What’s the asset that no one talks about?
Photo: Bryan Hanson. Source: Morguefile
When I discuss asset allocation, I usually focus on stocks and bonds. Bonds are a senior claim on a business’s cash flow, and stocks are a residual claim on cash flow. So stocks benefit from a business’s growth, but they’re riskier – they get wiped out if the business fails. Bonds are safer, but they don’t go anywhere. If everything goes right, you just get back what you put in, with a little interest.
But is there an asset in the middle – one that can benefit from growth, but also has some safety? One that has a claim on operating cash flow? The answer is real estate. Companies have to have a physical location somewhere. Even software firms like Facebook and Google need physical locations for their employees and computers. Their real estate leases get paid after their creditors, but before their shareholders. That’s why real estate is less volatile than stocks but riskier than bonds.
People who own their own homes already have exposure to real estate – perhaps more than they want! If folks weren’t aware of this before the financial crisis, they got a quick lesson. The combination of excessive leverage and excessive optimism almost took down the global financial system.
But real estate is more than a place to live and work. It’s a financial asset that’s critical to having an efficient economy. Before the industrial revolution, almost all wealth was tied up in real estate. Land provided sustenance, clothing, and income for the people that possessed it. The endowments of the great medieval universities were comprised of various estates. In many ways, the story of modern investment management has been a movement away from real estate.
But has the pendulum swung too far in the opposite direction? Now, real estate is an afterthought – usually considered a minor sub-sector of equities. Until this last year, the S&P 500 included Real Estate Investment Trusts as part of its Financial sector.
Investors should consider real estate as an intermediate-risk asset, and part of a diversified investment plan. As always, the devil is in the details—tax treatment and management incentives matter, especially over the long run. But just because an asset is hard to see doesn’t make it unimportant.
Douglas R. Tengdin, CFA