Real Estate as an Asset Class - Published in the SB News Press in April of 2011

Most advisers use software programs to produce recommended asset allocations for investors.  These programs normally use long-term historical averages for risk factors and returns for each asset class, along with the Markowitz Efficient Frontier, to produce a recommended portfolio at a given level of assumed risk.  The “assumed risk” part of the analysis typically comes from a series of questions that the client/investor is asked, relating to their feeling about various scenarios, such as how they would feel if their portfolio fell in value by a certain percentage.  As these programs have evolved, they have begun to include more asset classes, such as gold and real estate, in addition to the traditional classes, such as stocks, bonds and cash.  For investors who own real estate in expensive areas like Santa Barbara, where real estate values are still comparatively high, these programs may recommend too much real estate for the investor’s portfolio.

I have written extensively about these programs and more specifically about how using historical averages for risk and return is a poor method for recommending allocations for investment portfolios.  (Historical averages would not have been very helpful for an investor putting money into the financial markets in early 2008, for example.)  Asset allocation programs also typically recommend a sizable allocation to foreign markets, which I do not agree with (as last week’s column highlighted).  In a nutshell, I disagree with using asset allocation programs at all.  They are far too general and rely, again, on long-term historical data that has very little to do with the current and future market conditions investors will face.

Depending upon how one answers the questions in an asset allocation program, the recommended allocation will include anywhere from 5 percent to as much as 30 percent be invested in real estate.  For some strange reason, many advisors will make this recommendation, knowing that the investors owns a home worth a significant portion of their total net worth—sometimes 50 percent or even more of that total.  Early in my career, which has spanned over 20 years, conventional “wisdom” was that only liquid assets should be considered when creating an asset allocation.  For this reason, the personal residence was typically excluded from the analysis (which was ridiculous). 

I am from Texas originally, and in Texas, this kind of thinking wasn’t as dangerous because the average single-family home was worth $100,000 or so.  For an investor with several million dollars to invest, excluding $100,000 in real estate wasn’t too damaging.  However, for a Santa Barbara resident with a home valued at $1 million, which isn’t too far above the median home price here in town, and who may have a $2 million investment portfolio, excluding the personal residence when formulating an asset allocation could be a serious mistake.

In the above-stated scenario, the personal residence represents fully one-third of the total net worth of the investor.  Adding even an additional 5 percent of the $2 million investment portfolio to real estate would exacerbate an already massive overweighting in real estate for this investor.  By definition, if the advisor (and the computer program he or she was using to generate the asset allocation) was recommending that 5 percent of the portfolio should be in real estate, this theoretical investor would therefore be overweight real estate by $850,000, or by about 28 percent (5 percent of $3 million is $150,000, so if the investor owns a $1 million home, they have $850,000 more in real estate than the program would recommend). 

If anything, the advisor should, at a minimum, not recommend that the investor place even more money into real estate.  More to the point, the advisor should be recommending ways to reduce exposure to real estate, or reduce risk associated with real estate.

An even more concerning aspect to the issue of real estate exposure for those living in expensive areas and owning real estate, is that most don’t own their houses outright, but instead hold mortgages (debt) on them.  In the investments business, this is referred to as leverage.  If the house were a stock trading on an exchange, we would call it margin.  A mortgage has the exact same impact on the risk associated with real estate as margin does for a stock transaction.  The only difference is that with margin, the investor could get a margin call, requiring more cash to be deposited, whereas with a mortgage, there would not be a call no matter how low the value of the house fell.

With regard to the investor’s asset allocation, there are two ways to look at a house with a mortgage:

1.) The investor could include the total value of the property in their asset allocation
2.)  The investor could include only their equity position in their home—home value less their mortgage

Both methods involve some challenges.  With option 1, the asset allocation is more accurate for analysis and planning, but does not address the associated risk of loss (due to the leverage involved).    As an example, if the investor owns a $1 million home, but has a $500,000 mortgage, this option would have the full $1 million represented in the asset allocation.  However, due to the mortgage (leverage), a given percentage decline in the value of the property will result in double the percentage decline in the investors equity position in the home.  (If the house fell in value from $1 million to $800,000, or by $200,000 (20%), the mortgage does not change—it’s still $500,000 in this example—so the entire $200,000 comes out of the investor’s equity, causing that equity to fall from $500,000 to $300,000, or by 40% (twice the decline in the home value).  Therefore this method captures the dollar risk more accurately than option 2, but does not reflect the potential for percentage losses.  (The investor in this example has fully twice the percentage risk one would normally associate with owning a $1 million outright.)

With option 2, the investor will have a more accurate representation of their dollar exposure to real estate, but their asset allocation will under-represent their total real estate risk in dollar terms.  Using our same example, if the investor only includes the $500,000 equity position they have in their home, the asset allocation will not reflect the other $500,000 in dollar exposure they have to real estate.  This could potentially cause an over-allocation to real estate, if the investor uses an asset allocation program and only inputs a $500,000 exposure to real estate, when the reality is that they have a $1 million exposure. 

I would use the first method, although again, it does not fully capture the true risk to the investor, if one uses an asset allocation program (which is why I do not use these programs). 

Even if one believes in using an asset allocation program, it is advisable to include the personal residence as a real estate investment, when generating an asset allocation recommendation.  For most investors, however, the program would recommend an allocation to real estate that is far less than their actual exposure.  What to do?

Contrary to what many advisors might recommend—adding even more real estate—theoretically, the investor in this case would want to find a way to reduce exposure to real estate.  One possible method of doing this would be to short real estate through selling short REITs or some other real estate stocks.  Another, more favorable method would be to use an ETF that provides short exposure to real estate.  But be careful!  Shorting REITs can be tricky for several reasons.  First, they don’t necessarily track real estate prices well.  Also, they typically pay high dividends, so if you are short, you are responsible for paying the dividends.  Also, many of the short ETFs use REITs, so you have the same issues if you buy an ETF that is short real estate. 

An indirect way to protect your downside would be to short financials, such as banks that make loans for real estate purchases.  As we saw, the banks get hammered when real estate bubbles burst, so shorting the banks would act as a hedge against price declines in real estate.

All of this is a bit academic and not very timely, to say the least, since real estate prices are down about 40 percent here in town from the peak, and we have already seen the negative impact on the banks, etc.  However, this discussion will hopefully inform investors of the dangers of depending too heavily on asset allocation programs, or the advice of advisors blindly using these programs and recommending large exposures to real estate.