A recent executive order has opened the door for private real estate to be included in 401(k) retirement plans, a move that has generated significant interest from investors. However, financial experts are advising caution, pointing to fundamental challenges related to liquidity and valuation that must be addressed before these assets can be widely adopted.
Key Takeaways
- An executive order now permits alternative assets, including private real estate, as investment options within 401(k) plans.
- A study by Schroders found that over 70% of 401(k) investors believe private investments would improve their portfolios.
- Major obstacles for including private real estate are its lack of liquidity and the difficulty in obtaining timely, transparent valuations.
- Experts predict that the first offerings will likely be private REITs, which closely resemble their publicly traded counterparts.
- Tax considerations are important, as tax-inefficient real estate debt may be more suitable for a tax-deferred 401(k) than tax-efficient real estate equity.
Investor Enthusiasm Meets Market Reality
Following a February executive order aimed at expanding investment options in retirement accounts, many savers have expressed strong interest in private real estate. The potential for high returns and portfolio diversification has made it an attractive prospect for those looking to move beyond traditional stocks and bonds.
According to a recent study from global asset management firm Schroders, this interest is widespread. The research revealed that more than 70% of 401(k) investors feel that private investments could enhance their retirement portfolios. Furthermore, just over half of the respondents indicated they would be willing to allocate at least 10% of their retirement savings to such options if they were available.
Understanding the Appeal of Private Real Estate
Unlike publicly traded Real Estate Investment Trusts (REITs), private real estate's value is not typically swayed by daily stock market sentiment or geopolitical events. Research from Blackstone highlights this distinction, showing that private real estate has a zero correlation to public stocks and a slightly negative correlation to investment-grade bonds, making it a powerful tool for diversification.
This low correlation has historically translated into steady performance. In the eight calendar years since 1980 when the S&P 500 index posted a negative return, private real estate delivered positive returns in all but one of those years (2008). The asset class has also served as a strong hedge against rising prices, outpacing inflation in nearly every year for the past two decades.
The Core Challenges: Liquidity and Valuation
Despite the potential benefits, financial experts caution that the practical application of including private real estate in 401(k)s is complex. Two fundamental characteristics of standard retirement plan investments are liquidity and the ability to get a transparent, daily valuation. These features are essential for investors to rebalance their portfolios or withdraw funds.
Craig Bitman, a partner at Morgan Lewis, explained that many private real estate investments lack these qualities. “If you have a fund directly investing in a building, how do you get that money out?” he noted. “Even if you don’t want to take your money out of your 401(k), the question will come up if you want to reallocate your account.”
The Valuation Dilemma
Publicly traded REITs, already common in many 401(k)s, are priced daily on major stock exchanges. In contrast, private real estate assets are typically valued through appraisals that might only occur quarterly or even annually. This lag creates significant issues for a system built on daily account statements and transactions.
The executive order did not provide specific rules for overcoming these hurdles, instead tasking the U.S. Department of Labor, the Treasury Department, and the Securities and Exchange Commission with developing the implementation framework.
“The executive order doesn’t mandate anything. It allows alternative asset classes to be included, but doesn’t say how that should happen,” Bitman added.
One potential solution could involve regulatory guidance. Bitman suggested that agencies might establish new rules, such as allowing the use of a valuation that is less than 30 days old to facilitate transactions.
What Will Early Offerings Look Like?
Given the complexities, the initial wave of private real estate options in 401(k) plans is expected to be limited. Rather than direct ownership in properties, investors will likely see products that are structured to address the liquidity and valuation concerns.
“Most of the investments you’re going to see implemented in 401(k)s are going to be more traditional REIT investments but in the private form,” said Brian Pollak, a partner at Evercore Wealth Management. He explained that these private REITs would function similarly to their public counterparts but without being listed on an exchange.
Public vs. Private REITs
While both invest in real estate, public REITs trade like stocks, offering high liquidity and daily pricing. Private REITs are not publicly traded, which can lead to lower volatility but also makes them much harder to sell quickly. The returns between the two are often comparable.
Pollak also cautioned that investors should manage their expectations regarding returns. “Theoretically, you’re not going to get a lot more return in a private REIT portfolio than a public REIT portfolio,” he stated. “The low-liquidity, high-return options that provide more diversification, I suspect, will be harder to put into a 401(k).”
Strategic Tax Considerations for Investors
Beyond the structural challenges, investors should carefully consider the tax implications of holding private real estate within a retirement account. Jack Ablin, chief investment strategist at Cresset, advises that not all real estate investments are a good fit for a tax-deferred vehicle like a 401(k).
He distinguishes between two main types of private real estate investments:
- Real Estate Debt: This involves lending money to property buyers or developers and earning income from interest and fees. This income is taxed at ordinary rates, which can be as high as 37.9%. Placing this tax-inefficient asset inside a 401(k) can be a smart move, as it allows the investment to grow tax-deferred.
- Real Estate Equity: This involves direct ownership of properties. This type of investment is often highly tax-efficient on its own, thanks to deductions for depreciation that lower the taxable income.
Ablin suggests that holding real estate equity within a 401(k) could be counterproductive. “Income-producing real estate, structured properly, offers investors pretty good after-tax yields,” he said. “Why waste the tax benefit inside the tax-deferred wrapper of a 401(k)?” For many investors, it may be more advantageous to hold such assets in a taxable account to take full advantage of the deductions.
