Real Estate and Asset Allocation
by Adam Stauffer, CFA, Chief Investment Officer at Offshore Investment Advisor
US home equity peaked in 2005 at $13.1 trillion when it accounted for over 22% of households’ net worth, according to the Federal Reserve. Now five years later it stands at $7 trillion and accounts for only 13%. The magnitude of this fall and its unprecedented global reach have left many investors breathless—questioning the role that real estate BVI plays in maximizing long-term wealth.
Historically, real estate has been an excellent way for individuals to not only save but to build wealth. Despite this, many wealth managers do not include it in their asset allocation calculations. In fact, there is a relative dearth of research on how home equity fits into an individual’s overall portfolio. In my opinion, this is a mistake. Not only can real estate offer great diversification relative to other assets, such as stocks and bonds, but it also forces investors into a regimented savings plan.
Some of the best asset managers in the world, the managers of the Harvard and Yale endowments, currently allocate 23% and 32% to real assets, respectively. Real assets are instruments, such as commodities and infrastructure, that tend to preserve their value during periods of heightened inflation. Real estate is a subset of this—currently Harvard allocates 9% and Yale an estimated 14%.
Given their success in providing superior returns with less risk, we can use the average of their allocations, or 11.5%, as a logical starting point for individuals. There are no set rules, since every investor has different objectives and risk constraints. A significantly higher allocation, and your portfolio may be too geared to inflation and more risky than you think; too little, and it may not be hedged enough against inflation.
Taking this a layer deeper, data suggest that foreign real estate offers even greater diversification benefits and may enhance return. When analyzing foreign real estate, the two most important factors to consider, in addition to the risks inherent in all real estate, are political—the stability of the government and the level of bureaucracy—and economic—the stability of the exchange rate and the economy. The British Virgin Islands seems to grade well on both fronts.
However, the journey forward remains riddled with potholes and real estate’s previously squeaky clean ability to grow wealth is now soiled. Many analysts forecast prolonged weakness in US real estate as anemic demand and high inventories extend the slump. To make matters worse, the European sovereign debt crisis threatens to be a major aftershock to the global credit crisis, which means real estate could face new deflationary headwinds.
As a result, every investor, whether just beginning or well underway, should have an idea of their exposure to real estate as well as equities, bonds and commodities to ensure they are not overly concentrated in any one asset or region.
When deciding between real estate versus other investments, a simple analogy guides the way. Asset allocation is like farming—the risk of failing to produce anything can be significantly reduced by dividing the land into smaller plots and then planting a variety of vegetables and fruits that grow under different conditions. The end result is farm-fresh produce regardless of what Mother Nature throws your way. The same applies for long-term investing—by spreading wealth across uncorrelated assets and culling losers before they overtake your portfolio, you can produce superior risk-adjusted returns and a portfolio that performs regardless of the economic environment.
Your wealth manager can help you conduct this analysis. And while sometimes working with your advisor can seem like going to the doctor—it is easy to put off and you hesitate to tell all—you are almost always better off after you go.
