Part 2: Why adding Real Estate to your portfolio makes sense

In Part 1, I gave a quick run through the basic principles that should be top of mind when evaluating the pros and cons of investing in any single investment or asset class relative to another.?

Here I will attempt to highlight some of the properties (no pun intended) that make Real Estate a good (or depending on your perspective, bad) addition to your portfolio:

1.????Tangibility – Real Estate is a physical asset. It occupies a physical space that will, except in certain force majeure events, such as a major natural disaster or war, almost always retain its utility as a place of shelter/domicile or business (ie. people always need a place to live and work). In terms of significance, the asset class provides safety and security, making it almost as essential as food and water and rest (think Maslow’s hierarchy of human needs). Therefore, by definition it has a higher ‘recovery value’ than a financial asset, such as a stock or bond, which are ultimately claims on assets (hard, operating or other). For reference, recovery value is a term used, mostly by banks who provide secured lending, to describe the price at which an asset can be sold for in the case of default. This is often termed the ‘fire sale’ value. A higher recovery value asset is a more stable and therefore, credit-worthy asset to lend against.

2.????Dual return profile – Real Estate has the unique ability to generate two components of return on investment: a) income (or cash flow), and b) capital appreciation (or growth).

In today’s world, equities typically provide very little (if anything at all) by way of regular income distributions, i.e. via dividends. For this reason, they are generally viewed as instruments of growth, with the largest share of investment returns coming not from dividends, but from the upward price movement a stock, usually as a result of the perceived value of the underlying business having grown.

When it comes to earning a predictable regular cash flow, bonds and bank deposits (both effectively forms of lending/debt instruments) are the assets that pay ‘fixed income’ returns. They do so in exchange for little to no growth prospects (i.e. a deposit or bond matures at its original issue price, often called par value).

By delivering both income and growth, Real Estate therefore behaves almost like a hybrid between a debt instrument and a stock. In fact, given the high recovery rate on Real Estate (as described in 1 above), you can have sort of similar downside protection as you would get in a deposit or a bond, especially when looking at a long term horizon. This is also true particularly when property prices reach levels that are the bottom of the market cycle, a state like where we are currently in Dubai.

On the cash flow side, Real Estate generates rental proceeds from leasing the physical premise to a tenant, which, after deducting operating costs, can be a great source of passive income. At the same time, similarly to a stock, Real Estate has a price that fluctuates according to its perceived value. If the value has appreciated from the time of purchase, this is a source of capital growth. In fact, there are studies that prove that if held through long periods of time, the total combined return that is generated from Real Estate (i.e. from both income and capital appreciation) is pretty much the same, if not actually more, as what public equities deliver in total returns.

Therefore, effectively what you’re getting with Real Estate is the best of both worlds, i.e. some of the same properties of a bank deposit (like income, stability, lower volatility and downside protection) but upside in growth similarly to a stock.

3.????Risk diversifier – Real Estate has a low correlation with stocks and bonds. It also exhibits less volatility than most financial assets. This makes it a great diversifier for a cross-asset class investment portfolio.?

However, it must be noted that although Real Estate offers more stability and downside protection than stocks, it is not a ‘capital protected’ product like a bond, bill or other debt instrument (which benefits from a capital guarantee from the issuer).

4.????Reframing liquidity to your benefit – One of the main weaknesses of owning Real Estate outright is that it typically takes longer to sell a particular property than a financial asset, which is often at the click of a button. Also, because financial markets have so many parties buying and selling every day, those markets are considered more liquid that a property in a specific part of town with specific details that make it valuable and so on. The universe of buyers for such a more specific investment opportunity is, almost by default, much smaller than for stocks and bonds, which are effectively standardized units of equity and debt claims on businesses and governments. That is why Real Estate is classified as an ‘alternative’ market. But that need not be a disadvantage only. It can actually work to an investor’s advantage in that, behaviorally and psychologically one can withstand shocks better in more private, “illiquid” markets like Real Estate. This is namely because a) Real Estate prices are not as readily observable or standardized as stocks and bonds and b) you cannot pull out as fast and easily as in financial markets, therefore one will be less likely to react out of emotion when/if circumstances change.

In Part 3, I will attempt to put the merits of investing in Real Estate into the context of today's world at large and present my case as to why it makes sense right now to allocate more of your portfolio than you would usually to this asset class.