The Growing Role of Alternative Investments

Why Investors Seeking Diversification Are Choosing Alternative Investments Increasingly

It is standard practice for people to open retirement accounts with their employers, then hand control of those accounts over to the plan's custodian, who will deploy the funds based on the participant's age, income, and retirement goals. Many consumers choose a hands-off strategy after the initial account setup and allow the custodian manage investments as they see fit.
The issue with this strategy is that the majority of custodians will opt to invest in conventional assets like equities, bonds, and mutual funds. Because of this, a person's portfolio is very vulnerable to the ups and downs of the stock market, and they are unable to invest in other places where they might receive superior returns.

This refers to alternative investments in this context. Alternative investments, traditionally seen as "too hazardous" for participation by private investors, are growing more popular. Individual investors are now imitating institutional and wealthy investors who have been making alternative investments for years. Alternative investments have the potential to offer individual investors a great deal of value, from diversification to increased stability, growth potential, and more.

Continue reading to find out more about investing in alternative assets, such as real estate, and how you can start doing so right away.

Alternative Investments: What Are They?

The majority of individuals are instructed to invest in a mix of stocks, bonds, and mutual funds, whether for retirement or other purposes. These publicly traded shares are the most popular investment options and are regarded as "conventional" investments. When someone refers to "diversifying" their portfolio, they typically mean investing in a variety of these equities, from historically "safer" bonds or mutual funds to "riskier" stock options. As a means of further diversification, some investors may choose to invest in particular industries (such as technology or energy), while others may want to do so in emerging industries (such as a "sustainable leaders" fund).

Whatever the case, all of these conventional investments are fairly liquid and closely correlated with the overall stock market action. It follows that the value of conventional assets may fluctuate, occasionally substantially, even on a daily basis.

Alternative investments frequently differ significantly from conventional ones.

Diverse assets, such as precious metals, collectibles like artwork or antiques, crops, and other commodities, might be included in alternative investments. They could also be investments in financial assets like hedge funds, distressed securities, carbon credits, venture capital, private equity, and distressed securities. The most well-liked alternative investment nowadays is real estate, notably private equity real estate.

Important Characteristics of Alternative Investments

A few crucial characteristics serve to set apart alternative investments from standard ones. These qualities consist of:

Very little historical association with the stock market.

Alternative investments typically operate more independently from the overall stock market than do standard stocks, bonds, and securities. This partly results from alternative investments' lack of liquidity (more on this below). Simply said, unlike conventional publicly traded securities, the majority of alternative investments cannot be quickly bought or sold with the press of a mouse. As a result of the lengthier lead times involved in buying or selling alternative assets, which frequently include a thorough due diligence period, these investments have historically been less susceptible to market volatility.

During the COVID-19 pandemic, investors had first-hand experience with this. When the pandemic was at its worst, the Dow once dropped 10,000 points in a single day. It has subsequently recovered, but in the interim, a number of other assets, many of which were real estate investments, maintained their worth (with a few notable exceptions, like hospitality which took a hit due to widespread pandemic-related restrictions on travel).

Identifying the underlying value may be challenging.

The fact that it can be difficult to determine the underlying value of these assets is one of the difficulties involved with investing in alternative investments and one of the reasons why these investments have historically been limited to institutional and high-net-worth investors. Those interested in alternative investments will discover that they are operating in a world of incomplete knowledge and marketing information, in contrast to investing in stocks or bonds, where the majority of data is publicly available.

One might be prepared to pay more for a certain property, for instance, if they have a strong personal connection to that investment. This is just one example of how the value of some things can be wholly subjective. Properties in tourist markets are a fantastic example of this phenomenon: if someone's family has a long history of taking vacations in Cape Cod, they might be willing to spend twice what someone else is willing to pay for that home. In this instance, the investor's willingness to pay a certain value may not be logical. The value that the "market" assigns to an item may also be unduly influenced by other factors, such as a person's desire to borrow against a property (and under what conditions). The market value of an alternative asset is simply the price that someone, even just one person, is willing to pay for it.

Lower liquidity compared to conventional investing.

Alternative investments tend to be less liquid than traditional investments. The lack of organized markets and the relatively low demand for certain of these assets in comparison to traditional investments might be used to explain the illiquidity (e.g., fine art).

In many alternative investments, the investor must commit to the transaction for a set amount of time or risk incurring penalties for an early exit. One could, for instance, invest in a real estate fund with a five-year minimum hold. Investors in this fund might be able to withdraw their money early, but doing so might incur some sort of withdrawal fee.

Alternative investments typically require significant due diligence and/or processing time for a transaction to complete, even in a situation where someone is free to buy or sell at any time. For instance, if someone wants to sell an office building, they still need to find a buyer, engage with a broker, and go through at least 30 days' worth of paperwork, processing, financing, etc. before the sale can be closed. The illiquidity of alternative assets is a result of this.

Historically prohibitive admission requirements.

