Maybe you’ve been thinking of adding real estate to your portfolio – why bother? Aren’t stocks and bonds just fine? Do you need to complicate things by investing in real estate?
The answer is yes! Most investors benefit by adding real estate holdings to their portfolio. Adding real estate to your portfolio allows you to take advantage of the magic of diversification. The theory behind diversification acknowledges that different asset classes behave differently as the economy changes – the relationship of asset classes prices over time is called correlation.
Let’s review why diversification across asset classes is important and why you need to more than the bread and butter asset classes of stocks, bonds, and cash. Adding real estate syndications to your portfolio can raise your overall return while lowering your total risk.
Any group of investments with similar features is an asset class. There are four asset classes:
- Fixed Income/Bonds
- Cash/Money Market Instruments
- Alternative Assets (Real Estate, Commodities, Everything that isn’t #1, #2 or #3)
Broadly speaking, an asset class describes one category of security. Traditionally, stocks, bonds, cash and real estate and are what most people think of when they hear the words “asset class”.
You can also get more specific and break this down further, by industry, country, and company size. For example, you could consider tech stocks as an asset class and financial services stocks as another asset class. Equities are also often broken down into small cap and large cap, which roughly describe company size.
But for purposes of our discussion, let’s keep it simple. We’ll refer to asset classes as stocks, bonds, real estate, and cash, with the disclaimer that, yes, there are many other types of assets. For simplicity’s sake, let’s compare real estate to stocks going forward.
Why You Need To Diversify Into Real Estate (Or Diversify Your Portfolio At All)
Diversification is a fancy term that means “don’t put all your eggs in one basket”. By spreading your money around into different investments, like stocks and real estate, you can improve your overall return but still decrease volatility. In other words, you make more money but with less downside risk. If you invest in multiple asset classes, you can weather the storm when one asset class is dropping like a rock during a recession. Since you’ve invested in other assets that perform well in rocky market conditions, your overall portfolio won’t collapse.
Why Does Adding Real Estate Improve Your Return?
The first part is easy – real estate improves your overall return because it’s been a profitable asset class for a long time. Decreasing risk is great, but the goal is also to make the highest return possible, for whatever level of risk you can tolerate. After all, if you just want to lower risk, you could put more money in cash. Not only does real estate lower your volatility but the performance of real estate has beaten the stock market since 2000. Specifically, multifamily investment has had the highest average returns of any commercial real estate asset class. In fact, residential real estate, not equity, has been the best long-run investment in modern times. (If you’re a glutton for punishment, check the data yourself)
Real estate performs better than stocks yet real estate prices aren’t as vulnerable to the same economic forces as the stock market. By adding real estate to your holdings, not only can you increase your returns, you can also lower your overall risk.
Why Does Adding Real Estate to Your Portfolio Decrease Volatility?
Let’s look at why real estate and the stock market are not well correlated. We have to get technical but don’t stop reading! Real estate values have not historically moved in lockstep with the stock market, as real estate prices and the stock market are not strongly correlated. Adding real estate to a portfolio of stock and bonds, therefore, decreases the overall risk of a dip in a portfolio.
Correlation is the relationship between the values of assets. If the price of coffee and the price of sugar always move up by exactly the same amount, the correlation is 1. If the price moves in exactly opposite directions and amounts, the correlation is -1. This has nothing to do with causation – the assets aren’t affecting each other. Correlation only describes how prices move in relation to another asset. Real estate and the stock and bond markets are not closely correlated, so adding real estate to your portfolio will lower the volatility. In a perfect world, you would build a portfolio of assets that are not correlated at all – so when one asset goes down in value, another asset in the portfolio goes up (ideally by more than the first asset falls).
Over roughly the last forty years, the stock market and the value of apartment complexes have had a correlation of 0.130. This correlation is less than one but still positive. Translation: when stocks go down, there is a small chance that real estate values go down – and real estate values probably won’t go down by as large an amount. Adding an asset class like real estate to a portfolio of stocks and bonds will decrease the volatility of the entire portfolio.
Why don’t real estate prices and stock prices do exactly the same thing? To understand the correlation between asset classes, you first need to understand the underpinnings of correlation, which is risk. Two types of risk explain the correlation between asset classes: systematic risk and specific risk.
Specific risk: This is a risk that is specific to a country, company, or industry. For example, If Mark Zuckerberg does something controversial, Facebook stock will suffer. You could reduce this risk in your portfolio by investing in multiple technology companies instead of only Facebook.
Systematic risk: This is also called market risk. Systematic risk is a risk to the economy as a whole. Think of it as the risk due to general economic conditions. Everything in your portfolio will always be exposed to this risk. It’s not specific to any one company or even one industry. For example, political instability can negatively affect the economy, leading to a recession, which poses a risk to all investments. This risk is the hardest to eliminate from any portfolio. You can reduce systematic risk to an extent, by investing in a range of investments, some of which will perform better in a bad economy than others. But you can never remove systematic risk, as no investment operates in a vacuum apart from the economy. But…
Real estate is not affected by inflation as much as the stock market – real estate is less vulnerable to systematic risk.
