Should You Add Real Estate to Your Portfolio?
We talk a lot about stocks and bonds, two of the largest asset classes in the capital markets. But we don’t spend a lot of time on hard assets like commodities or real estate.
You don’t necessarily want every asset class in your portfolio, but some real estate investments make sense in a well-diversified global portfolio. That doesn’t mean you should go out and buy just any building. As is always the case with investing, a sound strategy can be tainted by anything from poor decision-making to bad advice.
Investing in real estate is very similar to investing in stocks, so it requires many of the same principles as any other asset class, just with a little twist. I want to talk about how those same principles we’re always championing for stocks and bonds can be applied to real estate.
Diversification Is Still King
In case you haven’t noticed, we are huge fans of diversification. If diversification was a band, we would have its poster above our bed. And it’s not just for stocks.
You can diversify the number and types of holdings you own with real estate, too. The reasoning is the same: you’re minimizing your exposure to risk (deadbeat tenants, property damage, crooked property managers) while still positioning yourself to capture expected returns.
One simple way to achieve diversification in the real estate world is through something called a REIT (Real Estate Investment Trust) fund, or even a combination of multiple REIT funds. These “funds of funds” enable you to own hundreds of properties across a diversified range of domestic and global companies with broad exposure to the world real estate market.
Understand the Unique Risks of Real Estate
If stocks and bonds are so great, why even bother with real estate? It’s all because one magic word: correlation. As Forbes contributor Frank Armstrong III wrote a few years back:
“It’s really nice in times of volatile markets like now to have an asset class that may zig when traditional stocks and bonds zag. An asset with low correlation to others in your holdings can both reduce risk at the portfolio level and increase returns.”
Who wouldn’t want another stabilizer and source of returns in their portfolio? But it’s important to remember the risks.
- Taxes – One of the big reasons we don’t talk about real estate as much as other asset classes is because we are always looking to be as tax-efficient as possible and, to be honest, real estate investing tends to be relatively tax-inefficient. Tax codes are all over the place both domestically and internationally with a myriad of treatments for a myriad of real estate investment types. The potential of getting bad tax treatment when it comes time to distribute funds means they’re best relegated to your tax-sheltered accounts. You wouldn’t want the taxes to exceed the benefits.
- Liquidity – Real estate ventures are relatively illiquid when you put them up against publicly traded stocks, meaning they usually can’t be bought and sold on a moment’s notice. This is especially irritating if you’re an individual investor trying to make direct purchases, but it even affects fund investors. If the fund manager places ill-timed trades to meet popular demand, it can be costly for all shareholders.
- Volatility – While mixing in some real estate allocation can help decrease your portfolio’s overall volatility, the asset class itself tends to perform similar to stocks – in other words, unpredictable and wide ranging. Some providers may try to tell you that’s not true and show you their own biased reports, but investing in real estate is a bumpy ride, no matter what anyone says.
For proof, look no further than the financial crisis of 2007. That was largely caused by overconfident investors believing real estate was a sure thing. That resulted in nothing short of a global credit crisis. We’re seeing these risks play out again in the U.K. “in the shape of a concentrated sell-off of Open Ended Property funds.” Investors are discovering the same thing we learned nearly a decade ago. As one columnist puts it: “Just because risk is not immediately visible, does not mean it isn’t there.”
Allocation Depends on Your Goals
With all of these potential returns and known risks in mind, we strongly suggest that stocks and bonds serve as the meat and potatoes of your portfolio. Real estate should be the salt, sprinkled around as needed.
Beyond a well-balanced meal, your personal circumstances may play a part in determining the right allocation for you. For instance, if you already own a bunch of buildings, you might not want to hold as much real estate in order to offset your existing risks.
While we’re on the subject, I should mention that it’s not a great idea to treat your home as a real estate investment. If it’s value increases over the years, that’s great, but it’s primary purpose is shelter, not profit. That’s why we recommend viewing your home as a consumable expense rather than a reliable source of investment returns.
The less you spend on your investments, the more returns you get to keep, so there’s no need to go after more expensive funds. With plenty of well-managed, cost-effective REITs out there, there’s no need to go after more complicated, potentially overpriced alternatives.
Keep Your Eye on the Finish Line
While real estate is often a welcome addition to a well-rounded, globally diversified portfolio, as I said earlier the advantages are accompanied by portfolio performance that may often deviate from “the norm.” For that reason, real estate requires a patient, long-term approach to participating in its risks and expected returns, much the same approach we advocate for any other investing. If you don’t have the time or risk tolerance to let real estate do its thing, then you’re probably better off avoiding it altogether.
Use Investment Vehicles That Best Complement All of the Above
If allocating some of your portfolio to real estate makes sense for you, there’s still one more step: selecting a fund manager whose strategies line up with yours. You want a fund that is upfront and honest with you about investments held, approach taken, risks realized, and costs incurred. The right provider will be not only honest, but also a proponent of global diversification and appeal to disciplined investors who are less likely to panic and force unwise decisions in times of stress.
One last note: you could already be invested in real estate without knowing it. Stock or hybrid funds often include a shifting allocation to real estate. Unless you read the fine print in the prospectus, it’s hard to know just what you hold, in what amounts, so ask somebody.
Investing in real estate can be great for your portfolio, but it’s only a piece of the puzzle. While it is often tempting to analyze each piece of your portfolio in isolation, it is important to look at everything from a total portfolio perspective.