Understanding Your Time Horizon in Commercial Real Estate
When contemplating an investment, one of the most important questions to ask is “what is my time horizon?” Here are some insights on understanding your time horizon in commercial real estate
When contemplating an investment, one of the most important questions to ask is “what is my time horizon?” How you answer this question will influence whether an investment is appropriate and should always be considered in the context of other portfolio allocations. Moreover, risk and time are closely related. Investors with longer time horizons may have a greater appetite for high risk, high reward investment opportunities and should diversify their portfolios accordingly. The opposite is true for those nearing the end of their investment horizon, particularly if they plan to retire in the near future.
Read on to learn more about how time horizon impacts investment decisions, and how to determine which time horizon is best for your financial and lifestyle goals.
An investment time horizon, usually just referred to as “time horizon,” is the period in which an investor is willing to invest in a deal before receiving its initial capital contribution (plus profit) back. Investors usually refer to time horizons as either short, medium, or long-term in nature. Short-term time horizons can be as little as ten days (or less) to ten years. Medium-term horizons are generally ten to 20 years long. Long-term time horizons are typically 20 years or more.
Time horizons can change depending on a person’s age, income, and various other factors. For example, an investor may start out with a long-term horizon and its portfolio will be allocated as such. As that person ages, she may opt to shift some of those investments to align with a medium-term or even short-term time horizon if it helps her better achieve certain goals (e.g., like paying for college or early retirement).
Why should you know your time horizon?
It is important for any investor to understand its time horizon as long term investments are often riskier. The longer an investor’s time horizon, the more risk they can take on. The opposite is true for those with a short-term time horizon. For example, someone who has just graduated from college and is investing in a 401k for the first time may opt to invest in a portfolio weighted more heavily toward stocks (riskier) than bonds (safer), knowing that their portfolio has years (decades!) to balance and recover any potential losses. Meanwhile, someone in their early- to mid-60s who plans to retire in the next few years may opt for safer investments.
Investors should always have a clear sense of their time horizon because it helps them make investments to allocate their portfolio efficiently. Failing to do so can inadvertently derail an investor’s investment goals.
There are several factors that influence a person’s time horizon, including:
Your expenses (loans, buying your own home, other large expenses) Expenses play a major role in evaluating time horizon. Before determining your time horizon, it’s worth doing a comprehensive inventory of your finances. Take a look at current expenses as well as any major expenses on the horizon (no pun intended!). If you’re planning to buy a house in the next two to three years, for example, you may want to invest in a way that preserves short-term liquidity. Be sure to factor in the cost of all major life purchases and expenses, such as paying for college (your own or a child’s), planning a wedding, buying a new home or car, etc.
Your income now and in the future Your current and projected income will heavily influence your time horizon. A person who earns a solid six-figure salary may be comfortable investing $50,000 into a real estate deal where she won’t be getting her money back for seven years. This may be more of a stretch for someone who earns less and foresees needing that cash for daily living expenses in the short-term.
Lifestyle habits Investors should carefully analyze their lifestyle habits, particularly as it relates to spending and saving. There’s a very real phenomenon whereby those who are traditionally diligent savers find themselves spending more money as they earn more money (a term dubbed “lifestyle creep”). Lifestyle creep can quickly erode an investor’s savings which can have an impact on her investment time horizon.
Real estate levels An investor’s level of real estate expertise may also influence her time horizon. For example, someone who’s investing for the first time might take comfort in investing in a fully-stabilized asset. She may invest, for example, equity that someone needs to acquire a property but for which a modest return will be repaid quickly. Someone with more real estate experience may be more confident investing in a ground-up development deal which can have longer time horizons and carry more risk depending on the nature of the project.
Risk tolerance An individual’s risk tolerance is one of the key factors that influences investment time horizon. Someone who’s willing to accept more risk might be willing to adjust her time horizon in order to capitalize on a particular opportunity. A person who’s more risk-adverse might invest differently, in “safer” real estate deals over a different period of time.
Liquidity needs and wants We’ve already touched on liquidity, but it’s worth reiterating: investors’ liquidity needs will influence their time horizon. Someone may have cash on hand to invest today, but if she anticipates needing that cash for another purpose (whether that’s a big life purchase, another investment opportunity or the like), she may opt to invest that money over a shorter time horizon. Aside from liquidity needs, there are also liquidity wants: for example, an investor who senses we’re at the height of the real estate market might want to keep her powder dry in the short-term in order to have those funds readily available to capitalize when the market softens and others are already over-levered.
