Market Memo
For those new to P(Gain) we are not trying to convince you to invest in real assets, if your visiting our site, your likely already working within the field. Rather it is to provide what we see as context and more tellingly, our perspective of what we think are important characteristics about the asset class and characteristics about real assets within a broader portfolio.
In the contemporary investment environment, Real Estate is considered an alternative investment for institutional investors and is often compared against equities, fixed income assets and cash holdings. Unfortunately, for many individual and passive investors their attention remains on more liquid markets with the memories of the 2007 financial crisis remaining vibrant. For context, As of June 2018, the IRA is 44 years old, the 401(K) has been in existence for 37 years and the Roth variations of either are coming up on their 21st birthday. Although the fundamentals of these programs are sound, their high exposure to financial assets as well as their lack of operational history provides adequate justification for the greater inclusion of real assets within one’s personal and institutional holdings.
Real Estate is an idiosyncratic investment. It maintains unique characteristics that influence its risky premium for both systemic and unsystemic factors but despite this, it has served as the largest source of wealth generation and distribution throughout history. In 2018, for many individuals and institutions this lesson has largely been forgotten or replaced with the innovation of new financial products believed to either maximize return or minimize risk within more liquid markets. Despite this, traditional equity and debt investments within this Real Asset maintain qualities that warrant their inclusion within contemporary investment portfolios and provide significant and distinct alternatives to financial assets.
Real Estate up until several decades ago maintained a dominant position in most institutional portfolios. With the exception of the individual’s working within this very broad field, this fact is often forgotten with many individuals and institutions maintaining investments with lower barriers to entry regardless of the time horizon of their holding period. Real Estate has adjusted to this liquidity preference with widespread availability of Master Limited Partnerships, REITs, Closed End RE Mutual Funds and MBSs products Real Estate’s derivative products have become quite freely traded within liquid markets. However, this does come at a cost, often with characteristics and correlations that more closely confirm to equities and fixed income than their underlying asset. Characteristics that remain unique to direct equity and debt positions within Real Estate Properties and Projects include their potential to offer absolute returns, hedge against inflation, diversify the risk & return spectrum of traditional investments, provide cash flows as well as their potential to provide income tax advantages. Although contrasting investments may provide some of these benefits, these aggregated characteristics demand precise planning and expertise in order to maximize their return while minimizing downside portfolio risk.
Oppose to investments in stocks or mutual which often track their returns relative to an index or benchmark, ownership in private real estate ignores beta risk and offers investors and their portfolios the opportunity to track the performance of their investment in absolute returns. Absolute returns take into account an investments price appreciation, the depreciation of the asset and all subsequent cash inflows and outflows throughout the investments time horizon.
Real Estate provides hedges against inflation, which has remained below the Federal Reserves targeted rate of 2% since its establishment however, the point remains relevant in the event of forecasted inflation hikes as well as unexpected inflation hikes in the future. With inflation historically following non-linear patterns of growth, maintaining real assets with the ability to adjust to it’s corresponding increases provides a hedge its risk particularly in relation to traditional investments such as stocks and bonds which become discounted at greater inflation and interest rates.
Furthermore, real estate provides diversification with traditional investment with correlations across RE asset classes differing at times substantially from those of equity and bond indexes. The correlations are often increased substantially, if utilized with exchange traded derivatives or indexes, which capture liquidity preferences of investors operating within these markets. However, the underlying asset and its idiosyncratic features often offer a greater ability to mitigate systemic risk with traditional assets and derivatives of high liquidity.
Perhaps one of the most important characteristics of real estate investment is the tax benefits associated with its private ownership. Real Estate ownership in U.S. markets offers tax benefits for rental properties, apartments, and shopping centers, industrial, commercial and even vacant land through both depreciation as well as deductibility on debt interests. Subsequently, real estate sets itself apart from the direct ownership of stocks and bonds, which are subject to capital gains but fail to benefit from maintaining a depreciable basis.
Other Real Estate considerations, which make them somewhat unique within the investment landscape and often serve as a barrier to entry for many investors, is the heterogeneity, illiquidity and lumpiness of commercial and residential real estate. Unlike a broad index, such as the S&P or the Dow Jones, Real Estate is very property specific with diverse characteristics unique to each asset. Direct ownership in Real Estate ensures that owners maintain a high degree of unsystemic risk in addition to systemic risk. Furthermore, illiquidity may effect reported returns as well as create additional risk depending upon the investors exit strategy in the asset. Lastly, investors are acquiring lumpy assets in the sense they cannot easily be bought or sold in the exact quantities and sizes market participants prefer. Subsequently, diversification and portfolio balancing across this asset class is challenging in relation to exchange-traded alternatives.
The advantages and disadvantages associated with direct ownership in investable real estate are broad and significant. As a result, appropriately underwriting and managing these assets requires expertise within the asset as well as the specific market the property is located within. Despite the potential intricacies, Real Estate has historically and will remain an institutional quality investment with a enduring requirement to minimizing downside risk in order to maximize both project and portfolio return through active management and planning.