Investing in stocks or bonds has become so easy and widespread with advances in technology, with the likes of Robinhood. It also makes us wonder why invest in other asset classes like Commercial Real Estate (CRE) in the first place? In this article, we will attempt to answer this question. Along the way, we will also try to appreciate the risk profile and pros and cons of the three major asset classes – stocks, bonds, and real estate.
As we look into the three major asset classes – stocks, bonds, and real estate – we will review the basis for portfolio diversification to manage risk. We will also look into the performance of the major asset classes in the past 15 years to see how they have performed relatively. Finally, we’ll see the relative tax and other advantages of the various asset classes as that will affect the bottom line to the investors.
Portfolio diversification among asset classes
You must have heard the oft-repeated phrase “don’t put all your eggs in one basket”. Though cliched, it is the idea behind portfolio diversification. In financial terms, the intent of portfolio diversification is to reduce overall volatility and enhance risk-adjusted returns. As we have seen in previous FinYork articles, investing is all about having an investment strategy in accordance with one’s risk tolerance and executing on that strategy. Hence, portfolio diversification is a key tenet of investment strategy.
Here’s a chart from Savills on how much the world is worth divided into various asset classes. Real estate refers to residential real estate and CRE market size is $32 Trillion. It comes after Debt (Bonds) and Equities (Stocks) and only growing. Essentially, CRE is a major asset class globally.
When added to a stock and bond portfolio, real estate can provide diversification benefits as real estate has historically shown a low correlation to stocks or bonds. There have been a couple of instances when all asset classes move together as in the Great Financial Crisis (GFC). Still, it is fair to say that the addition of real estate to a mixed-asset portfolio may lower overall volatility and enhance risk-adjusted returns.
Real estate is likely the first asset class that we got exposed to whether it is to live, study, play, or work. Even if everything falls apart, humans need people need built space to sleep, live, and work. Simply put, humans cannot live without real estate. This provides a powerful argument for the longevity of the asset class and why a portfolio must have exposure to an asset class that meets the basic needs of humans.
Long-term investment returns
As of Feb 2021, stock markets are at all-time highs even though it has not been a good year for certain real estate property types like retail or hotels. Let us rewind a bit and look at asset class returns over a longer period. We found the following chart from Novel Investor that compares asset class performance since 2006. As it turns out, REITs (real estate securities) came out on top the most in 6 of the 15 years tracked. Including the 2007-2008 great financial crisis (GFC), which was triggered by real estate, REITs have performed well.
Income Potential
Real estate is in many ways different than a popular high-tech stock that may have doubled over a couple of years. For e.g. real estate offers investors relatively steady and recurring quarterly or monthly income that comes from operations. Many property types in real estate historically involved multi-year lease agreements (e.g. office leases) and hence the cash flow also tends to be relatively predictable and long-term in nature.
On the other end, an investor may be getting zero returns in her savings accounts. Relatively speaking, real estate offers higher yields for such investors. When the cash and equivalents produce close to zero interests. A lot of people (e.g. retirees) need steady and stable cash flows.
Inflation hedge and tax advantages
The fourth benefit real estate provides – inflation hedge and tax advantages. This is very powerful because it can make a big difference to how much money you can actually pocket. Compared to other asset classes, CRE provides a level of inflation protection. How does it provide protection? Real estate leases for the most part incorporate rent increases based on inflation. You may be familiar with your annual house or office rent increase based on inflation. In addition, property values also appreciate based on input costs. If the cost of input like construction material or amenities increase due to inflation, so does the property price and value. The above also doesn’t take into account inflation i.e. it assumes the dollar value is the same in 2006 as it is in 2020. We know that a dollar can buy less of gas or milk than before.
Investing directly in hard assets provides tax advantages in most countries. Tax policies favor real estate investing in many countries including the USA. For stocks and bonds, you’d have to pay taxes on interests, dividends, and capital gain. Depreciation and other treatment can lead to a paper loss when filing corporate or individual taxes. Hence, your tax burden may actually be very less. This deserves in-depth treatment and we will cover it in the future, but let us remember that many countries have historically provided very favorable treatment to the real estate sector.
Investor takeaways
We looked at the major asset classes and the role real estate can play in a portfolio to provide diversification. Real estate can help some investors meet their diversification strategy according to their risk tolerance. Looking at the long-term investment returns of various asset classes securities, Real Estate performance has actually been good in the long run. Scars of the Global Financial Crisis remain and COVID-19 will continue to be a challenge for many real estate property types.
We also compared the asset classes using inflation and a tax lens. Of all the asset classes, real estate provides the most inflation hedge and tax advantages due to real estate advantageous tax policies in many countries.
In summary, it may be worth investing in Real Estate as an asset class. We at FinYork believe all asset classes have a role to play in a portfolio, though we’ll be the first to admit we’re biased towards the real estate asset class. We also believe the real estate asset class is going to become more available and accessible to investors in the years to come. We want all investors to learn and benefit from this asset class. We plan to have a corresponding article on why NOT to invest in real estate. We encourage you to read both the articles and come to your own conclusions.