The entry hurdles into alternative assets have always been very high. This is especially valid when it comes to expensive alternative assets, such "trophy" real estate. Only institutional investors and high-net-worth people had access to deals of this scale and value. The ability to conduct "general solicitation" made crowdfunding for alternative assets simpler after SEC regulations changed in 2014. This, in turn, has made it possible for people to invest in alternative assets in lower amounts for the first time.

What is the perception of these assets' "riskiness."

The idea that investing in these asset classes entails higher levels of risk than investing in more conventional asset classes like stocks or bonds is the original source of the term "alternative" investment. However, institutional investors have significantly expanded their allocation to alternative investments over the past 20 years as a result of technological advancements and better access to data regarding specific alternative investments. Institutional investors made an average of 5% in alternative investments in 2000; by 2020, that figure had risen to 30% or more. Alternative investments are becoming increasingly commonplace as a result of their historical and potential risk-adjusted total returns, net of expenses.

True diversification is provided by alternative investments.

Investors can truly diversify their investing portfolios by making alternative investments. Generally speaking, experts advise putting between 15 and 20 percent of your holdings into some sort of alternative asset. Institutional investors invest more than this amount; endowments and pension funds occasionally allocate more than 30% of their assets to alternative investments, respectively. Individual investors currently invest just an average of 5% in alternatives, a figure that most experts advise tripling or quadrupling.

Diversification has a number of advantages. One benefit of diversification is that it might potentially increase stability and shield a portfolio from market fluctuations. Two: People may be able to increase returns by investing in alternatives instead of low-yielding asset types like government bonds.

Compared to traditional investments, alternative investments frequently aim for higher returns.
Compared to typical investments, many alternative investments have the potential for better returns. When examining risk-adjusted returns over a decade or longer, this is especially true. For instance, over a 20-year span, farms, timberland, and real estate all beat the S&P 500. Sometimes even more astounding were the absolute returns. For instance, the average total return on farmland from 1992 to 2018 was 10%, combining income and price growth.

Historically, alternative investments have frequently performed admirably during times of market turbulence. An otherwise significant drop in stocks and bonds was avoided thanks to alternative investments' superior performance in the early days of the pandemic, according to an EY report released in November. Alternative investments and diversification in portfolios protected them from potentially devastating losses.

"During Covid-10, alternative managers exceeded performance expectations, particularly in private equity, when a 4:1 ratio of investors believed their managers exceeded expectations. Although hedge fund success varied by strategy, on the whole, nearly all of them greatly outperformed key benchmarks. Early in 2020, when major indices were down by 15-20%, several hedge funds were merely down by low single digits. Funds proved valuable by protecting cash during the recession and swooping in when appropriate to profit from market turbulence."

We are currently experiencing a period of historically low interest rates, which is one of the reasons alternative investments are doing so well. While inflation is closer to 2 percent, the rate on 10-Year U.S. Treasury bonds is less, hovering at 1.6 percent. Greater yield-seeking investors are forced to choose investments with higher levels of risk, which frequently directs them to alternative investments like real estate.

Investing in Alternative Assets: A Guide

The process of investing in alternative assets has historically been time-consuming, difficult, and expensive, leaving regular investors perplexed and unhappy. Investing in alternative assets is now simpler than ever thanks to improvements to SEC rules and regulations.

There are several ways to begin. One strategy would be to sell your stocks or bonds and/or put your funds straight into a different asset class. For instance, you may accomplish this by working directly with a fund manager that specializes in alternative assets or a real estate sponsor. Individuals can participate in fractional shares of private equity firms like Delaware statutory trusts (DSTs), which enable them to invest in alternative assets like real estate.

A self-directed IRA (SDIRA) with an alternate asset custodian is another choice for rolling over your standard or Roth IRA. You can then invest in alternative assets of any kind through the SDIRA, including but not limited to real estate, DSTs, or other investments. In order to hold title to the assets on your behalf, the SDIRA will first facilitate the transaction.

Conclusion

Previously regarded as being too hazardous for private investors to invest in, alternative assets are now more widely accepted. Real estate will undoubtedly be an alternative that investors wishing to diversify their portfolios should think about. If you want to try to reduce the risk normally connected with alternative investing, investing with a real estate sponsor or fund that has a long track record of performance is a wonderful way to do it.

Are you prepared to begin? Get in touch with us right now to find out how our DST and real estate investment platform may assist you in your efforts to put your money to work.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

* There is no guarantee that any strategy will be successful or achieve investment objectives;
* Potential for property value loss - All real estate investments have the potential to lose value during the life of the investments;
* Change of tax status - The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
* Potential for foreclosure - All financed real estate investments have potential for foreclosure;
* Illiquidity - Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
* Reduction or Elimination of Monthly Cash Flow Distributions - Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
* Impact of fees/expenses - Costs associated with the transaction may impact investors' returns and may outweigh the tax benefits

Understanding the Holding Period of a "Like-Kind" Exchange

There are strict timeframes that every investor must adhere to successfully complete a 1031 exchange. However, investors commonly ask, is there a certain amount of time that a property must be held to qualify for an exchange? While the IRS has not explicitly identified a holding period, a few considerations may offer insight.

