Real Estate and Inflation

Some housekeeping to start.

One Day In July is growing and we have several positions open. Though I don't write most of the website anymore, I wrote this careers site. I won't say this is the usual approach but I kind of liked it and no one has been too insulting of it yet. If you know of talented people please forward this link to them. Our selectivity ratio is high - at least 25 people applied for every job in the last expansion round and I'd like to keep it that way.

Real estate has boomed the past six months, driven by a cocktail of low interest rates, second home buying, pre-Covid pent-up demand, regulatory friction facing builders, not-in-my-backyard syndrome, and Section 1031 exchanges trapping capital in the industry. The realtors on this newsletter could probably keep going.

One of the debates in asset allocation and investing is whether real estate itself should be broken out as a separate category. (Keep in mind that a real estate index is broad, covering things like hospitals and self storage and even cell towers - it's not just houses.) Every few years this debate flares up, usually because a paper is published or an exogenous event like inflation surfaces. In 2016 real estate was added as the 11th sector to the S&P 500, with an overall weighting of 2.62%. But should it get even more dedicated exposure?

Someone arguing "no" would say that real estate is already exposed in the S&P 500, and there is not a good reason to give it more - the market has appropriately weighted it, and there is nothing left to do. Why, a "no" vote would ask, should real estate enjoy increased presence while consumer non-durables (like Proctor & Gamble), not get invited to the party? What about health care - you can find all kinds of reasons, like demographics, that health care should be over-weighted.

Someone arguing "yes" would say lots of asset classes are not represented in the S&P 500, so the boundaries that define what that index covers are somewhat artificial.

We side with the "yes" argument for two additional reasons. The financing and operation of Real Estate Investment Trusts (REITs), in terms of their capital usage, leverage, and profit payout, are unique from other businesses. Their response as an asset class to something like an interest rate increase is different from other businesses, and hence they provide diversification.

In addition, REITs protect well against inflation, and because we have always viewed inflation as one of the primary risks an investor faces, it makes sense to have extra security. The primary point here being the scale of the risk.

Dan Cunningham

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