Is this a good time to add real estate to a portfolio?
Real estate is a cyclical asset. When times are good, everyone is expanding. They want to be a part of the boom. When times are bad, it’s impossible to even think about positive returns, much less growth. And, of course, your perspective is always affected by your personal experience. While real estate is a global asset class, all real estate is local.
Real estate comes in four major flavors: residential, office, retail, and specialty uses – like health care or industrial storage or hospitality. Its economic value comes primarily from the rental payments that can be charged. These payments are determined by two factors: the supply of available real estate, and the demand for leases in that particular location. When a location has significant economic growth, new construction booms. Seattle, for example, is now considered the crane capital of America. Growth at Amazon, Starbucks, and Microsoft is fueling a construction boom.
But should the economy turn down, all that new construction can look like excess capacity. People start talking about “see-through” office buildings: they don’t have tenants, so you can look right through to the other side.
As a result, it’s important to understand where we are in the cycle. Real estate goes through four distinct cycles: recovery, expansion, oversupply, and recession. Whenever you’re in one phase, it seems like that condition will last forever – that construction will always be booming, or that the recession will never end. But things always change. It’s impossible to predict exactly when and why, but change is inevitable.
Source: Wharton Business School
It’s important to understand that either supply is growing faster than demand or demand is growing faster than supply. They’re rarely in balance – and then usually at the top or the bottom of a cycle.
The best time to add real estate is during the recovery phase, when there’s no little construction happening but demand is rising. That will give you the longest period of growth before the next recession. Based on the number of cranes out there, that stage has been passed – at least in Seattle and Chicago!
But notice that not all regions are booming. Local economic conditions and restrictions on construction may hold an area back. And different regions have different economic exposures. Northern California is radically different than the industrial Midwest, which in turn contrasts with New England and the Northeast. The United States has distinct geographical regions. Real estate investments should therefore be regionally diversified as well as allocated among various property types.
Commuting regions of the United States. Source: PLOS One.
Real estate is a complex asset class with varying cycles, regions, and property types. Like all investments, it carries risk. But its risk should be measured in the context of the entire portfolio, and in light of the investors’ total financial picture – their assets, liabilities, and other considerations.
All real estate may be local, but real estate is a global asset class. It’s an important source of diversified returns. It’s hard to know exactly the right time to buy. The best time to add it to a portfolio may be when no one is looking – but then, you’ll be looking.
Douglas R. Tengdin, CFA