Real Assets Role in Multi-Asset Portfolio

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Introduction

Real estate is a common lawful term used to include land together with anything permanently attached to it (Brown & Matysiak 2000). The attachments may include assets such as buildings or any other thing that is fixed in location. Real estates till now maintains a quite high share of asset portfolio although when assets returns are attuned, real assets fail to match any of the best possible portfolios. Investment in real estate portfolio can take two ways of investment.

These modes can either be direct or physical investment and indirect investments. Indirect investments involve buying shares of real estate from investment companies. Direct real estate investment deals with acquisition and management of physical assets. However, real propertys role is increased because of its increased benefits and its risk reduction qualities. They are believed to have a high risk adjusted rate of returns compared to stock and bonds.

They also have an advantage in that they have positive connection with both predictable and unpredictable inflation and therefore able to preserve their real rate of return. Including real estate in a multi- asset portfolio therefore leads to less difference at each level of return. Recently due to the poor performance of real estates, investors have started doubting whether real estates should continue to be included into the multi- asset portfolio with long time investment options like bonds and stocks. This paper seeks to discuss the role of including the real estate in a multi-asset portfolio.

Comparison of risk and return characteristics of real estate and other investment instruments

In comparison to the equity investment such as shares, real estate investments depict a higher total degree of risk measured by the market index. For instance, considering the real estate debt instruments, they are influenced by the market interest rate. Their risk-return is also affected by the performance in the property market. The returns are also influenced by the changes in the credit market. This affects the capital market due to its influence in the demand and supply ultimately affecting the values of the real estates. This shows a multi-factor influence which tends to increase the degree of risk (Robert 2009).

According to the Sharpe ratio, real estate is attractive due to the fact that they produce the best good risk-return ratio. Some of the investment in real estate are linked to a particular index hence its possible to monitor their degree of risk and make adjustment appropriately.

Conventional bonds are also considered as a part of investment in U.Ks gilt market. These investment vehicles have got a fixed rate of return and definite maturity date. The current coupon rate of gilts is spread from 2% to 13.5%.This means that the investor can be able to determine the return for his investment unlike in the real estate investment where the rate of return is dynamic due to market changes.

Real estates have the characteristic of reducing the risk. This is due to their characteristic of them being leased such as through the long term leases. This means that they are shielded to a certain degree from the market movements reducing their risk exposure. Other investments such as bonds and shares do not have this characteristic (Robert 2009).

Real estate investments have the characteristic of hedging against risk of inflation. According to a research by John, he found that the returns in real estate investment are higher than that of shares, bonds and other investments (1991).

With regard to considering inclusion of real estate in a multi-asset portfolio, investors should consider the property concentration. This can either be by type of property or area. This is due to the fact that the returns in real estate are affected by the basics in the local market. If a multi-asset portfolio investment consists of investment in real estate that is concentrated in one location or nature of the property, they tend to lose their risk mitigation characteristic.

Considering the type of investment in real estate, there are divergent options that are available to the investor for the construction of a multi-asset portfolio. These sectors include the retail, industrial, office building amongst other properties. For instance in case the investor has made a decision to invest in retail properties such as multi-family units, he should consider the trend in this sector in comparison to other sectors. This can be with respect to variables such as total return, income growth, capital growth, rental value growth and the yield over a given period of time.

Considering the case of investment in real estate with respect to retail property investment in U.K for the period of 2000 and 2005, the total return showed an upward trend. The total returns increased from 863.7 in 2005 to 1719.9 in 2005 while capital grew from 266.7 to 399.5. There was also growth in the rental value overtime from 317.4 to 380.3.Upon factoring in the inflation to depict the market conditions, the trend does not fluctuate but depicts an upward trend.

For instance with respect to total returns, there is an increment from 350.2 to 619.0.This trend is also replicated in with respect to all other properties (IPD UK Digest 2006).Amongst investment in real estate in U.K, retail sector was the best. The returns in this sector had a return of 5.3%.Capital and rental values have continued to grow while the yields have dropped. This means that investors should not lose their confidence in considering real estates in their multi-asset portfolio due to the growth in the market (Finfacts n.d).

