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Why you need property as part of a diversified portfolio

“The most powerful tool an investor has working for him or her is diversification. True diversification allows you to build portfolios with higher returns for the same risk. Most investors…are far less diversified than they should be.”

The above quote is by Jack Meyer who managed Harvard University’s endowment from 1990 to 2005. During his tenure he grew the endowment from $4.8 to $25.9 billion.

Residential property has outperformed most other asset classes over the last 20 years and continues to offer the well-informed investor opportunities for significant returns. In this blog I want to investigate why real estate should be part of any investors portfolio.

But before we look at utilising property as a means of portfolio diversification I think we should first investigate a couple of aspects of investing in general so we can gain a greater understanding of the terms used by asset managers.

The first is asset allocation:

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and the length of time of the investment (known as the investment horizon). Asset allocation will vary from person to person and is a complex question and there is no simple formula that can find the right asset allocation for every individual. But it needs to be covered and is a critical aspect of building any investment portfolio.

The next thing to investigate is diversification itself.

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so the positive performance of some investments neutralizes the negative performance of others.

I strongly believe in spreading risk, a non-diversified portfolio will expose individuals to unnecessary non-systematic risk which is easily mitigated by simple portfolio diversification. But to do this the investor needs to focus not only on the individual asset’s risk/return characteristics but also importantly on how that asset interacts with other portfolio positions. I think any serious investor should look at risk verses return in a holistic way. It is not enough to look at the characteristics of a potential investment on its own but instead one must be aware on how an investment impacts the risk return profile of the overall portfolio.

So, let’s now look at the benefits of diversifying using property.

Real estate fits well as part of a diversified portfolio because it has a number of qualities that can enhance the return of a portfolio, or reduce risk at the same level of return the main qualities are:

  • Property returns have relatively low correlations with other asset classes (traditional investment vehicles such as stocks and bonds), which adds to the diversification of your portfolio.
  • Yield enhancement; as part of a portfolio, real estate allows you to achieve higher returns for a given level of portfolio risk. Similarly, by adding real estate to a portfolio you could maintain your portfolio returns while decreasing risk.
  • Inflation hedge; real estate returns are directly linked to the rents that are received from tenants. Some leases contain provisions for rent increases to be indexed to inflation. In other cases, rental rates are increased whenever a lease term expires and the tenant is renewed. Either way, rental income does tend to increase faster in inflationary environments, allowing an investor to maintain its real returns.
  • Ability to be able to enhance performance. Property is a tangible asset hence; an investor can do things to a property to increase its value or improve its performance. Examples of such activities include: adding value by developing and improving the asset, re-tenanting the property with higher quality tenants and reducing void times through proactive management. The result is an investor has a greater degree of control over the performance of a real estate investment than other types of investments.
  • Stable income generation; the income generated through rent can be both passive or active depending on the investor but most people investing in property expect to generate a passive income by using a property management company to look after the day to day running of the asset.

Property is now recognised as an important component in a person’s overall wealth and the effect and contribution of property as an asset class in its own right to the overall portfolio is being recognised.

So, in summary the primary benefits of residential property are: attractive risk adjusted total returns, stable residual income, hedge against inflation and diversification resulting in risk reduction against volatility.

Property offers canny investors fantastic rewards but as with any investment there is risk. The route to investing into the residential property market has become increasingly more complex with ever increasing levels of regulation, changes to taxation, legal framework changes. This has led to rising costs and increasing levels of risk. The result is that there is now a significant need for investors to seek out professional asset management companies that fully understand these complexities and who can put strategies in place to mitigate risk and work towards purchasing a solid investment that offers the best potential for yield and strong returns.

The opportunity for individuals to make mistakes, and in the worst cases bad investments that might end up with someone losing money are greater than ever before. I am continually surprised by the number of individuals who see no benefit in seeking the best advice possible and in fact only see the negatives and make decisions based on initial cost rather than long term gain.

The secret to coming out on top is to focus on approaching the process of property investing in a new way – a holistic way. Investors need to learn that a more rigorous approach to each property purchase is necessary if they want to reap the large rewards that property can offer.

As a forward-thinking asset management company and experts in the field of residential property investment we at Glenham embrace this view and through our network of trusted partners offer a 360° approach to investing in property. This means we work closely with our clients to build a planned and calculated investment strategy which is focused on maximising their returns and mitigating risk.

Please do get in contact to have an informal chat about the Scottish market and the opportunities therein.

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