The second best performing asset class is overlooked by many investors. In the long term, real estate has performed second only to stocks as a broad asset class. Yet few investors hold sufficient real estate positions in their portfolios.
Investors, in general, know they need to include investments in both stocks and bonds to have a diversified portfolio. What they may not know is that adherence to a strict stock and bond model is likely hurting their long-term results.
Why Real Estate
Investors can invest into real estate as an equity investment or as a debt investment. Though both have merits, the equity side of real estate can help drive portfolio returns while simultaneously reducing portfolio level volatility. Many investors are over investing in bonds, to the detriment of their retirements or other goals.
Bonds can help stabilize a portfolio, reducing volatility and making investors more comfortable with their portfolio’s performance. But bonds are not a great place to be at the moment, and haven’t really been so for a long time.
Investors are trading away their portfolio’s long-term gains so they can have some more predictable day-to-day returns. That is really all they are achieving with their over concentrations of bond investments in long-term portfolios.
Because many investors are or may be underfunding their retirements, subpar returns are something they can ill afford.
There are two things investors need to be very cognizant of in building toward long-term goals. One is their gross level of return, even small differences in returns compound across time. This is the primary reason for so much advice to minimize fees — they erode returns across time, leaving investors far less to use for their goals.
The second thing is the deleterious effect of inflation. Inflation erodes real rates of return by reducing the purchasing power of future dollars. Portfolios need to not only outpace the current rate of inflation, but also hedge against a run-up in inflation. We have been in a benign inflation environment for many years, but that can change at any time.
Real estate correlates positively with inflation. Real estate prices move up with other prices, providing a degree of hedge against inflation.
How to Invest in Real Estate
There are a number of ways investors can invest into real estate. They have options to do so directly, or they can pool with other investors. Here are some of the main options available to investors.
Rental Real Estate: Investors can purchase one or more properties and rent them out. This approach is certainly not for everyone. It gives you a lot of control over what you own, but comes with a lot of work and a lot of potential headaches.
Not everyone is cut out to deal with problem tenants. Owning real estate and renting it out can be a great way to make money, if you are willing and able to do the work. For most investors, this approach involves too much time and too much risk.
House Flipping: There are many television shows showing professional house flippers making “easy money” flipping houses. There is no easy money in house flipping; there is a lot of work and a lot of risk.
Some people can make money house flipping, but far more people probably can’t. For most investors, this would be a worse idea than rental real estate.
Crowdfunding Options: The number of things we cannot do online continues to dwindle. Investors can invest into real estate investments through several online platforms, similar to crowdfunding.
The more serious of these require accreditation or have other barriers to entry, limiting their applicability for the average investor.
Also notable for the average investor is the lack of liquidity in crowdsourced investments, limiting their practicality for smaller investors.
Real Estate Investment Trusts: Real estate investment trusts (REITs) pool investors together to fund the purchase and/or development of real estate projects.
Many focus on particular sectors, and hence there are different risk characteristics depending on the underlying investments and other factors. REITs can either be publicly traded on exchanges or private placement through brokers.
Both can offer investors a great way to get into real estate without the headaches of direct ownership and with somewhat lower risk characteristics. Investors can further limit their risk by investing into different types of REITs.
Exchange Traded Funds: Investors can invest in a variety of real estate investments through Exchange Traded Funds (ETFs).
ETFs offer investors the chance to invest into real estate through indexes or a variety of other options, which provides investors with the upside of real estate without the liquidity problems of many other real estate options.
There is no magic bullet for portfolio construction. But ignoring a strong performing asset class that can reduce overall volatility while providing a hedge against inflation would be a mistake.
There is not a single risk profile for real estate investments, as there are many types of real estate and many ways to invest into real estate.
Investors need to do their due diligence to make sure they understand what they are getting into and what the risks associated with the investment are.
One large factor in the performance and risk or real estate investments is leverage. Some real estate portfolios are constructed on an all-cash basis; others use a degree of leverage by borrowing money for a portion of the funding.
Using leverage increases an investor’s potential return, while simultaneously increasing risk. There isn’t a right or wrong way; it is just a factor that the investor should be aware of. Leverage can be a wonderful tool if understood and used correctly. But no risk should be undertaken without understanding any potential consequences.
Risk is always a double-edged sword. Many investors focus on minimizing volatility without giving adequate consideration to how much potential return they are sacrificing for that perceived advantage.
By minimizing their short-term risk, they are unknowingly increasing the risk of not achieving their goals. In the end, what you have accumulated is what will enable you to achieve your goals.
Real estate investments deserve consideration for any long-term portfolio. They’re not a silver bullet, but they can help a lot of too conservatively structured long-term portfolios.