Tag: real estate investments

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.

We looked at how understanding our risk tolerance and setting goals is the first stage of investing in a previous post. What do we do once we understand our risk tolerance and the goals are set? The next step is to have a basic idea of the investing universe and determine the areas to put investment dollars to work.

Many individual investors have a typical journey when it comes to investing. We would have started with savings accounts or CDs and then moved to dabbling in stocks and bonds. It is also very likely that many were forced to manage our retirement portfolios when we started working and got introduced to mutual funds and index funds. Along the way, some may have got exposed to real estate, commodities, or derivatives.

In essence, many individual investors do not have the opportunity to look at their portfolio holistically. After all, most of our time is consumed with our daily job and family commitments. The purpose of this article is to provide a holistic picture of investing. We will go through the various investment options available for investors to put their assets to work. We’ll get some ideas from top institutional investors who have performed well in the long run.

Myriad of Investing options

An investor has a myriad of investments to choose from these days. We may have heard about many of these investments, but we may have just invested in one or two of them. It can sometimes be confusing and sometimes daunting.

Unfortunately, investing is not taught for many in school or college and hence we don’t have any structured approach or framework for investing to follow. Let us first understand the myriad of investment options available. In the financial world, the various investment options are also called asset classes.

An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations.

https://www.investopedia.com/terms/a/assetclasses.asp

The major asset classes are depicted below. Historically, the  popular asset classes have been stocks, bonds, cash-equivalent, commodities and real estate as depicted below. This misses some of the relatively newer investing options like private equity, hedge fund, derivatives and cryptocurrencies.

If you’re interested further in evaluating the various asset classes, nerdwallet has a detailed review of major asset classes.

How do you allocate the assets?

Understanding asset classes provide a lay of the land or big picture that will help you chose the asset classes that you can invest in. Understanding various characteristics of the asset classes helps you diversify your assets (the often used “don’t put all your eggs in one basket”).

The key is to understand the characteristics of an asset class, whether you invest in it or not. For e.g. when one thinks of transportation, one intuitively understands the difference between various modes of transportation – cars, trucks, trains, buses, planes, etc, and their characteristics. Assets classes are similar when it comes to characteristics between the various asset classes.

There are various traditional asset allocation calculators available to help allocate the assets. Many of them only consider traditional assets – stocks, bonds, and cash – only. We’ll see in the upcoming section, why investors should also consider diversifying beyond these traditional assets.

Yale University’s Asset Allocation

Let us look at industry leaders when it comes to investment performance. We can look at enterprises with a good record of investment returns. Yale University is one of them. Yale University is known for its portfolio performance as it has performed better than many peers and many college endowments compare themselves to Yale’s endowment performance. Let us take a look at Yale’s portfolio below.

As we can see, Yale has allocated amongst many asset classes, some available to individual investors and some that aren’t (except for those with high net worth). Yale does invest in cash and fixed income, equities, and real estate that are available to individual investors. It also invests in private equity, venture capital, etc. that may not be available to individual investors.

California Pension Fund’s Asset Allocation

Let us look at another institution that manages many people’s money – Calpers. Calpers is California’s pension fund and manages the pension funds of its 1.9 million members. They are a leading institution when it comes to investment portfolio management. Let us take a look at Calpers portfolio below.

Essentially, Calpers has major allocation to cash equivalents (liquidity, inflation assets), fixed income, real estate and equities.

Personal Asset Allocation

Looking at Yale and Calpers has given us an idea of how a couple of leading institutions are allocating between assets. We can draw some lessons for our personal portfolio from them though some asset classes may be out of reach for many individual investors.

Thinking through risk tolerance and portfolio asset allocation is a key pillar of investing. For a majority of us, the investment universe may just consist of cash and fixed income, equities, and real estate. The exact percentage allocation for your portfolio would be based on your risk tolerance and your goals. The traditional calculators and thinking behind asset allocation is undergoing a big change.

• Traditional Assets
  • Cash
  • Bonds
  • Stocks – Domestic and Foreign
• Alternative Assets
  • Real Estate – REITs, crowdfunding, direct ownership, or private placements
  • Private Equity
  • Venture Capital
  • Commodities
• Your Business

If you need more ideas on the % allocation, check out articles that address the various asset classes described above. We highly recommend you do this exercise on a regular basis. Here’s some advice from US SEC for investors.

