Real estate investment is the purchase of a future income stream from property and can offer several advantages over other types of investments, including potentially higher returns, stability, inflation hedging, and diversification. Here are some of the key reasons to consider investing in real estate.
Competitive Risk-Adjusted Returns
Based on July 2018 data from the National Council of Real Estate Investment Fiduciaries (NCREIF), private market commercial real estate returned an average of 9.85% over the past five years. This credible performance was achieved, together with low volatility relative to equities and bonds, for highly competitive risk-adjusted returns.
Critics argue that the low volatility characteristic of real estate is the result of infrequent real estate transactions and property values often determined by third-party appraisals, which tend to lag the market. The infrequent transactions and appraisals result in a smoothing of returns, as reported property values underestimate market values in an upturn and overestimate market values in a downturn.
While it’s true that historic estimates of real estate volatility should be adjusted upward, real-time markets are vulnerable to sudden unexpected shocks. A good example of this would be the “Flash Crash” of May 2010, when $1 trillion in stock market value was erased in just 15 minutes. In an environment where market volatility is an issue and the dynamics of algorithmic trading are murky, the more stable pricing of real estate is attractive.
High Tangible Asset Value
Unlike stocks, and to some extent, bonds, an investment in real estate is backed by a high level of brick and mortar. This helps reduce the principal-agent conflict or the extent to which the interest of the investor is dependent on the integrity and competence of managers and debtors. Even real estate investment trusts (REITs), which are listed real estate securities, often have regulations that mandate a minimum percentage of profits be paid out as dividends.
Attractive and Stable Income Return
A key feature of real estate investment is the significant proportion of total return accruing from rental income over the long term. Over a 30 year period from 1977 to 2007, close to 80% of total U.S. real estate return was derived from income flows. This helps reduce volatility as investments that rely more on income return tend to be less volatile than those that rely more on capital value return.
Real estate is also attractive when compared with more traditional sources of income return. The asset class typically trades at a yield premium to U.S. Treasuries and is especially attractive in an environment where Treasury rates are low.
Another benefit of investing in real estate is its diversification potential. Real estate has a low and in some cases negative, correlation with other major asset classes. This means the addition of real estate to a portfolio of diversified assets can lower portfolio volatility and provide a higher return per unit of risk.
The inflation hedging capability of real estate stems from the positive relationship between GDP growth and the demand for real estate. As economies expand, the demand for real estate drives rents higher and this, in turn, translates into higher capital values. Therefore, real estate tends to maintain the purchasing power of capital by passing some of the inflationary pressure on to tenants and by incorporating some of the inflationary pressure in the form of capital appreciation.
The Drawback: Lack of Liquidity
The main drawback of investing in real estate is illiquidity or the relative difficulty in converting an asset into cash and cash into an asset. Unlike a stock or bond transaction, which can be completed in seconds, a real estate transaction can take months to close. Even with the help of a broker, simply finding the right counterparty can be a few weeks of work.
That said, advances in financial innovation have presented a solution to the issue of illiquidity in the form of listed REITs and real estate companies. These provide indirect ownership of real estate assets and are structured as listed corporations. They offer better liquidity and market pricing but come at the price of higher volatility and lower diversification benefits.
The Bottom Line
Real estate is a distinct asset class that is simple to understand and can enhance the risk and return profile of an investor’s portfolio. On its own, real estate offers competitive risk-adjusted returns, with less principal-agent conflict and attractive income streams. It can also enhance a portfolio by lowering volatility through diversification. Though illiquidity can be a concern for some investors, there are ways to gain exposure to real estate yet reduce illiquidity and even bring it on-par with that of traditional asset classes.