David is the Founder and CEO of Realized, a firm whose mission is to improve lives through innovative investment property wealth solutions.
Investing in real estate is historically a proven way to diversify a portfolio. Yet surprisingly, there is a lack of modern portfolio theory application (MPT) in commercial real estate (CRE) to measure quantitative risk and returns.
Even with the perceived volatility of the current economy and drop in commercial real estate deal volume, real estate investment still offers the possibility of high returns for investors. You wouldn’t invest in a single stock and call it a diverse portfolio. This same logic can be applied to real estate investing. This article will explore the potential benefits of alternative assets as part of portfolio allocation and explain how to use modern portfolio theory in CRE investing.
What Is Modern Portfolio Theory?
Modern portfolio theory is used by investors to create a portfolio that seeks to maximize returns while managing risk through diversification. MPT was developed by Harry Markowitz in the 1950s, winning the economist a Nobel Memorial Prize in Economic Sciences. Markowitz reasoned that, given the choice of several portfolios, an investor will select the one that offers the highest return with the lowest amount of risk.
A relatively simplistic use of MPT is illustrated by Vanguard, including an example of a traditional 60-40 portfolio of stocks and bonds. While this analysis is certainly accurate and supports the principles of diversification, it does not consider potential additional benefits of including alternatives assets — such as real estate and commodities — in a portfolio.
Potential Benefits Of Alternative Investments
In Seeking an Alternative: Understanding and Allocating to Alternative Investments, global investment firm Blackstone describes the new investor barbell of traditional and alternative investments.
Traditional investments are characterized by factors such as standardization of options between fund managers, management constraints and a high correlation to the overall market. On the other hand, alternative investments provide a number of potential benefits that traditional options do not, including:
• Low correlation to the traditional stock and bond markets
• More active and performance-driven fund managers
• High level of asset differentiation between funds offer investors greater choice
• More counter-cyclical invested capital due to extended holding periods
Blackstone notes that among the various alternative investment options, only private real estate in both the equity and debt portions of the capital stack offer meaningful current income as a component of total return. This is something that is becoming increasingly difficult to find, as the federal funds rate hovers near zero percent.
Currently, 30% of pension funds and over 50% of endowments invest in alternative assets, according to Blackstone. Yet despite what the big players are doing, individual investors only allocate about 5% of their portfolio to alternatives. However, that percentage is likely to grow as smaller investors turn to alternative investments with a low stock market correlation — such as commercial real estate — to pursue targeted returns.
Applying Modern Portfolio Theory To CRE Investment
Traditionally, investors adjust the mixture of equity and fixed income investments in their portfolios depending on the risk tolerance level. For example, the portfolio of an investor with a low-risk tolerance may contain 80% bonds and 20% stocks, while an investor with a higher tolerance for risk may have a weighting of 80% stocks and 20% bonds.
Modern portfolio theory improves portfolio diversification by using both asset classes and the correlation of returns to help manage risk. By adding alternative investments, including real estate, to the portfolio mix, annualized returns can be potentially increased without compromising the level of risk — or conversely, risk can be managed without sacrificing return.
For example, the previously referenced research from Blackstone compared the risk-return spectrums of traditional portfolios consisting of only stocks and bonds to portfolios which also incorporated an allocation to alternative assets. The results showed higher returns for the same level of risk variance at every point across the spectrum.
Like we’ve said — well-managed property rarely decreases in price over time. This low volatility of cash flow generates stable returns that grow in line with cash flow compared to the fixed rate in bond investment.
We believe that this high reward option is not more widely used because of a lack of knowledge. It is difficult to find a professional who is knowledgeable both in commercial real estate and portfolio theory. Proper asset management by a well-trained professional can significantly reduce the level of uncertainty in all of these variables, allowing an investor to comfortably use commercial real estate as an alternative asset class.
Quantifying Risk In Commercial Real Estate
To be fair, successfully quantifying risk in real estate is not as easy as it may seem. Because the majority of commercial real estate transactions are private, data is often opaque. In addition to the lack of perfect information, the illiquid nature of real estate and the high transaction costs can make applying MPT to real estate portfolios difficult.
Further still, there are often property-level and investment-level nuances that need to be accounted for that may potentially impact commercial real estate returns, including property type; the physical condition of the property; market and sub-market; tenant lease term and credit quality; debt terms and structure; and investment structure — to name a few. Understanding these nuances is difficult and many traditional portfolio managers don’t understand them.
However, not all of these factors lead to the same amount of investment risk. In fact, proper investment selection can help match the investment to the investor’s risk and return profile. Asset management may help manage the risk of these variables, allowing for the application of modern portfolio theory in portfolio construction, including allocations to commercial real estate as an alternative asset class. Remember, real estate holds its value well. The same risks that stocks and bonds have are not as present in CRE. By including the CRE investments with the right characteristics, research has shown that inclusion of commercial real estate in a broader portfolio can result in stronger returns without greater risk.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.