Private Real Estate for Affluent Investors

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Congratulations - you just sold your business! What are you looking to do with your newfound millions? 

Besides high-risk, high-reward investments such as direct venture investments or starting another company, or perhaps even an income-oriented portfolio (your Market Bucket), chances are that you are looking to upgrade your living arrangements. Or more specifically: You might be looking into buying an apartment, house, and/or holiday home.

And as you think about purchasing your first piece of private real estate (although maybe not your first piece of investment real estate), you might find yourself asking a number of questions. Such as:

• How much of my (liquid) net worth should I be spending on my personal residence?

• What mix of debt and equity should I use for my purchase? How can I optimize?

• And should I even be buying private real estate? Is that even a good investment when I could be putting it into other asset classes like private equity? And do I even want to own a home in the ‘Western world’, or is that too much of a geopolitical risk?

In today’s newsletter, let’s tackle all those questions. An important ‘disclaimer’ ahead: As I often say, me and my colleagues are not trained real estate investors. But maybe that is exactly not what is needed when it comes to private (non-investment) real estate. Let’s dive in!

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About the Position:
We are offering an unique opportunity to work with Tamara, Markus and I in one of Germany’s fastest-growing wealth management firms. Assist us with topics such as client relationship management, investment research, portfolio design, and a variety of operational tasks that come with building a modern wealth management business.

Key Responsibilities:
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Cape May offers a competitive salary, performance-based bonus, 30 vacation days, career development support (including certifications such as CFA or CFP if desired), and the chance to help shape a fast-growing wealth management firm. Interested candidates should send a short cover letter and CV to [email protected]. We look forward to hearing from you! 🚀

Philosophical Views on Private Real Estate

Before we get into the academic details, let’s tackle the topic of private real estate from a philosophical level. When working with our affluent clients, we generally see two philosophical approaches to buying a private residence (although there is a third approach, which we’ll tackle in the final section of this article).

First, optimizing for peace of mind. While there are many places in your portfolio where you can (and should) try to optimize your ‘capital structure’ (i.e. your mix of equity and debt) and your achievable returns, private real estate might not be such an area. Clients that go by this philosophy might buy their private residence with little or even no debt, i.e. financing it fully with equity. Furthermore, they might make sure to hold the property directly (i.e. at their private level) or at least separately from the rest of their wealth to avoid any external risks (i.e. lawsuits from an operating company stake they might still retain). To them, their private residence is not an asset from which they hope to generate any sort of direct or indirect return.

Second, optimizing for overall capital structure. Perhaps the opposite of the ‘peace of mind’ model, investors favoring this approach see their private residence as yet another investment with a optimal capital structure relative to its risk and return parameters. As a private residence generates no external cashflow (as the owner would pay rent to themselves), the only return comes from long-term appreciation - meaning that many investors see it as an asset that should take up as little equity as possible. As a result, they might try to maximize the debt share in their capital structure, and might also try to optimize where the asset is held (i.e. at entity rather than private level) if that allows for more favorable tax treatment.

While neither approach is wrong or right, we’d typically lean towards the ‘peace of mind’ approach. Frequent readers know us as proponents of the Aspirational Investor Framework and its focus on combining individual goals or objectives with a corresponding amount and split of assets. We do agree with the view of the second approach that a private residence is typically not an asset generating a substantial return, which would speak for taking on more debt. However, more debt as well as any time of capital structure optimization comes with more cost and complexity (more on that later) - which we’d like to avoid in the ‘Safety Bucket’ in which we’d see a private residence. There are many parts of a portfolio where complexity might come with a positive trade-off of higher return and/or lower risk, but for your home, any potential upside is typically limited. So if you can keep it simple, we’d recommend keeping it simple.

To also add Tamara’s German tax perspective: While holding it at your company level might avoid any necessary distribution or shareholder loans, things are complicated by a requirement to pay rent to your entity if the property is used privately. Things are further complicated when trying to think about said property in the context of estate planning. Just hold the property at your private level, despite any potential tax challenges, and try to optimize somewhere else.

But that brings us to an important questions: Can you afford to keep it simple?

How much of my net worth should I invest into a private residence?

Imagine you are a founder based in Germany who just sold their business for net proceeds of 10M€. You are looking to generate income of 15K€ per month from your portfolio so that you never have to work again (unless you want to). But you’d also really like to buy a beautiful house for you and your family. How much can you afford?

