Using Real Estate as Diversification in Asset Allocation

The Ghost of Business Past

Throughout the last three decades, “financial planning” has developed from non-existent to hot button marketing for hundreds of firms. Where did all of the terminology come from that lead investors to a barrage of confusion? Confusion that lead to “financial planners,” telling their clients what was right for them. Let’s start with the 1990s. The financial services industry changed more in the 1990s then it had since a group of men with government bonds began trading under the buttonwood tree on Wall Street in 1792. There really was no such thing as a “financial service industry” before 1990. Prior to this there were four heavily armed camps, each occupying different sector war zones: banks, insurance companies, stockbrokers and real estate brokers.

Banks took deposits and made loans; insurers insured life and health and sold fixed annuities to the terminally chicken-hearted; stockbrokers sold stocks and bonds and did a marginal business in a wimpy little product called mutual funds; real estate brokers sold homes to the American family, raw land to speculators and income producing properties to investors. Each combatant spent tens of millions of dollars every year telling the public that the other guy’s products were carcinogens.

With the advent of the wild bull market starting in 1982, stockbrokers began gaining market share from both banks, through money market funds, and life insurers by licensing their reps to sell insurance/annuity products. Given the nature of this greatest of bull markets, stockbrokers essential marketing message (“Risk is Good”) had turned out to be right, just as banks’ and whole life insurers’ message (“Risk is Death”) was seen to be wrong. On the outside looking in were real estate brokers whose major business was homeowners and only a select few elite were part of the investment side of real estate.

By the early 1990s, the three major financial service combatants were all in the same business. Real estate was still left on the outside looking in. The private placements and highly leveraged limited partnerships of the mid 80s had left them bloodied and bruised. Real estate was still looking for a way to attract the average investor.

The three financial arenas had joined forces as uneasy allies when they turned together to face a new and impeccable enemy: the “no-load” fund. They now faced a foe who said, “You’d be better off not paying any of ‘em.” Real estate, still on its own, was able to sell its product and market to investors on the value of tax deductions, depreciation and write offs. The ability to invest in real estate within IRAs, although around as long as IRAs themselves, was not being marketed by real estate agents or reps of the financial industry like traditional investments were being marketed by banks, insurers and stockbrokers. At best, the advent of the Real Estate Investment Trust (REIT) was the answer of stock brokerage firms to gain market share in real estate.

Now, with no-loads banging away at the ability of “do it yourself” investors, eyes were opened to the fact that they could make their own decisions for investments and retirement planning. Unfortunately for real estate agents, they never thought there might be a way to assist in educating their clientele in “do it yourself” real estate buying.  This led to the advent of “for sale by owner.” Only now in the 21st century, with loss of market share, do we see real estate agents starting to educate themselves on “do it yourself” retirement planning through IRAs. This awareness gives value added service to the client they may previously have lost because those investors could not see the value of their real estate broker.

Diversification and Asset Allocation

Not a day goes by when the media isn’t discussing the terms diversification, asset allocation, asset class. What exactly do these terms mean? Are they interchangeable?  How does someone practice this art themselves? Where does real estate fit into the modern portfolio theory of asset allocation?

One of the most ridiculous statistics I have ever heard, one delivered with an astoundingly straight face by some professional financial advisor types (including me at one time), is that 87% to 90% of your total investment return comes from asset allocation of your portfolio, rather than from the selection of individual investments within an asset class. Let’s take a look at the index returns of the 3 major financial asset classes: stocks, bonds and cash, per Ibbotson Associates 1925-2005.

Stocks                                          10.4%
Long-term corporate bonds    5.5%
Cash (T-Bills)                               3.7%
Inflation                                       3.0%

Looking at various indices for real estate, which is a little vaguer, we find conclusive historical returns using JMB Institutional Realty Corp. and others with a cross section of 1974-2005:

Real Estate                                   8.2-12%

An investor may infer from this, that the more assets in the things that returned 8-12% as opposed to the things that returned 5.7% and 3.7%, the higher the portfolio return would be.