The real estates values have fallen recently causing low rates of returns. This however should not interpret that real assets should not be held in real- asset portfolio. According to James, real assets should be included in a multi- asset portfolio due to the various benefits that accrue to such a move (2009). This is because the returns for real assets are not connected with the returns for listed stocks and bonds.

Real assets traditionally usually have a high risk- adjusted rate of returns compared to bonds and stock. These risk factors include lack of liquidity, lawful complications and possible agency problems of several of the possession structures. Traditionally, real estate may have seemed to outdo stock and bonds on a risk adjusted basis since other risk factors were not properly measured. The returns from real estate provide an inflation escape as they tend to be associated with changes in inflation. From the above argument, it can be concluded that including real estate in a multi- asset portfolio has the effect of diversifying portfolio capable of providing the same return with less risk compared to a portfolio that do not include real estate (Brown & Matysiak 2000).

Due to the recent poor performance of the real assets investment returns, stock and bonds have recently performed better. This means that the returns for the real-asset investment cannot absolutely collate with the income from bonds and stock. Not all classes of direct real asset and indirect real assets are likely to result to low returns. However not all real assets are likely to perform poorly and hence we should not rule out that real estates should not be included in the multi- asset portfolio.

Advantages and disadvantages of investing in real estate

There are several advantages associated with real estate investment. This class of assets offers powerful diversification benefits. Real assets are tangible assets associated with low volatility to changes within the business environment. They generate good returns and offer durable capital growth. For instance, with real estate investments, there is a possibility of increase in the value of these assets due to their appreciation characteristic (James 2009).

In comparison with stock and bonds, direct real investment has some disadvantage like low liquidity, need for specialist administration, as well as need of high start up capital makes investment in this field costly. The global investment in both direct and indirect real assets stands at over 15 trillion pounds. This is estimated at 37% Europe, 36% North America, 21% Asia and 6% in the rest of the world (Piet, Ronald& Peter 1994).

Real estate has some advantage in that they offer the investor the option to either invest in indirect or direct real estate. Indirect real estate gives the investor the much needed liquidity option. This is due to the characteristic of being traded in the stock exchange market.

Degree of volatility to risks

Unlike other classes of investments, it does not respond in the same way to the dynamic changes in economic circumstances that affects the economy. The dynamic changes in inflation, exchange rates and interest rates for a long time have always had a differential effect on direct and indirect real estate investments. This has an effect on their returns compared with other investment classes. This is because the basic characteristics of direct and indirect real estate, stock and bonds have not changed.

Concept of high risk-high return

Concerning the threat characteristics of the direct investment in real estate investment, it is evident that it outsmarts stock and bonds on the bases of risk adjustment for a long period of time. The higher returns are justified on the basis of the threat factors. According to Lawrence, the higher the risk involved in investment the higher the returns from that investment (1994). Some of the threat factors that justify this condition may not be fully addressed in traditional risk management. Such a measure can be the variance of past rates of return. Such factors may include lack of liquidity, issues of lawful complication and problems that affect the environment.

Traditionally real estate was assumed to do better in terms of returns than stocks and bonds on a risk adjusted basis. This is due to the fact that other risk factors were not well measured. Recently real estate returns has gone through a period of acute capital shortage where appraisal based returns have severely been affected by low liquidity in real estate markets. There is now a more practical risk and returns measures for asset allocation choice in place that can be used to give the actual rate of returns from their investment. Statistics show that about 10 percent to 20 percent of the multi-asset portfolio should be set aside for real estate. This is also in accordance with the real asset portfolio optimization model (Martin 2005).

Even with the declining values of the real estates that have resulted to the previously lower rates of returns, the current market values of the real assets to provide a competitive risk- adjusted rate of return is minimal. In this case, the investors should not think that real estates investments cannot do as good as the stock and bonds on a risk -adjusted basis, in cases where that risk and the assessed value are correctly measured.

Possibility of reduction in the degree of risk

Although the measurement of real assets risk has not been appropriate, investors should not generally believe that the overall riskiness of the real assets as one class of assets will be superior in the future. There is possibility that as the real asset market increases in liquidity and as more and more information concerning its liquidity is availed, the threat associated with real estate market will be greatly reduced. Having in mind that most of the tax benefits that were enjoyed in real estates have been removed, there is little danger that new tax laws will have any adverse impact on real estate worthiness.