If you understand your time horizon and risk tolerance – and have some investing experience – you may feel comfortable creating your own asset allocation model. “How to” books on investing often discuss general “rules of thumb,” and various online resources can help you with your decision.

For example, although the SEC cannot endorse any particular formula or methodology, the Iowa Public Employees Retirement System (www.ipers.org) offers an online asset allocation calculator. In the end, you’ll be making a very personal choice. There is no single asset allocation model that is right for every financial goal. You’ll need to use the one that is right for you.

Some financial experts believe that determining your asset allocation is the most important decision that you’ll make with respect to your investments – that it’s even more important than the individual investments you buy….

Source: US SEC’s Investor Beginner’s Guide

Investor Takeaways

Coming up with a personal asset allocation model is the biggest decision an investor can make. An investor should devote significant time and attention to this effort and get trusted financial advice as needed. After taking a risk tolerance assessment and understanding your risk profile, the next step is to understand the major asset classes and allocate them amongst your portfolio.

We’ve seen some examples of leading institutional investors and how they invest in both traditional and alternative asset classes. Leverage calculators and modern thinking around asset allocation. Write down your asset allocation model and visit it on a periodic basis. This exercise is in itself worth your time in Gold.

We looked at how understanding our risk tolerance and setting goals is the first stage of investing in a previous post. What do we do once we understand our risk tolerance and the goals are set? The next step is to have a basic idea of the investing universe and determine the areas to put investment dollars to work.

Many individual investors have a typical journey when it comes to investing. We would have started with savings accounts or CDs and then moved to dabbling in stocks and bonds. It is also very likely that many were forced to manage our retirement portfolios when we started working and got introduced to mutual funds and index funds. Along the way, some may have got exposed to real estate, commodities, or derivatives.

In essence, many individual investors do not have the opportunity to look at their portfolio holistically. After all, most of our time is consumed with our daily job and family commitments. The purpose of this article is to provide a holistic picture of investing. We will go through the various investment options available for investors to put their assets to work. We’ll get some ideas from top institutional investors who have performed well in the long run.

Myriad of Investing options

An investor has a myriad of investments to choose from these days. We may have heard about many of these investments, but we may have just invested in one or two of them. It can sometimes be confusing and sometimes daunting.

Unfortunately, investing is not taught for many in school or college and hence we don’t have any structured approach or framework for investing to follow. Let us first understand the myriad of investment options available. In the financial world, the various investment options are also called asset classes.

An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations.

https://www.investopedia.com/terms/a/assetclasses.asp

The major asset classes are depicted below. Historically, the  popular asset classes have been stocks, bonds, cash-equivalent, commodities and real estate as depicted below. This misses some of the relatively newer investing options like private equity, hedge fund, derivatives and cryptocurrencies.

If you’re interested further in evaluating the various asset classes, nerdwallet has a detailed review of major asset classes.

How do you allocate the assets?

Understanding asset classes provide a lay of the land or big picture that will help you chose the asset classes that you can invest in. Understanding various characteristics of the asset classes helps you diversify your assets (the often used “don’t put all your eggs in one basket”).

The key is to understand the characteristics of an asset class, whether you invest in it or not. For e.g. when one thinks of transportation, one intuitively understands the difference between various modes of transportation – cars, trucks, trains, buses, planes, etc, and their characteristics. Assets classes are similar when it comes to characteristics between the various asset classes.

There are various traditional asset allocation calculators available to help allocate the assets. Many of them only consider traditional assets – stocks, bonds, and cash – only. We’ll see in the upcoming section, why investors should also consider diversifying beyond these traditional assets.

Yale University’s Asset Allocation

Let us look at industry leaders when it comes to investment performance. We can look at enterprises with a good record of investment returns. Yale University is one of them. Yale University is known for its portfolio performance as it has performed better than many peers and many college endowments compare themselves to Yale’s endowment performance. Let us take a look at Yale’s portfolio below.

As we can see, Yale has allocated amongst many asset classes, some available to individual investors and some that aren’t (except for those with high net worth). Yale does invest in cash and fixed income, equities, and real estate that are available to individual investors. It also invests in private equity, venture capital, etc. that may not be available to individual investors.