Asset allocation, as defined by William F. Sharpe the inventor of the Sharpe Ratio which measures reward to risk, concludes that, “investors can allocate their money among three major asset classes-stocks, bonds and cash-and numerous subcategories within those asset classes.”

What we don’t see in any model of asset allocation or diversification within those models is real estate. It has been conspicuously left out of the mix. Is this because the major financial institutions have not been able to figure out how to control the independence of real estate ownership? Possibly. Is it because of the extra effort and work it takes for an investor to identify and consummate the real estate transaction? Possibly. But the real question I have, is why wouldn’t the real estate industry embrace the incredible tools available to them to assist investors in using real estate in their retirement planning through IRAs and qualified plans?

Well, let’s look at what professors really mean by asset allocation the “moving into, out of, and among stocks, bonds and cash at just the right times.” What we have here is an academic theory that is of no practical utility whatsoever. This is the same as saying, “the key to superior returns is to be able to consistently time the markets.” That’s terrific in a computer model, and completely impossible in real life. If you simplify that argument even further, you realize that reduced to its essence, the asset allocation theory just says:

“The higher your equity exposure as a percentage of your total assets, the better your overall return.”

Why then has the financial services industry made a virtually secular religion out of “asset allocation”? If you believe in the myth of “higher returns with lower risk,” that by some mixture of stocks bonds and cash you can somehow magically get higher than 10.5%, there is nothing I can say to help you understand a better model. “Higher returns with lower risk” isn’t modern portfolio theory, nor even ancient portfolio theory. It’s voodoo portfolio theory. “It defies both logic and arithmetic,” Nick Murray, The Excellent Investment Advisor, 1996.

At best, all an investor can ask of asset allocation is to forgo some of the permanent ups so you can miss some of the temporary downs. The question is, why would anybody want to do that? The answer is: nobody would (if an investor really believes that downs are temporary). The other real life problem with asset allocation as it is defined is that stocks and bonds correlate quite positively with each other. That is, when one is taking on water in a hurry, the other usually is too (and for the same reasons).

I would like to propose a theory of total market asset allocation that simply states: allocate your assets between separate but equal returns. Consider using equities from the business world and real estate from the hard asset world causing a portfolio to create “higher returns with different market risks.” I have coined this theory as, “Independent Asset Allocation.” It’s simple and obtainable. An individual can take more control over their future and direct their retirement plans towards things that are concrete and graspable. Separate your funds into 2 areas, 50% equities, diversified into 5 areas of the stock market, and 50% real estate.

If real estate debt for income is a goal then look at first trust deeds. These give higher income that can give an investor the 6-12%% area of return, equalizing it with the overall return of a stock portfolio. If an investor wants real estate equity to maximize capital appreciation, they could look at the possibility of raw land. If the equity diversification goal is a large dividend, paying stock funds could be allocated to an income producing property. And certainly any bond or bond funds could be self-directed to income properties to satisfy income needs, while giving the investor the opportunity of growth stripping the direct relationship between bonds and stocks that quite frequently move in the same direction.

Things in life will not always run smoothly. Sometimes we will be rising toward the heights—-then all will seem to reverse itself and start downward. The great fact to remember, is that the trend of civilization itself is forever upward; that a line “drawn through the middle of the peaks and valleys of the centuries always has an upward trend.”—Rev. Endicott Peabody, headmaster of Groton, quoted by his former student, Franklin D. Roosevelt, in FDR’s last inaugural address, January 20 1945.

Dr. Peabody’s permanent uptrend line, “drawn through the middle of the peaks and valleys of the centuries,” is mirrored in the long-term behavior of both equity and real estate prices. It is the permanent upward bias of the trend line, not the jagged slopes between peaks and valleys of which you should be most concerned with as you  make your investment decisions within your self-directed IRA and other qualified plan accounts.