November 26, 2022

When building a diversified portfolio, not all investments or asset classes are created equal. This is especially true when you are retired or soon-to-be-retiring. There's a school of thought that you should have real estate in retirement because it provides income that is diversified from the stock market and bond market. In other words, you're investing in another asset class, real estate, by purchasing physical property. Not only do you get the cash flow from rent, but the ability to increase rents over time can be considered a hedge against inflation. This is invaluable for those who live on a fixed income in retirement, but is it practical?
Anessa Custovic
To be diversified in your real estate investments, you need to have a lot of money to buy a lot of properties across a number of geographic regions. But if you have a lot of properties, you probably don’t want to manage them yourself, so you need even more money to pay for management. For the average American, this is likely not an option. Consider a simple example: Assume the average house can be purchased for about $200,000, which in today’s market is extremely unlikely, and you want to keep your real estate exposure to about 25% of your overall portfolio. You would need to buy five houses and have a total portfolio worth at least $4,000,000. If you wanted to diversify your real estate position even further to only 10% of your portfolio, you would need a total portfolio of $10,000,000. For most people, it’s simply not financially feasible to buy multiple properties all across the country and hire different management companies. So, what to do?
Enter real estate investment trusts or REITs, a type of pass-through investment company. REITs are pre-made, sometimes diversified packages of properties managed by a professional; REITs pass on the income from the properties managed. Now, if we combine a number of REITs across different sectors, we have what is called a REIT exchange-traded fund or ETF. So, buying the ETF should be just as good as buying property, right? Not so fast, turns out this isn’t as clear-cut as one might think. The type of real estate and the location make a huge difference in the performance and diversification benefits.
There are, of course, a number of publicly-traded REITs, but these investments do not provide the same diversification as a real estate investment that is owned outright. Why do we care about diversification anyway? Diversification lowers overall portfolio risk, meaning your investments are safer, and in theory, you should experience less volatility, which is especially important if you are retired and drawing off your assets. You need assets that are negatively correlated to one another, or move in opposite directions, to diversify and lower your portfolio risk.
The amount of diversification and return provided can vary substantially depending on where you live and the type of real estate you buy for investment purposes. In the example below, we will use the S&P 500 as a proxy for the U.S. equity market, Realty Income Corporation as a proxy for REITs, and the Vanguard REIT ETF as a proxy for REIT ETFs. We acknowledge that using different proxies could yield different results, but believe these proxies are sufficient to capture general relationships between the assets. The housing data is from Zillow.com and proxied by a four-bedroom home (data ranges from 2000 to present day).
Here’s how a scenario might play out:
Let’s start with the simple scenario where a retiree named Sally purchases a home for the rental cash flow and to hedge the stock market with an eventual asset sale. Sally purchases a four-bedroom home to rent in each of the following regions: Modesto, CA; Cincinnati, OH; Colorado Springs, CO; and the Miami, FL, area. Can we say that Sally has achieved her goals of rental cash flow and a stock market hedge? Not necessarily! Sally now has rental income, so that’s half of her goals. What about diversification? Despite diversifying geographically in popular areas with plenty of demand, all of these regions are positively correlated to the S&P 500, Realty Income Corporation, and the Vanguard REIT ETF. So, in reality, Sally is adding more risk to her overall portfolio by purchasing correlated assets.
If Sally really wanted to decrease her overall portfolio risk, she should purchase rental homes in areas that have negative correlations with the S&P 500 (for instance: Jamestown, NY; Danville, KY; and Newport, TN, are just a few examples among many options). What if Sally just purchased a REIT stock or a REIT ETF? Does this achieve her goals of recurring income and a market hedge? No: The S&P 500, the Realty Income Corporation, and the Vanguard REIT ETF are all positively correlated with one another. So again, Sally gets some recurring monthly income through dividends, but she does not hedge her portfolio and, again, increases the overall risk!
What if Sally buys into commercial real estate (CRE) like industrial, retail, or office space rather than rental homes – will this achieve her goals of recurring income and a market hedge? Once again, it depends on the type of real estate and the location. Consider the Harrisburg, PA, metropolitan area. Sally is looking to invest in some CRE there. If she purchases industrial real estate in that area, it will be positively correlated with the S&P 500 but negatively correlated with the Realty Income Corporation. If she instead invested in retail space in the Harrisburg area, she’ll gain an asset with a negative correlation to the S&P 500, giving her recurring monthly income and a bit of a market hedge.
Now, what if Sally only cares about the risk/reward trade-off of the CRE investment? Again, the real estate type and location matter. For example, in Akron, OH, the return/risk trade-off is about 2.19 – meaning that for every unit of risk you are getting about 2.19 percent units of return – that’s a good trade-off. But this is only true for industrial-type CRE in Akron. If she is looking at office-type CRE investments, the return/risk trade-off is about 1.50. (Note: total returns are from the CoStar database ranging from 2000 to present day).
So here are the key learnings from Sally’s story:
Anessa Custovic, PhD, is Chief Investment Officer at Cardinal Retirement Planning, Inc. (www.PlanWithCardinal.com). She earned her PhD in Financial Econometrics from the University of North Carolina at Chapel Hill in 2020. To request a copy of a white paper on correlation risk in real estate investing, a free resource authored by Custovic, email Anessa@PlanWithCardinal.com
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