California Pension Fund’s Asset Allocation

Let us look at another institution that manages many people’s money – Calpers. Calpers is California’s pension fund and manages the pension funds of its 1.9 million members. They are a leading institution when it comes to investment portfolio management. Let us take a look at Calpers portfolio below.

Essentially, Calpers has major allocation to cash equivalents (liquidity, inflation assets), fixed income, real estate and equities.

Personal Asset Allocation

Looking at Yale and Calpers has given us an idea of how a couple of leading institutions are allocating between assets. We can draw some lessons for our personal portfolio from them though some asset classes may be out of reach for many individual investors.

Thinking through risk tolerance and portfolio asset allocation is a key pillar of investing. For a majority of us, the investment universe may just consist of cash and fixed income, equities, and real estate. The exact percentage allocation for your portfolio would be based on your risk tolerance and your goals. The traditional calculators and thinking behind asset allocation is undergoing a big change.

• Traditional Assets
  • Cash
  • Bonds
  • Stocks – Domestic and Foreign
• Alternative Assets
  • Real Estate – REITs, crowdfunding, direct ownership, or private placements
  • Private Equity
  • Venture Capital
  • Commodities
• Your Business

If you need more ideas on the % allocation, check out articles that address the various asset classes described above. We highly recommend you do this exercise on a regular basis. Here’s some advice from US SEC for investors.

If you understand your time horizon and risk tolerance – and have some investing experience – you may feel comfortable creating your own asset allocation model. “How to” books on investing often discuss general “rules of thumb,” and various online resources can help you with your decision.

For example, although the SEC cannot endorse any particular formula or methodology, the Iowa Public Employees Retirement System (www.ipers.org) offers an online asset allocation calculator. In the end, you’ll be making a very personal choice. There is no single asset allocation model that is right for every financial goal. You’ll need to use the one that is right for you.

Some financial experts believe that determining your asset allocation is the most important decision that you’ll make with respect to your investments – that it’s even more important than the individual investments you buy….

Source: US SEC’s Investor Beginner’s Guide

Investor Takeaways

Coming up with a personal asset allocation model is the biggest decision an investor can make. An investor should devote significant time and attention to this effort and get trusted financial advice as needed. After taking a risk tolerance assessment and understanding your risk profile, the next step is to understand the major asset classes and allocate them amongst your portfolio.

We’ve seen some examples of leading institutional investors and how they invest in both traditional and alternative asset classes. Leverage calculators and modern thinking around asset allocation. Write down your asset allocation model and visit it on a periodic basis. This exercise is in itself worth your time in Gold.

There are beginner investors who can’t wait to invest or do a deal. They want to put capital to work right away and see the returns. On the other end of the spectrum, there are investors who hesitate to invest as they fear losing the money. And then there is a wide range of investors in between.

So, with this wide range of investors, where does one start? We’ll argue in this article that the first step to start investing is to understand risk, our tolerance to risk, and our goals. Understanding ourselves, our motives, and behavior is probably the hardest and most time consuming for many beginner and intermediate investors. In this post, we’ll share key steps with some resources for investors to assess their personal risk tolerance and create investing goals.

Where does an investor start?

Remember the first time you built a hobby? It probably happened over months or years. You tried a few things, liked that particular activity, and started doing more and more of it. Consciously, you may not have even taken the time to observe our actions. But, but you enjoyed it and continued it. Though many won’t consider investing as a hobby, the journey is similar. There is a lot of learning involved – technical and behavioral – and it is a very long journey to get better at investing. What is the first step in this journey? It comes down to understanding risk and our tolerance for risk. In the first place, what is risk?

In simple terms, risk is the possibility of something bad happening……

Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value…such as health, well-being, wealth, property, or the environment…. often focusing on negative, undesirable consequences.

Source: https://en.wikipedia.org/wiki/Risk

It is easy to get carried away in this day and age as most of us are exposed, sometimes overexposed, to finance and investing from general and financial media? We maybe seduced to get stock tips from our favorite financial media or guru and act on it. We need to be careful. Investing is not speculation and is for the long-term, and patience and learning are key. A good investor learns the basics and continues to learn every day!

Understanding and having an appreciation for risk is at the heart of finance and investing. Reward or returns is a by-product of risk. Many of us focus on rewards without appreciating the underlying risk. We’re always enticed by the higher return. But, we need to start with understanding our risk tolerance as explained below.

