Why You Should Diversify Your Portfolio by Investing in Real Estate
“Real estate investing, even on a very small scale, remains a tried and true means of building an individual’s cash flow and wealth.”
— Robert T. Kiyosaki
Every investor has, or at least should have, the goal of building a portfolio that has the highest return with the lowest amount of volatility. Between 2009 and 2017, the Russell 3000 has increased over 250%, but all this has occurred during a time when several economic conditions and trends present challenges (discussed in the next chapter) for equity returns over the next decade or so. Equities, bonds, and other investment classes tend to be cyclical and can experience extended periods of underperformance. For instance, during the Great Recession, the S&P 500 dropped more than 50% from its peak and did not fully recover until 5 years later in 2013. Therefore, many institutional and savvy investors look to diversify their portfolios with asset classes that are as uncorrelated to each other as much as possible.
The NCREIF Real Estate Index is a metric of privately held (i.e., direct investment) commercial real estate as measured by the National Council of Real Estate Investment Fiduciaries (NCREIF) property index (NPI). The following table is a comparison of the correlation coefficients of the NCREIF Index to the following markets: Russell 3000 Index (equities market), Barclays U.S. Aggregate Bond Index (U.S. bond market), and the NAREIT Index (publicly traded U.S. real estate companies). A correlation coefficient value of “1” indicates a perfect positive correlation, a value of “-1” indicates a perfect negative correlation, and a value of “0” indicates no correlation. Private commercial real estate has low or negative correlations to stocks and bonds because real estate is relatively illiquid, trade infrequently, and not prone to speculation. This makes private commercial real estate a strong diversifier that dampens portfolio volatility. In the case of a publicly-traded real estate investment trust (REIT), the share price will fluctuate similarly to equities as it is subjected to the same market dynamics. A REIT may trade higher or lower than the value of its underlying assets. Therefore, a publicly-traded REIT will be more highly correlated to equities than to direct ownership of commercial real estate.
Publicly traded assets offer better liquidity than private investments, however, private investments have the advantage of offering lower volatility. Most investors are heavily weighted in stock, bonds, and mutual funds through their personal and retirement holdings and could substantially benefit from diversifying into privately held commercial real estate assets.
An absolute return is a measurement that includes all the money generated from an investment; specifically, asset appreciation, depreciation (benefit), and cash flow. According to the research firm Preqin, a $100,000 investment on January 1, 2001, would yield $380,000 and $255,000 in commercial real estate and the S&P 500, respectively, on March 1, 2017. Private commercial real estate generates higher absolute returns than equities.
The figure below is a comparison of the investment returns and volatility of commercial real estate, equities, and bonds. Investments in commercial real estate have produced two notable benefits. These investments have generated returns higher than equities and bonds, and the returns came with a volatility lower than equities and scarcely higher than bonds. On a risk-adjusted basis, that means that commercial real estate is a more favorable investment than both equities and bonds.
Source: ©2019 Black Creek Capital Markets, LLC
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