If you’re buying in cash (i.e. no debt), you could technically spend up to 10M€. If we include running costs like maintenance or property taxes, for which you’d want to keep some capital aside, you might probably spend a bit less. But of course, if you spend that much, you might not be able to achieve your other goal - generating your desired monthly income so you never have to work again.

So we can tackle the question from another side: How much capital you’d need to put aside so that you’ll likely never run out of money despite your ongoing income requirement. Based on our models at Cape May (including factors such as taxes or inflation), and a target return of 6% p.a. (after fees, before taxes and inflation - which we’d deem achievable for a long-term, diversified, and liquid portfolio), we’d see a required initial investment of 7.5M€ to maintain your portfolio after spend and inflation. Or in other words: If you invest 7.5M€ at a 6% p.a. net return, you could draw your desired 15K€ per month (also increasing with inflation over time), and still maintain your initial capital after inflation, over a 50-year period.

(Two remarks: A) Please note that this is a very simplified model over a long period of time, in which a lot can change. B) Many simple models like the 4% rule fail to account for inflation, which in our view could lead to clients underallocating capital to such a ‘Market Bucket’ portfolio.)

So to summarize: Deducting the 7.5M€ for our income-oriented portfolio leaves us with 2.5M€ to be spent on our private residence. Depending on where you live, definitely an amount that allows you to buy a satisfactory personal residence. If you have ‘just’ 8M€, leaving you with ‘just’ 500K€ to spend on a property, you might be less satisfied. 

In the end, either are just hypothetical examples, and your personal situation would likely look differently. You might be much better off and might thus be able to pay for your dream home many times over while still having a sufficient portfolio to maintain your long-term income requirement. Or your exit proceeds might not be so substantial, requiring you to complement your portfolio income with an external salary in order to be able to purchase your dream home. Practically, we see most of our clients allocating 10-20% of their net worth as equity to a personal residence (although that is sometimes complemented by debt).

But let’s assume your exit proceeds are 8M€, and you aren’t happy with the 500K€ to spend on a property - you’d rather be able to buy a bigger, more expensive residence. Or you are better off, but believer in our second philosophical approach. Can a mortgage help you solve your price gap, and/or help you optimize your personal capital structure?

Should I use debt to finance my private property purchase?

While dependent on the exact jurisdiction you might find yourself in, few means of leverage are as widely accessible at such favorable terms as mortgages for a private residence. Here in Germany, it is not uncommon for affluent investors to receive mortgages covering 110% of the purchase price (i.e. including broker and notary fees), secured primarily by the property itself. Interest margins also tend to be on the lower side, with credit margins as little as 30 to 50 basis points. Admittedly, some jurisdictions are less favorable - for example, Spain tends to cap the LTV at 70% of the purchase price.

But despite all these favorable terms, its easy to forget a very simple fact: Mortgages don’t come for free. Borrowers have to make ongoing interest payments to the bank, and also have to repay the loan over time. Taken together, they create an ongoing cash flow requirement, which might be substantial depending on the size of the mortgage. And any ongoing cash flow requirements needs to be paid - either from an external salary, and/or additional income from the portfolio.

So let’s go back to our prior example. Let’s assume you made 8M€ from your exit, of which 7.5M€ are allocated to your income-oriented portfolio. That leaves you with 500K€ in equity to be spent on a property. But you want to buy a property for 2.5M€, meaning you need to take out a 2M€ mortgage. One client that we helped with a mortgage earlier this year was offered a loan of comparable “loan to value” at an interest rate of 3.5% p.a. and an initial ongoing repayment of 1.5% p.a. If we apply these figures to our hypothetical entrepreneur, we get an ongoing cashflow requirement of 5% p.a., or in their absolute terms, roughly 100K€ p.a. (5% * 2M€).

And if we add that to our existing annual income requirements of 180K€ p.a. (15K€ p.m.), our required target return increases considerably - from the prior 6.0% p.a. to 6.7% p.a. (excluding any additional mortgage- or real estate-related expenses).