Why Isn’t Real Estate as Vulnerable to Inflation as Stocks?
Real Estate is a hedge against inflation (one of those systematic risks). Getting a bit technical again now but stay with me. Hedging against inflation is one of the biggest advantages of investing in real estate. Inflation is the biggest enemy of an investment portfolio and real estate can protect you from it (to an extent). Inflation is how much the prices of goods go up year over year. Real estate is a “good”, a thing you buy, so when inflation drives the prices of goods up, the price of real estate goes up too. Inflation is a systematic risk – it affects the whole economy, but real estate suffers less from inflation than other asset classes and can even benefit from it.
Let’s say for example that the inflation rate is 2%. Your buy $10,000 of bonds that pay a modest return of 5%. By the end of the year, you get $500 or 5% from those bonds. The actual return will be 3% even if the fixed-income bonds you invested in actually achieve a 5% return. The reason is that you need to subtract the increase in inflation rate from your returns. After all, you may have $500 in your pocket, but that $500 doesn’t go as far anymore, as everything costs 2% more than last year, thanks to inflation.
Real estate is a hard asset – an asset you can touch. Inflation causes the price of commodities (tangible things) to rise. So with the rise in inflation, the real estate will also rise in value. In fact, not only that the value of your real estate investment increases but your returns will also probably rise. If you invest in an apartment building through syndication, and inflation causes rents to go up, the total income from the building rises too. So both the appraised value of your real estate as well as the cash flow it generates will go up as inflation rises.
How Much Should You Invest in Real Estate to Achieve Diversification?
Let’s assume you have $200,000 invested. In order to benefit from portfolio diversification, you want to invest across all four types of asset classes. Your current portfolio looks like this:
- $80,000 in different types of stocks including small-cap value stocks, large-cap growth stocks, and international stocks
- $60,000 in government and high yield bonds
- $60,000 in a money market fund
- $0 in real estate
You have allocated 40% to stocks, 30% to bonds, 30% to cash and 0% to real estate. These percentages are your asset allocation.
You want to add real estate to minimize risks by dividing your investment portfolio among uncorrelated asset classes. How much real estate should you add to your holdings and how much should you take away from the other asset classes? This is where your financial advisor should come on board.
Your investment timeline, liquidity needs, and risk tolerance are the building blocks of your personalized asset allocation. In order to figure out these three basic tenets of your asset allocation, you and your financial guru must decide on your financial goals – how much money do you need, when you need it and how much risk you can tolerate.
Real estate is a long term investment – if you have a need for lots of cash in the near term, your allocation to real estate may be small. Real estate is also illiquid – you can’t sell it in 10 seconds on ETrade. If tying up your money in something you can’t easily sell conflicts with your financial goals, it would reduce your allocation to real estate as well. However, hard assets like real estate tend to be less volatile than stocks, so if you prefer fewer ups and downs in your portfolio, you might increase your real estate allocation. As you can see, asset allocation is individualized – your financial situation is unique to you alone. To determine how much real estate is the right amount, talk to your financial planner about your goals first, then together you can work backward to figure out how much real estate exposure is right for you.
So how much should a typical investor have in real estate? Sorry, there is no typical investor. There’s just you. And your allocation depends on your goals, which are unique.
How Do You Add Real Estate to Your Portfolio?
You’ve learned why you need real estate for diversification. You and your financial planner figured out how much to allocate to alternative assets like real estate. Now how do you actually add real estate in your portfolio?
There are multiple ways to invest in real estate, such as direct investment in single-family homes, or multi-family apartment buildings. However, most people want high returns and decreased volatility of real estate without directly dealing with clogged toilets and demanding tenants. Another option for investing in real estate is investing in a REIT, or real estate investment trust. REI values are strongly correlated with stocks, which defeats the purpose of diversification. REIT offers real estate exposure but the goal here is real estate exposure and lower volatility, which REITs don’t’ offer.
For the accredited or sophisticated investor, a carefully vetted mix of real estate syndications generates the highest return while decreasing the volatility in your portfolio through diversification. Investing via syndications also frees you from the day to day grind of finding, financing and managing your own properties. You get the benefits of high returns, low correlation with the stock market and never have to get your hands’ dirty fixing and flipping properties.
Ready to Explore Real Estate Syndications?
You understand the benefits of diversification for reducing risk and why real estate values are not strongly correlated with stock prices. You’ve seen the historically high returns of real estate. You’ve worked out your asset allocation and how much to dedicate to real estate.
The next step is education – learning how to vet a real estate syndication and understanding real estate jargon. Stay tuned! Our upcoming articles will answer all your syndication questions.
In the meantime, feel free to email me with your questions.