Considering that the overall risk of real estate is high, there is no guarantee that it will remain high ever. As more and more information is gathered on the performance of the real estate, the real estate market will become less risky as the real estate market becomes more liquid. As it has been traditionally, real estate investment is positively correlated with inflation. It preserves the real rate of return. Unlike indirect real estates, direct real estates have been showing a good inflation hedge. This is because; in construction building costs tend to increase with inflation. Market rents also increases with increase in the values of the buildings and when the demand and supply of the buildings are in equilibrium the market forces equates the value and the cost of the building.

Indirect real estate assets offers more transparency with low information costs, liquidity ratio is higher than in real direct estate and their performance measurements are a bit less. In the recent times, real estate investment has not been able to preserve its real rate of return. There is evident of high vacancy rate and the market has been overbuilt. Real estate investment can be considered to preserve the real rate of returns unlike other classes of investments if the building replacement or construction costs increase in the same ratio with inflation and if market rent increase in line with increase in building value. The demand and supply of buildings should be in equilibrium. This denotes that the force of supply and demand should equate building value with building costs (David & Brian 1992).

The gross lease supplies, disposable leases and percentage rent for retail leases permit contracts to go with inflation. From the above argument, real assets should preserve their real rate of returns when demand and supply are in equilibrium and when new buildings are possible. Historically investment in real estates was through the direct gaining of personal investment properties. This provided direct control over assets with the capacity to add value through management know-how together with assets.

Availability of professional management of real assets

Investors are shying away from direct investment in real estate due to the high costs involved. They have seen the need to invest jointly as joint ventures and funds with different investment strategies and risk profiles. There has been a major shift from direct investment to real estate investment trust. Real estate investment trust offers higher asset liquidity and market pricing as opposed to appraised values offered by investing in real assets. Real estate investment trusts can be traded in public just like any other publicly traded assets such as stocks (Brown & Matysiak 2000).

Cash flow risks constitute the main portion of the unsolved risk for equity real estate investment trust, unlike the discount rate risks which constitute most of the disparity in stock returns. This analysis shows that real estate returns depends mostly on various aspects of the free market that affects the rent values more than those factors that affects the discount rates in the financial market. This means that real estate investment trusts may be affected by different risk factors than stock and bonds and allow the benefits of diversification to multi-asset portfolio that already contains stock. This suggests that even though real estate investment trust cannot substitute direct real estate investment, it has a major role to play in multi-asset portfolio.

Real estate investment returns does not largely depends on free market factors that might affect rent levels as compared to those factors that affect the discount rate in the capital market. This means that real estate investment trust may be prone to various risk factors than stock and bonds and yet provide diversificated gain to a portfolio that contains stock. Real estate investment trust cannot wholly substitute real direct investment in real estates but they participate in a major role in multi-asset portfolio.

This trust manages funds by considering the asset allocation strategy by making use of extensive selection of investment in the world capital market. It periodically increase or decrease investment in each market segment in line with the basic value-based analysis. This is largely determined considering the current economic conditions and investment opportunities (Ball & Macgregor 1998).

According to Ball & Macgregor, investment in real estates decision is basically based on price or value difference as determined by its basic valuation process. Investors may use policies with diverse principal investment approach to direct the funds overall risk- return experience. Investors of real estates in multi-asset portfolio should be capable of withstanding short-term fluctuations of market returns of fixed income markets for potentially high returns on the long run. Returns from real estates has drastically gone down in relation to stock due to changes in value of the portfolio affected by changes in interest rates, general market conditions, political, social and economic conditions as well as materials linked to businesses in whose investments the portfolio invests (1998).

Risk diversification in the long run

Investing in portfolio is one of the constituent of a balanced investment plan. Investments in emerging markets are more risky in developing countries for issuers. Portfolio investments in real estates contain significant higher risks than investing in private equity. These two classes of investments provides considerable different risks and return characteristics. Investment in real estates contribute about 5- 15%, Unite States bonds 0-48%, non United States bonds 0-37%, high yield bonds 0-13% and cash equivalent 0-50.

