By Ian Woychuk, CFA
As we discussed in Chapter 1, real estate is usually held as part of a larger portfolio, and is generally considered an alternative investment class. Real estate fits well as part of a portfolio because it has several qualities that can enhance the return of a larger portfolio, or reduce portfolio risk at the same level of return.
Some of the benefits of having real estate in your portfolio are as follows:
- Diversification Value - The positive aspects of diversifying your portfolio in terms of asset allocation are well documented. Real estate returns have relatively low correlations with other asset classes (traditional investment vehicles such as stocks and bonds), which adds to the diversification of your portfolio. (To read more about diversifying, see Achieving Optimal Asset Allocation,Introduction To Diversification, The Importance Of Diversification and A Guide To Portfolio Construction.)
- Yield Enhancement - As part of a portfolio, real estate allows you to achieve higher returns for a given level of portfolio risk. Similarly, by adding real estate to a portfolio you could maintain your portfolio returns while decreasing risk.
- Inflation Hedge - Real estate returns are directly linked to the rents that are received from tenants. Some leases contain provisions for rent increases to be indexed to inflation. In other cases, rental rates are increased whenever a lease term expires and the tenant is renewed. Either way, real estate income tends to increase faster in inflationary environments, allowing an investor to maintain its real returns. (To find out more about inflation, see All About Inflation, The Importance Of Inflation And GDP and Curbing The Effects Of Inflation.)
- Ability to Influence Performance - In previous chapters we've noted that real estate is a tangible asset. As a result, an investor can do things to a property to increase its value or improve its performance. Examples of such activities include: replacing a leaky roof, improving the exterior and re-tenanting the building with higher quality tenants. An investor has a greater degree of control over the performance of a real estate investment than other types of investments.
Real estate also has some characteristics that require special consideration when making an investment decision:
- Costly to Buy, Sell and Operate - For transactions in the private real estate market, transaction costs are significant when compared to other investment classes. It is usually more efficient to purchase larger real estate assets because you can spread the transaction costs over a larger asset base. Real estate is also costly to operate because it is tangible and requires ongoing maintenance.
- Requires Management - With some exceptions, real estate requires ongoing management at two levels. First, you require property management to deal with the day-to-day operation of the property. Second, you need strategic management of the property to consider the longer term market position of the investment. Sometimes the management functions are combined and handled by one group. Management comes at a cost; even if it is handled by the owner, it will require time and resources.
- Difficult to Acquire - It can be a challenge to build a meaningful, diversified real estate portfolio. Purchases need to be made in a variety of geographical locations and across asset classes, which can be out of reach for many investors. You can, however, purchase units in a private pool or a public security, and these units are typically backed by a diverse portfolio.
- Cyclical (Leasing Market) - Not unlike other asset classes, real estate is cyclical. Real estate has two cycles: the leasing market cycle and the investment market cycle. The leasing market consists of the market for space in real estate properties. As with most markets, conditions of the leasing market are dictated by the supply side, which is the amount of space available (or, vacancies), and the demand side, which is the amount of space required by tenants. If demand for space increases, then vacancies will decrease, and the resulting scarcity of space will cause an increase in market rents. Once rents reach economic levels, it becomes profitable for developers to construct additional space so that supply can meet demand.
- Cyclical (Investment Market) - The real estate investment market moves in a different cycle than the leasing market. On the demand side of the investment market are investors who have capital to invest in real estate. The supply side consists of properties that are brought to market by their owners. If the supply of capital seeking real estate investments is plentiful, then property prices increase. As prices increase, additional properties are brought to market to meet demand.
Although the leasing and investment market have independent cycles, one does tend to influence the other. For instance, if the leasing market is in decline, then growth in rents should decrease. Faced with decreasing rental growth, real estate investors might view real estate prices as being too high and might therefore stop making additional purchases. If capital seeking real estate decreases, then prices decrease to force equilibrium.
Although timing the market is not advisable, you should be aware of the stage of the market when you are making your purchase and consider how the property will perform as it moves through the cycles.
- Performance Measurement - In the private market there is no high quality benchmark to which you can compare your portfolio results. Similarly, it is difficult to measure risk relative to the market. Risk and return are easy to determine in the stock market but measuring real estate performance is much more challenging.
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