The 1031 Holding Period

The holding period is how long an investor holds their property. As mentioned, Internal Revenue Code (IRC) Section 1031 does not define how long a holding period must be. Rather, it comes down to the intent of the investor.

The IRS explains: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

“Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.

“Real properties generally are of like-kind, regardless of whether they’re improved or unimproved. For example, an apartment building would generally be like-kind to another apartment building. However, real property in the United States is not like-kind to real property outside the United States.”

Understanding Intent

Section 1031 is designed to enable investors who have held their property for an extended period of time – specifically, those who held the property for income-producing purposes – to trade into another property that would serve the same purpose.

like-kind-exchange-holding-period-1031-exchanges-California-investment-strategies-retirement-planning

However, not all real estate qualifies because not all is held for the same purpose. The most common example to look at is a primary residence. Since a primary home is not “held for productive use in a trade or business or for investment,” it does not qualify for an exchange. On the other hand, apartment buildings, offices and medical complexes, retail centers and single-tenant assets generally qualify since they are held as an investment.

Developers also face challenges when trying to complete a 1031 exchange. Since a property must be held for investment purposes, buying land, building a property, and selling for a profit often disqualifies the transaction from a 1031 exchange. In this scenario, the property was held to resell for profit, not for investment.

However, investors should consider holding the property for at least one year, if not two, if they are uncertain the property will satisfy Section 1031.

While the IRS has never stated that there is a minimum hold period, there have been situations in which the IRS did not permit an exchange because the owner’s intent was unclear.

Investors uncertain about whether they qualify may generally want to adhere to the two-year recommendation. However, as always, speak to your tax professional to get their professional advice about your particular situation.

The two-year holding period was mentioned by the IRS in 1984 in Private Letter Ruling 8429039. The letter was written in response to an investor who wanted to trade his property via an exchange. The property in discussion was used as the investor’s primary residence until 1981. In 1983, the investor rented the property out. When pursuing a 1031 exchange in 1984, the investor requested a 1031 exchange; the IRS approved, stating that holding rental property for a minimum of 2 years is sufficient to meet the holding period test prescribed by Section 1031. However, a private letter ruling only applies to this particular case and is therefore only considered to be a general guideline for 1031 exchanges.

The one-year holding consideration, on the other hand, was introduced in 1989 when congress proposed a 1-year holding period for a property to qualify for a 1031 exchange. However, this proposal was never integrated into the Tax Code and is therefore not a requirement. Instead, tax advisors have referenced this proposal when determining if a property could qualify under Section 1031.

Another consideration for the one-year holding period is that by holding the property for at least 12 months, the investment will be reflected as an investment property on one’s taxes for two filing years.

These considerations, however, are just that – considerations. Historically, the IRS has made decisions regarding like-kind exchanges that do not align with these proposals. For example, in 1953, in the case Allegheny County Auto Mart v. C.I.R., the court permitted an investor to complete a 1031 exchange after holding property for only five days, whereas in other cases, such as one in 1967 in Klarkowski v. Commissioner, an investor was disqualified even after a six-year holding period.

Does a vacation home qualify?

While most commonly 1031 exchanges are discussed amongst commercial investors, those holding property as a vacation home can typically sell it and purchase a new property via a 1031 exchange. However, the vacation home must have tenants, and the property must be treated in a business-like manner. Furthermore, if the vacation home is acquired as the replacement property, the property must continue to be used for investment purposes. Generally, the home cannot be converted to a primary residence within five years following the exchange.

1031-exchanges-CA-investor-relations-real-estate-retirement-planning

Other Important Timelines in a 1031 Exchange

To qualify for a like-kind exchange, investors must understand and adhere to the timelines outlined in Section 1031.

Once a property is listed, there is no guideline on how long an investor has to sell the asset. They can sell it on or off-market and market it for one day or five years. In fact, they can list the asset and then change their mind. Up until the property is sold, any gains are unrealized. It is not until the property actually closes that a timeline kicks off, and the investor could be responsible for paying taxes on the realized gains.

When the initial property – or relinquished property – closes, an investor has 45 days to identify their replacement property and 180 days to close. The 180 days also commence from the closing date of the relinquished property. With few exceptions, any exchange that does not meet these deadlines results in all gains being taxable.

Speak to a Qualified Professional

Many 1031 exchanges look different, and for those considering selling their real estate and purchasing a new property via a 1031 exchange, speaking with a qualified professional is highly recommended. Not only can they offer insight on the possible exchange, but 1031 experts can also introduce investors to alternative 1031 exchange investment solutions that may otherwise be overlooked.

General Disclosure

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

There is no guarantee that any strategy will be successful or achieve investment objectives;
Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
Potential for foreclosure – All financed real estate investments have potential for foreclosure;
Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits