Real estate asset class positioning on the efficient frontier ; the stupidity of putting your cash under your mattress (let alone someone else’s mattress!)
- For most portfolio managers, investment assets can be thought of as sitting somewhere on the risk-return curve shown below. Of course, depending on valuations at particular points in time, positioning in the economic cycle, or overall geopolitical risks, some of the relative positions may change. But over long periods, investment assets have tended to display the risk-reward characteristics highlighted by the efficient frontier below.
- The green curve highlights the effect of leverage or taking on debt in each real estate transaction. This can increase the level of risk and return to private equity levels. Portfolios that lie below the efficient frontier are sub-optimal because they do not provide sufficient return for the level of risk undertaken – the blue curve that highlights the defined rate of return. Therefore, it is imperative to structure the real estate transaction efficiently with the use of leverage. Risk may increase as a result but “In investing, what is comfortable is rarely profitable” (Robert Arnott)
Real estate provides competitive Risk-Adjusted Returns ; pretty strong versus shares over the past 20 years
- The London property price curve (as opposed to all UK property given the focus of this site) has increased at a greater pace versus the FTSE 100 and FTSE All share over the past 20 years. It has also registered more stable growth demonstrated by less volatility and less steep declines in downturns.
High Tangible Asset Value ; we take pride in our bricks and mortar
- Unlike stocks and, to some extent, bonds, an investment in real estate is backed by a high level of brick and mortar.
- This helps reduce the principal-agent conflict, or the extent to which the interest of the investor is dependent on the integrity and competence of managers and debtors.
- Security is the underlying property and serves as collateral for lending purposes.
Portfolio Diversification ; don’t put all your eggs in one basket…until you get comfortable going in heavy
- Another benefit of investing in real estate is its diversification potential. Real estate has a low, and in some cases, negative, correlation with other major asset classes. This means the addition of real estate to a portfolio of diversified assets can lower portfolio volatility and provide a higher return per unit of risk.
- “Wide diversification is only required when investors do not understand what they are doing” (Warren Buffett). Diversification is relevant in the beginning but once you’ve gotten your feet wet and have confidence in your investments, you can adjust your portfolio accordingly and make bigger bets.
- We are not voicing percentages for investment allocations. We are simply seeking to emphasize our experience of having weighted investment allocations to real estate has generated stronger returns than returns in the majority of other investment assets.
Inflation Hedging :
- The inflation hedging capability of real estate stems from the positive relationship between GDP growth and demand for real estate. As economies expand, the demand for real estate drives rents higher and this, in turn, translates into higher capital values. Therefore, real estate tends to maintain the purchasing power of capital, by passing some of the inflationary pressure on to tenants and by incorporating some of the inflationary pressure, in the form of capital appreciation.
The Drawback: Illiquidity
- The main drawback of investing in real estate is illiquidity, or the relative difficulty in converting an asset into cash and cash into an asset. Unlike a stock or bond transaction, which can be completed in seconds, a real estate transaction can take months to close. Even with the help of a broker, simply finding the right counterparty can be a few weeks of work. Please note however that London assets typically enjoy high levels of liquidity within the real estate asset class given the supply and demand mismatch.
Read on by clicking here for a detailed overview on the Pros and Cons of Investing in London real estate.
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