Real Estate: The Best Alternative

There our powerful forces that influence how we think about things, and these forces often create and use terminology to advance their objectives. In the field of finance/investments this is certainly the case.

It has always been broadly accepted that investment portfolios benefit from a mix of both fixed income investments as well as equity investments. In the best case, each of these two offer different qualities that every investor prizes. Fixed income is designed to provide investors with a great degree of predictable and consistent cash flow along with a reasonably strong degree of principal safety. There is typically no upside in a fixed income investment, so the downside ought to be commensurately low. Equity investments are very different in that they typically can have significant upside when things go well, and also have meaningful downside when they don’t. Absent from most equity investments is meaningful and predictable cash flow. When they function properly, equity investments provide investors with a great inflation hedge that preserves an investor’s purchasing power even in the face of the natural reduction that inflation brings about.

There are times, both during different periods of an economic cycle as well as different stages in one’s life, when one might favor a portfolio composition with larger fixed income holdings or larger equity holdings. Today, for example, with equity valuations at historically high levels, one might naturally contemplate shifting some equity holdings over into fixed income, and yet with traditional fixed income yields as low as they are this is not an easy decision to make.

All of that is basic to finance and investments. What is more interesting to me as I contemplate this portfolio allocation issue is the fact that when the terms “equity” or “fixed income” are used they are automatically interpreted by most everyone to mean corporate equity or corporate, and sometimes government fixed income; or in more common jargon: “stocks and bonds.” Other investments – those that don’t fit neatly into the categories of “stocks” or “bonds,” have been unceremoniously lumped into the category called “Alternatives,” which is a wonderfully manipulative word that reinforces the notion that stocks and bonds are the natural main course of the investment meal while everything else is just a sideshow, kind of like ketchup or green beans. This perspective clearly serves the interests of some, but I’d argue does not serve the best interests of investors who have shortchanged themselves by favoring corporate risk over that of real estate.

Real estate investments, unlike corporate investments, have downside that is naturally limited by the existence of a physical property. When a company is mismanaged the downside can be fatal and the loss near total. The same cannot as easily be said of real estate, which, if well-conceived and well-located, will much more likely retain its ability to survive bad management and have any value loss ultimately revived. One might make the same observation regarding fraud or other criminal behavior. Criminal management can and will likely destroy a company, yet a criminal manager can typically only steal a month or two’s rent before being caught. They cannot walk away with a building, nor would the reputation of a building likely be irreparably destroyed by a dishonest management team. Further, access to transparent information upon which to make investment decisions is infinitely better for real estate investments, which quite simply involve assessing a property’s rental income and expenses,  than in corporate investments, which are typically quite complex and where business plans are often speculative, even unknowable, and can be acceptably kept in secrecy. Finally, when tastes change and the product that companies make are no longer attractive to consumers, the company’s fate is usual very bad if not fatal. Well-located real estate does not have this same downside risk.

On the real estate fixed income side of things, not only is the downside protection superior to that of their corporate bond or loan corollaries thus implying that they’re safer, at the same time the yield available in real estate fixed income is also higher than that of corporate debt.

I have spent my life in the investment business, where as a young man I was taught that the primary job of any investor is to avoid principal loss. It would seem to me that pursuing that objective would be much easier when favoring real estate equity or real estate fixed income over their corporate corollaries. Yet, because real estate falls into the investment category called “Alternatives,” and is not traded actively on an exchange and is thus deemed to be “illiquid,” it typically represents less than 10% of investors’ portfolios, while traditional stocks and bonds represent the giant majority. I personally think that this is a big miss for investors.