According to the standard portfolio theory, an asset which is considerable in size and which is by no means connected with other assets continue to provide diversified benefits in a multi-asset portfolio. In the short run, investors may consider the risk element to be of higher magnitude while compared with the rate of returns, but in the long run the returns from real estate investment should be proportionate with the anticipated risk if proper measurement is done (Martin& Macgregor 2000).

It is clear that even if the rate of real estate values have gone down in recent years resulting to historically low rates of returns, this should not be the only basis to suggest that only a small proportion of real estate should be held in multi-asset portfolio. According to Martin and Macgregor, it is practical that low rates of returns would directly lead to lower historical rates to returns, the lower values also suggests that the expected rate of returns will increase in future. The current market values of the real estate investment are expected to provide a competitive risk adjusted rate of returns to those investors who buys the estate today (2000).

Conclusion

Even if there is much to be leaned concerning how to measure real estate risk, investors should not hold that the overall rate of risk of real estate as an asset class will not reduce in future. In this regard as the real estate market continues to be more liquid and more information concerning its performance continue to be availed, the real estate market will become less risky. Investment in real estates requires serious commitments on the side of the investors.

There are various risks involved. However these risks makes investment in indirect real investment preferred than direct investment and some economists argue that these classes of investments should not be included in multi-asset portfolio. In real estate investment, there are long term benefits associated with tax benefits, cash flow and equity pay down. However every element of real estate investment demands a quite substantial amount of time.

It is good to realize that real estate investment carries all the risks that any business can have. It requires good time management aspects in direct real estate investments. Investors should know that the recent negative cash flows experienced in investment in real estate investment are short lived. It is quite normal for real estate investors to get a period of low cash flows at one point during real asset investment process.

Direct and indirect real estate investment in actual sense provides diversification benefits to stock and bonds. The low correlations between the direct real estate investment with inflation shows that investment in real estate provides little inflation hedge and hence they should be included in multi-asset portfolio. Within the recent past including real estate investment trust in a portfolio dominated by stock and bonds can lead to more positive risk- adjusted results than with direct real estate investment alone. Real estate can be considered to represent a significant portion of various institutional portfolios. Considering that real estates are not transacted directly on a centralized exchange system, the market is portrayed by relatively short of liquidity, high transaction and management costs and lack of homogeneity.

Real estate market is also characterized by low transparency resulting in lack of potential balanced information. This in turn provides high returns to investors who obtain the required information. There is no reason whatsoever for investors to conclude that real estate should not be included in a multi-asset portfolio and that real estate should not perform as well as stock and bonds on a risk adjusted basis.

References

Ball, M.L, & Macgregor, B.D. 1998. The Economics of Commercial Property Markets. University of Aberdeen, London. Web.

Brown, G.R., & Matysiak, G. A., 2000. Real Estate Investment: a capital market approach. Prentice Hall: Sydney. Web.

David, J.H., Brian, W.R.1992. Commercial real estate and inflation during periods of high and low vacancy rates. Web.

Finfacts, 2006.Irish, U.K and European property returns. Web.

James, K., Top 6 ways that real estate investment property returns profits. The New York Times Company: New York. Web.

John, L.G. 1991. Market conditions, risk, and real estate portfolio returns: some empirical evidence. Journal of real estate finance and economics, Springer Netherlands: Baton Rouge. Web.

Lawrence, W.T., 1994. High risk, high returns investing. Wiley Publishers: London. Web.

Peter, B., Stephen, S.,1995. Is there a place for property in multi-asset portfolio? Journal of property finance. Vol. 6, issue 3, pp. 60-83. MCB UP publishers Ltd: Bradford. Web.

Piet, M.A., Ronald, M., & Peter, C.S., 1999. Real Estate Diversification: By Country or by Continent? Limburg institute of financial economies: London. Web.

Martin, H., 2005. Martingale pricing applied to dynamic portfolio optimization and real options. Fall publishers, Sydney. Web.

Martin. & Macgregor, B.D. 2000. Property Investment: principles and practice of portfolio management. Longman Publishers, Harlow. Web.

Robert, S., 2009.Can real estate stabilize your portfolio?. Web.

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