Real estate market trends The state of the real estate market can also influence a person’s time horizon. For example, a young adult with a long-term time horizon might not mind investing at the height of the market if she’s planning to invest for the long-haul. Someone who feels she can weather multiple real estate cycles may be less risk adverse than someone who’s nearing retirement.
Zero- to ten-year time horizon Investors with a short-term, or roughly zero- to ten-year time horizon, typically want to preserve their liquidity. There’s a huge difference between needing that liquidity in zero to five years versus five to ten years, so depending on an individual’s needs, even her short-term investing strategies may vary. For example, someone wanting to preserve flexibility may only want to invest in commercial real estate via a real estate investment trust (REIT), shares of which can be purchased and sold as easily as a stock. Those with a five- to ten-year horizon may be more focused on investing in deals with solid cash flow now or during this period. Someone who is nearing the end of this short-term horizon will want to invest in “safer” markets that exhibit stable income and growth through appreciation.
Ten- to 20-year time horizon Someone with a medium-term time horizon, approximately ten—to 20 years in length, will likely pursue a more diversified investment approach. When investing in real estate, this may take shape in the form of investing in neighborhoods that have strong local economies, healthy job markets, and continued plans for expansion. These areas often have strong current cash flows with room to grow. Someone with a medium-term time horizon might be attracted to value-add real estate deals in which an investor plans to purchase, renovate, and fully stabilize the property before refinancing and allowing investors to cash out their original investments alongside their preferred returns.
Investments made on a medium-term basis are often made by leveraging other assets, such as drawing on lines of credit to fund the investment opportunity. The duration of the investment allows ample time for the investor to repay this obligation while simultaneous building additional equity in their investment portfolio.
20+ year time horizon An investor with a longer-term time horizon, 20+ years, has the most flexibility to invest in riskier real estate deals. The long runway provides the most time for an investor to recover from serious economic shocks or market corrections. Of course, this doesn’t mean investors should throw caution to the wind. They should still opt for a balance portfolio, investing in some assets that carry minimal risk, but perhaps also investing a greater share of their portfolio in less conservative opportunities that have increased yields. This could include value-add real estate deals as well as ground-up developments. It may also include investing in secondary or tertiary markets that show promise but are not currently on the radar of prime-time, institutional investors. Someone with an extended time horizon might also look for deals that stand to appreciate in value, as opposed to someone with a shorter time horizon who may opt to invest strictly for in-place cash flow.
Example of a time horizon
Let’s use the example of a 20+ year time horizon to better understand how time horizons work in practice. How someone with a long time horizon invests will largely depend on how much capital they have to invest, both now and in the future. Assuming they have significant funds to invest, they may opt to invest in high-risk, high-return real estate deals. This may entail investing in a value-add office building in which the sponsor’s business plan has a ten+ year strategy for renovating the property, bringing it into Class A condition, stabilizing the property and then refinancing at highly attractive terms as provided by life companies, pension funds and other institutional investors. This investor, given her longer time horizon, may be comfortable foregoing short-term cash flow during the renovation and stabilization process in exchange for long-term value and cash flow appreciation.
How to determine your time horizon
Those looking for a guide might want to turn to an old rule of thumb: subtract your age from 100, and then that’s the percentage of your investment portfolio that should be kept in stocks. If you’re 30 years old, that means 70% should be invested in stocks. If you’re 70, only 30% should be invested in stocks. Those with a shorter-term time horizon might instead use a portion of their stock allocation to invest in REITs or other real estate-related securities.
Of course, age is only one factor that should determine your time horizon, and therefore, portfolio allocation. The primary factor to consider outside of age is risk. Each asset class has its own level of risk and return. Investors should consider their own risk tolerance and investment objectives, as this plays into their time horizon.
Before making any investment, in commercial real estate or otherwise, an investor should consider how various factors will influence her time horizon. Understanding one’s investment goals and objectives will impact time horizon. In general, your investment time horizon will help determine the types of assets you should invest in, including the risk profile of each.
Most investors will strive to have a balanced portfolio based on their investment horizon. It can be incredibly helpful to sit down with a financial planner to understand how certain investments will impact your portfolio.
It’s not uncommon for investors to think of large office buildings with dozens of tenants as being broadly diversified, risk mitigated investments. Like an apartment building, it is often assumed that by having a good mix of many tenants without overdependence on just a few, a building can be operated with relative impunity because if one tenant moves out, the impact will be minimal.
Most real estate investors understand the value of a good property manager as a key member of their team.
Do-it-yourself (“DIY”) property management is way too time-intensive for serious investors. That time is better spent finding more deals. Even if you make a little less money each month by paying some of your gross income to a property manager, you could end up purchasing five, ten, or twenty properties with a fraction of the effort.