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August 20, 2020

Why Real Estate is a Strong Investment

Introduction

KingsCrowd’s goal is to be the leading providers of ratings, research, and analytics for online private market investments, with a primary focus on startup equity. That said, real estate investing has also moved online and benefited from recent innovations and regulatory changes. Real estate investment opportunities are now more accessible than ever. We think the return potential, diversification value, and innovative investments available makes real estate an opportunity that you should know about. So, we are kicking off a new 4-part series about real estate investing.

A Brief History

I like history, so let me tell you a little story about asset allocation.

For the last 50 years or more, if you wanted a quick sanity check on your portfolio’s asset allocation you might have used the “Rule of 100.” It was a simple formula of 100 – your age to get the percentage of publicly traded stock you should hold, with the remainder going to bonds. This formula recommends 80% stocks for 20-year olds and 40% stock for 60-year olds. If you’ve talked to a financial advisor, they may have split the difference and recommended 60% stocks and 40% bonds. This allocation became an industry standard, often referred to simply as a 60/40 portfolio.

There is good reason that 60/40 became the asset allocation standard. It delivered great returns! According to Vanguard, from 1926 to 2018 the 60/40 portfolio delivered an average annual return of 8.6%. Since 1980, its performance has been even better, averaging 10% per year with 40% less volatility than a 100% stock portfolio. Trying to eke out more return simply wasn’t worth the increased risk.

Unfortunately, all good things must come to an end. And that’s what is happening to the 60/40 portfolio. Over the last 20 years, the 60/40 portfolio has only returned 6% per year. Morgan Stanley forecasts that returns will decline to 2.8% over the next 10 years. This raises at least two questions. Why is the performance of the 60/40 portfolio declining? And why are we only considering stocks and bonds in our asset allocation?

What Happened to the 60/40 Portfolio?

The story of declining returns for the 60/40 portfolio centers on bonds and interest rates. In September 1981, Federal Reserve data shows that the yield on the 10-year Treasury bond (a benchmark for interest rates) peaked at over 15%. In the 40 years since, Treasury yields and market interest rates have been on a steady decline. But there is more to the story than that.

The decline in interest rates during the 20-year period from 1981 to 2000 delivered a welcome boost to the total return of bonds through price appreciation of the bond itself. The way the market drives down yields of existing bonds is by bidding up its price. In other words, if you want to buy a bond yielding 10% when prevailing interest rates are 8%, you have to pay a premium of roughly 14% over the bond’s par value (also called face value or principal value). So an investor might get a 10% cash yield plus a 14% capital gain. That helped juice the returns of a 60/40 portfolio.

For the last 10 years though, the average yield on the 10-year Treasury Bond has been 2.3%. As of August 14th, it was down to 0.70%. That’s a paltry return for 40% of your assets. With near zero (or negative) interest rates around the globe, there is limited opportunity for additional capital gains to supplement the low yield. Worse still, you may not be able to count on bonds for their safety. While low rates may persist for several years, the risk bias for interest rates is to the upside. Investors may not realize how rapidly bond prices will fall when interest rates rise. As an example, if interest rates increase from 0.70% to just 2%, a bond’s price could fall 18%.

The evaporation of bond yields and returns — as well as low growth economic conditions — is why many analysts are predicting the demise of the 60/40 portfolio and updating their recommendations. Some have suggested updating the Rule of 100 to the Rule of 125. Jeremy Siegel — the well known Wharton professor and author of Stocks for the Long Run — cuts to the chase by recommending a 75/25 allocation. In my opinion, these are minor rearrangements of the same advice. I think it’s time to rethink asset allocation by including different assets.

Rethinking Asset Allocation

The origin of the 60/40 portfolio comes from the findings of Modern Portfolio Theory (MPT), developed in 1952 by Harry Markowitz. MPT provides a way for an investor to construct a portfolio that maximizes return at a certain risk level, or conversely, to minimize risk at a certain return level. It was so revolutionary that Markowitz won the Nobel Prize in Economics in 1990. So, why does MPT only consider stocks and bonds? More specifically, why doesn’t it include real estate?

I wasn’t around in 1952, but I have three plausible explanations. First, in order to develop and prove an economic theory like MPT, you need high-quality data that is available over long time periods and broadly accepted by peers. For that reason, Markowitz may have been limited to publicly traded stock and bond data. Second, Markowitz was awarded a Nobel prize in 1990. That was right in the middle of the best 20-year period for the 60/40 portfolio. Both investors and advisors had little incentive to experiment with alternative assets or allocations.

Finally, specific to real estate, the Real Estate Investment Trust (REIT) structure wasn’t established until 1960. And according to Statista data, REITs didn’t accumulate a significant amount of assets until the mid-1990s. Even today, there are only 225 publicly traded REITs. They account for $1.24 trillion in market cap and make up only a 2.8% weighting in the S&P 500. This is despite the fact that the total value of US residential and commercial real estate more than eclipses the $35 trillion dollar value of all publicly traded US stocks.

Where is the other +$34 trillion? With 65% home ownership rates, a large portion of residential real estate is owned by individuals. From an investment perspective, there are more than 800 private REITs that own $1 trillion in a wide range of real estate (still a small portion of total real estate value). These private REITs have historically been available to only accredited investors and came with high minimum investment requirements — just like startups and traditional venture capital until recently. That is what is changing and why your asset allocation might deserve an update.

The Benefits of Real Estate

Just because you can invest in something doesn’t mean you should. So given all your options, why choose real estate?

The real estate sector has delivered strong long-term returns. Using the SPDR S&P 500 Index ETF (SPY) and the Vanguard Real Estate Index ETF (VNQ) as proxies, over the last 10 years stocks have averaged 13.7% per year while real estate has returned 9.1%. Not bad. Looking at the years from 1978 – 2018 (based on the Dow Jones REIT Index), the performance for both converge to 12%, with a low correlation between them.

Real estate is a cash flowing asset delivering a portion of its return through dividends. By rule, REITs have to payout 90% of their net income as dividends, resulting in consistently higher yields than most stocks and Treasury bonds. Currently, the yield on the VNQ is 2.8% compared to the SPY’s 1.7% and the 10-year Treasury’s 0.7%. Historically, REITS have averaged 3.7% or more. Private REITs yields can be higher still. Many yield 5%. Over time, an investor could build a portfolio that delivers the equivalent of a second income.

The rest of returns come through capital appreciation of the real estate. The mid-single digit annual appreciation ensures that real estate values outpace inflation. In fact, some investors use real estate as a hedge against inflation specifically.

Finally, real estate is a “hard” asset that has intrinsic value independent of its market value. You can certainly lose money in real estate, but there is almost always some value that can be recovered through rent, renovation/conversion, or a sale of land or buildings. While hotel and mall real estate are out of favor, some owners and investors are getting creative. In Branson, Missouri, a developer converted a Days Inn Hotel into affordable housing, effectively moving “supply” from the hospitality sector to the residential market.


If you are interested in learning more, stay tuned for the next article in this series. I’ll review some real estate basics and talk a little about real estate asset allocation as part of a portfolio.


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About: Mike Cozart

Mike is a Director of Product Management and part-time start-up investor. Mike started his career as an investment banking analyst and venture capital associate before taking on general management and product management roles with Amazon and Axon Enterprise. He earned an MBA from Columbia Business School in New York City, a BA in Economics from The University of Texas at Austin, and a BS in Geographic Information Science from Texas A&M University at Corpus Christi.

View Mike Cozart's articles

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