January 24, 2020
"Stocks appear to be detached from reality" trumpeted the main headline of CNBC last weekend. A sentiment to which economist John Maynard Keynes once responded "The market can stay irrational longer than you can stay solvent."
Whether or not stocks are detached from reality is unknown, and the market, being the ultimate voting machine, has decided that reality is where reality trades. But investments just concentrated in stocks is not a diversified investment program. We invest in other asset classes, and today I'd like to talk about one of the big ones: real estate.
Real estate is a broad topic. I'll focus on one aspect of it today: private REITs (real estate investment trusts), which are not listed on major exchanges, versus public REITs. A real estate index fund is composed of public REITs.
Hidden within real estate investments is leverage: in almost all real estate, money is borrowed to make an investment. That borrowed money adds risk, but the physical nature of the asset, such as a building, makes lenders comfortable. An asset offsets the liability.
Leverage, as many Americans learned the hard way in 2008, has a downside. The problem in real estate is that many private REITs deliver returns not because of value added by the managers, but by the financial engineering of leverage. It's not all that visible, but it's important, because it changes the risk equation.
For example, a Chicago Booth School of Business study found last fall that private real estate funds, over a seventeen year time period from 2000 to 2017, generated value of -3.26% (yes, that's a negative) annually versus a core index. The authors stated "The higher fees charged by these funds were a material factor contributing to their negative [performance]." But it wasn't just fees. The paper goes on to conclude that active real estate managers made investments that were sub-optimal over time as well.
In real estate, cash flows and leverage tend to obscure this underperformance.
There are three other major benefits to public REITs:
1. They are liquid. If you need to get out in an hour, you can. This differs from the extreme illiquidity in private REITS, which sometimes means your money is locked up for 2 - 3 years.
2. In an economic downturn, public REITs may have more access to capital markets than private REITs. When assets become cheap, this gives them an advantage - they can raise or borrow money more easily. In addition, a failing public REIT may be bought at a discount by another public REIT. If you own an index of public REITs that owns both, this means you did not lose your asset - it just transferred from one of your firms to another.
3. Due to tax considerations, it often makes sense to hold real estate in tax-sheltered accounts. While this is possible in a private REIT, it can be more difficult.
We like real estate as a means of diversification, but we'll stick to a strategy of indexing it in the public markets.
Shelburne, VT 05482
Burlington, VT 05401