COVER STORY, NOVEMBER 2007
WEATHERING MARKET VOLATILITY
A diversified portfolio can help you weather the storm.
In light of the recent pullback in the equity markets as a reaction to the current lending environment and sub-prime woes, investors have been reminded of just how sensitive and emotional the stock market can be. While no one can predict which way the markets will react, one thing for certain is that market volatility will always remain a constant in the stock market.
Bearing a degree of risk in your portfolio is a proven investment strategy. However, successful investors will also tell you that allocating a percentage of the investments to less volatile assets is the key to weathering wild fluctuations in the stock market.
A truly disciplined approach to building a diversified portfolio should include an allocation of hard assets. Quite simply, hard assets are defined as a class of investments that hold an intrinsic value and are inherently non-financial. Generally, gold and precious metals, petroleum and coal products, timber and paper products, and real estate fall into this category.
By far the most easily accessible of these investments is real estate. Large institutional investors such as pension funds and insurance companies have made significant allocations to real estate investments for many years.
The introduction of non-traded, hard asset investments into the typical equity and debt-base portfolio is profound. An investor can realize lower portfolio volatility (beta) and increased yields (alpha) with non-traded real estate investment allocations between 5 percent to 20 percent of their total portfolio. A recent study by Wells Real Estate funds found that between 1978 and 2006 investment portfolios that included a 10 percent to 20 percent allocation in real estate historically outperformed portfolios with a traditional mix of stocks and bonds. Moreover, portfolios including a 10 percent real estate allocation reduced the portfolio’s calculated risk (standard deviation) from 10.08 to 9.65.1
Recent history points to the advantages of including real estate in an investment portfolio. The NCREIF Property Index (NPI) reflects returns on investment-grade, income-producing properties. Total average annual returns for the NPI over the past 3 and 5 years were 17.05 percent and 13.38 percent, respectively. But what about stocks during the recent bull run? Surely they outperformed non-traded real estate. Not so fast. The annual returns for the S&P 500 were 11 percent over the past 3 years and 12 percent over the past 5.2
So how does one go about including real estate in their portfolio? An easy way for investors to round out their holdings in this manner is to add interests in professionally managed, non-traded public REITs or real estate limited partnerships and LLCs.
A major benefit to REIT ownership is that most of these investments are already somewhat diversified by geography and asset class (offices, apartments, retail, and industrial). In addition, according to the Internal Revenue Code, a company must pay 90 percent of its taxable income to shareholders every year to qualify as a REIT. It must also invest at least 75 percent of its total assets in real estate and generate 75 percent or more of its gross income from investments in or mortgages on real property.
Another type of real estate investment gaining popularity is Tenant-In-Common investments, more commonly known as TICs. A TIC is a form of holding title to real property. It allows an investor to purchase an undivided fractional interest in a single property. In addition, it has become the preferred investment vehicle for real property investors who wish to defer capital gains via a 1031 exchange and own real property without the management headaches.
Because TIC opportunities are often packaged with management and financing in place, TIC investments offer greater efficiencies in owning and operating real estate.
While the headlines in the media portray the turbulence of the stock market and housing crises daily, investments in hard assets such as commercial real estate have proven to be an important component of a successfully diversified portfolio. By investing in a REIT or TIC, investors can easily balance their investment holdings and create a hedge against market volatility.
Josh Slaybaugh is the president of Trade Up 1031 is a nationally recognized leader in real estate investing and tax solutions regarding real estate.
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