Evaluating our personal risk tolerance

We take risks on a daily basis though we may not see it as such. We make decisions based on risk all the time. Every time we cross a road we assess and take the risk of safely crossing the road. We select a college and course after weighing the risks and rewards. Will this college help me secure a job? We may not see it as such but some of the major life decisions are also risk-based decisions:

Given the importance of risk in finance and our daily lives, understanding our individual risk tolerance is of paramount importance. This will save months and years of worry and regrets.

Let us take an example. Say, you’ve $1000 to invest and are looking for ways to invest. You have done your research and narrowed it down to 3 options. The first option will give $10 after a year, but $1000 most likely not get affected. The second option will give you $100, but you could also lose $100 and end up with $900. i.e. Option 2 is riskier than Option 1. Some may prefer Option 1 and some may prefer Option 2. There is no universal single correct answer. It depends on the individual. It is important to understand which option you prefer i.e. what is your risk tolerance.

FinYork recommends taking an Investment Risk Tolerance Assessment, as the first step in assessing investment risk tolerance. The one below from the University of Missouri is popular. It is worth every minute of your time as this will set the stage for your investment planning.

Once you finish answering all the questions, you’ll be given an assessment of your risk tolerance. You can use this as the basis of your investments or discuss it with your financial advisor. You may have seen your brokerage’s investor profile questionnaire which is another tool for individual risk tolerance assessment. The whole purpose of this exercise is to evaluate your individual risk tolerance and even confront your fears upfront.

The survey gives a risk tolerance score at the end as shown below. The score will indicate whether you have a HIGH, MEDIUM or LOW risk tolerance. Your investment strategy has to follow your risk tolerance level. For e.g. someone with a LOW risk tolerance should go with a conservative investing strategy and invest in less risky asset classes. We’ll cover this in detail in upcoming articles.

Investing Goals

We have so far looked at evaluating our risk profile and risk tolerance. Once we have an idea of our personal risk tolerance, what do we do next? The next step is to set up investing goals which will form the basis of our personal investing approach. If you already have investing goals and approach to meet those goals, that is great. If you don’t, please take the time to write them down. You need to make sure that you don’t stop at personal finance and budgeting but also think about your net worth and investing goals with a long-term view. You’ll find it beneficial to evaluate where you’re today in terms of personal finance (income/expenses) and net worth.

Investment Goals will differ by age and personal situation

Investment goals for people in their 20s are quite likely different from people in their 40s or 60s. Similarly, goals for people with families are going to be different for singles or couples. More importantly, they are going to be different based on your risk tolerance and personal financial situation. Please take note of your work situation, financial cash flows when coming up with goals. It is best for goals to follow the SMART method of setting goals. For further reading, please visit Corporate Finance Institute’s site on setting up SMART goals.

Write down Investing Goals

Before we get into the how of investing, particularly real estate investing, it is very important to assess your risk tolerance and have clear investing goals. Please take the time to write down the investing goals even if it takes a few hours a day. Above all, investing is a habit. You need to be committed and keep practicing it consistently to get better at it. Your investing goals may consist of the following or more:

• Your goals and why you want to achieve those goals? For e.g. “My goal is to retire by 55 with X income and Y assets so that I can be financially free”
• What are your guiding principles? For e.g. “I will invest in companies that also do some social good”
• Your fears and how to overcome them? For e.g. “My fear is that I have little confidence in myself when it comes to money matters. I plan to overcome my fear by learning about investing by spending an hour every day.”

Investor Takeaways

In this article, we understand the basics of risk and risk tolerance and why understanding our risk tolerance is so important. Risk and our tolerance of risk is in itself not a good or bad thing. We just need to understand our risk tolerance as this will define our investing strategy. Having a true appreciation of our risk-taking will define our investing strategy. It will lead to the kind of investments – stocks, real estate, etc. we chose. We hope we’ve convinced you as an investor to evaluate your risk tolerance before making your first investment as it will save a lot of headaches.

Complete the above-referenced questionnaire, evaluate your risk tolerance, and keep it for your reference. In addition, take the time to think through and write your Investment Goals. We suggest doing this exercise on a regular basis (say, year-end every year) as that will inform us of our risk tolerance and come up with an appropriate investment strategy to manage risk. This will be the topic of upcoming articles.