portfolio allocations oftentimes require a combination of all the above methodologies.

A Management Example

Real estate can be a very useful aspect of a high net worth client’s portfolio as it provides an array of opportunities. As monitoring agents, financial advisers have been a major factor in the commercial real estate boom.

For example, consider the Smith family, which had financial assets totaling approximately $10 million. Bob Smith, age 50, and Lorain Smith, age 40, had two children. One was a freshman in college and the other was in eighth grade. Bob made his money by selling his interest in a restaurant chain for stock in a company that went public. He had owned the land and buildings where his restaurants were operating, giving him some real estate experience out of the gate.

Bob had multipronged concerns, including providing income for his retirement and asset protection, creating a legacy vehicle for his children, protecting his interests from creditors, and creating a method to transfer his interests over time to his family.

The first priority was to provide income for his retirement. McKeelGesek was building a mixed-use project and offering clients the opportunity to invest. Smith wanted to take half of the LP interest; however, it was recommended he diversify his investment into several properties of varying types to hedge his risk. To accomplish the retail-office project, a small three-year-old office building was added to the portfolio. The building was 97 percent leased and the major tenant recently had completed a seven-year lease. Land, which was leased to an industrial warehouse on a 20-year land lease, also was added to the mix.

Additionally, the Smiths’ property interests were rolled into a family limited partnership to help protect their interests from creditors and give them a vehicle to transfer interests over time to the family. The strategy also included taking advantage of the estate valuation discounts in the event of Bob’s death.

Bob was extremely interested in creating a legacy for his children and giving them the opportunity to get involved in the business. Through the ownership and management of properties, his children would be able to secure their future while creating their own opportunities.

In the end, 20 percent of the Smiths’ available investment assets were allocated to commercial real estate to help successfully meet their needs.

A Real Estate Professional’s Role

As described, the decision of how much real estate a firm allocates to its clients’ portfolios depends on its methodology and varies according to the circumstances. While a firm’s methodology may dictate an amount of allocation, wealth management firms can benefit greatly from education on how the different types of real estate offerings fit within their allocation. For example, some strong cash flow investments can take the place of a percentage of their typical bond allocation.

Real estate professionals should advise their clients to buy right, consider their long-term objectives, and weigh all the risks of Section 1031 tax-deferred exchanges versus paying capital gains taxes. Having an intricate understanding of not only their investment deals but how financial advisory firms allocate clients’ money will go a long way toward ensuring a mutually beneficial relationship.

John L. McKeel

John L. McKeel is an investment adviser, founder, and chief compliance officer of McKeelGesek Financial Advisory Services in Coppell, Texas. Contact him at (972) 745-9080, jmckeel@mckeelgesek.com, or www.mckeelgesek.com.

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