We construct portfolios out of various asset types in order to diversify, or spread out our risk associated with any one asset type. Most often these asset types include equities (stocks) and fixed income (bonds), which provide for basic diversification. Quite often we include additional asset types in order to achieve further diversification. Examples of additional asset types include commodities, foreign equities, foreign-denominated bonds, timber, and real estate.
It is important to keep in mind as we review various asset classes for inclusion in our portfolio, that we must achieve appropriate return for the inherent risk associated with the specific asset class in question.
Why Include Real Estate?
It is for that very reason that we choose to include real estate as a component of the well-rounded portfolio – due to real estate’s ability as an asset class to deliver a greater reward-to-risk ratio than most any other asset class. This goes, in general, for both personally-owned real estate and real estate owned via Real Estate Investment Trusts (REITs), which are a sort of mutual fund of real estate holdings, primarily commercial real estate holdings.
During periods of high inflation (as many folks expect that we may experience again soon), residential real estate has always provided a good hedge against rising inflation – even in these times when some residential real estate has lost value. The fact remains that, although many folks have been hit and hit hard by having purchased real estate at grossly-overvalued prices, present value is generally expected to appreciate at a greater pace than inflation in the long run. On the downside, commercial real estate doesn’t necessarily share residential real estate’s inflation-hedge benefits.
However, global commercial real estate will provide the opportunity to benefit from currency gains where domestic inflation is higher than that of the countries that you hold property in. This is a similar benefit to owning foreign-currency bonds.
In a period of deflation, another similar benefit is found, although it is more related to the appreciation of foreign currencies due to appreciating yields. But the greater benefit during deflationary periods is found because commercial property rental rates tend to lag the market, which in turn produces real gains to the owner of commercial property.
As we know, during a normal (not inflationary or deflationary) economic period, residential property (directly owned, as in “your own home”) provides both an economic benefit and many emotional ones. Commercial property on the other hand, provides not only a generally more stable return with less risk than equities, but a higher return than can be found with bonds. In other words, the reward-to-risk ratio that you achieve with real estate is greater than with bonds or real estate, although the risk is different.
We use a term – correlation – when describing how various asset types are affected by similar circumstances. If, for example, when one asset increased in value by 10% and a second asset class always increased by the same amount, 10%, then we would indicate that the two asset classes are perfectly correlated. If another asset class only followed the first asset class about half the time, sometimes increasing more, sometimes less, or even decreasing when the first increases (or vice versa), then we might indicate that this third asset class is 50% correlated to the first asset class. (The math is much more complex than this, but I wanted to give you an easy-to-follow example.)
By investing in the first and third asset classes in equal amounts, it stands to reason that we’d benefit by having different sorts and degrees of risks that affect our investments, and not all of our funds would be negatively impacted at any one time. Real estate is just such an asset class, when related to equity or stock investments. Historically speaking, real estate in general is only about 40% correlated with equities, making it a very good diversifier.
I realize that you may not necessarily agree with all of this in light of what we’ve seen happen lately in the real estate world, but there is reason to believe that the same sorts of returns will continue in the future for commercial real estate. Plus, it is very important to keep in mind that real estate is only a small part of your overall allocation – in no case have I recommended more than a 5% allocation to this investment class, and many times we’ve avoided it altogether (eg., last couple of years). But now, valuations should be in a good position to bring this asset class back into your portfolio – to do the job of diversification that we expect.