This example calculation works out to a somewhat acceptable result with a notable but somewhat modest increase in required return. But we’ve also seen more extreme examples, in which clients have taken on a mortgage with monthly rates equal to or in excess of their living expenses. Often, they are also long-term mortgages (think 20, 30, or 40 years), which might be seen as inflation hedges, but also require those investors to fulfill a substantial cashflow requirement over those long timeframes. 

With all that in mind, what do we deem as an ideal capital structure for a private property purchase? We’d say to focus not on the loan amount, but on the resulting cash flow need. Once again, we’d lean towards the first philosophical approach, i.e. ‘peace of mind’: Don’t over-optimize, but instead make sure that your mortgage rate is not substantially higher than what you might pay in rent for a comparable residence. Or if you go for a larger mortgage for the sake of capital efficiency, make sure that this freed-up capital is invested in a way that a) exceeds the cost of debt and b) ideally is somewhat flexible so that it could be used after a few years to pay off all or some of the loan (i.e. at the end of the 10-year Zinsbindung in Germany).

Despite our conservative approach, let’s conclude this section with a few creative ideas we’ve seen when it comes to creative use of debt in your private real estate purchase:

• Perhaps obvious, but still worth mentioning: Make sure you compare different banks when looking for a mortgage. In my last family office job, we took out multiple mortgages, but many of them with banks that were not our day-to-day partners. You might be surprised about the terms at which banks in the most remote towns of your country want to lend you money.
  

• For a (temporary) equity gap, you could also consider borrowing against your portfolio with a margin loan. In some cases, financing costs might be even cheaper than a comparable mortgage. However, beware of the resulting asset-liability mismatch (illiquid, long-term asset vs. short-term liability). If you do all three with one bank (i.e. hold a portfolio against which you take out a margin loan, and from which you get the mortgage), you might be able to optimize your terms substantially.

• If you are cash-rich when taking out your mortgage but want to limit your long-term cash flow requirement, consider an amortized discount (Disagio or Abgeld in German). Such a Disagio allows you to pay some of the expected interest payments over the loan’s term upfront, reducing your ongoing cash flow requirement.

Should I even buy private real estate? Why not just rent?

In a recent meeting, a client raised an interesting question: All of my affluent friends are buying property, but I don’t really see the purpose - in terms of flexibility, but also in terms of capital efficiency. Why not just rent? Which brings us to our third philosophical approach to private real estate: Not owning any private real estate at all.

The truth is: If you find yourself in the lucky situation of having sold your business you don’t have to listen to anybody on what the right or wrong approach is to doing anything in your personal wealth. There are of course some rules and recommendations that a financial advisor like us would always make, such as staying within your means, and/or not incurring any oversized liabilities, which includes a mortgage. But in the end, it’s up to you on how you want to spend your money. And that includes on whether you want to own private real estate, or not.

In the case of the aforementioned client (but also other clients that we worked with), he liked the idea of being geographically flexible, i.e. being able to live elsewhere without feeling tied to a certain city or country. Ever since interest rates have increased over the recent years, renting tends to be comparably cheaper than owning a comparable property outright, at least in most of the German cities in which we have clients. That desire for flexibility has also become more widespread amid an increase in geopolitical turbulence, as well as perceived long-term challenges for Western nations (including Germany, but also the US). Or said differently - many affluent clients simply don’t want to tie up a substantial part of their net worth in a geography for which they have an uncertain long-term outlook.

There is also another point that the aforementioned client brought up, and that is the question of returns (once again related to philosophical approach #2). I am no expert on real estate price development, but given that a private residence loses a significant portion of real estate’s typical revenue source (rent), I would expect the performance contribution of a personal property to be limited. And even if it appreciates in significant value during the holding period (imagine having bought a property in Berlin or Munich 10 or 20 years ago!), it’s unlikely that the investor can actually benefit from this in a meaningful way: They would likely not want to sell it, nor capitalize significantly through taking out another loan.

Besides those two somewhat rational reasons, let’s not forget my initial point: Once you’ve sold your business and made your millions, you don’t have to justify your decisions to anyone but yourself. So if you want to buy a property, buy one (but make sure to be reasonable about the purchase price and size of your mortgage). If you want to rent, rent - and spend the freed-up liquidity in another way you desire. For either way, there are ways to optimize your capital structure, your tax structure, and so on - but as mentioned initially, a personal residence is a deeply personal topic, and it’s up to you on how you want to tackle the matter.

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