"My clients own their own homes. Many of them own vacation houses, too. Doesn't that give them all the real estate they need in their portfolios?"
That's a common question posed by financial advisors about the role of real estate in investment portfolios. After all, even among very wealthy Americans, net equity in their primary residence comes to a significant share—commonly around one-fifth—of total net worth, while the norm for other homeowners is upwards of three-quarters.
Interestingly, I've never fielded the same question from homeowners themselves. That revealing fact hints at the answer: While a house may represent an important component of net worth, that doesn't mean it's part of an investment portfolio.
Consider the financial situation of a client with total net worth of $1 million, composed of home equity ($250,000) and an investment portfolio ($750,000) allocated to domestic large-cap stocks, 60%, and domestic bonds, 40%. The client's questions are: What role should real estate play in a portfolio? And, by changing the asset allocation, can wealth be increased without taking on additional risk?
Houses as Investments
Investors typically want strong returns with moderate risk, of course, and portfolio diversification. They also look for liquidity, scalability (or "right-sizing") and rebalancing. Now consider what clients want from their homes: a location in the city where they want to live, a neighborhood convenient to their work and community resources, and a house of the right size.
The Federal Housing Finance Agency estimates that house prices have appreciated by 3% percent per year, on average, since early 1991. Most of the benefit from owning a house comes from living in it, meaning that you save on rent; the Bureau of Economic Analysis estimates the value of that "imputed rent" as the equivalent of a return averaging nearly 5.6% per year. Historically, owner-occupied housing has made sense for most people—but that's almost entirely because of the value of living in the right home, not because of its price appreciation.
Think about your client's investments: Since Q1'91, the financial portfolio would have generated returns averaging 8.62% per year with volatility of 9.55%. The total "portfolio," including the house, would have returned slightly more, around 8.65% per year, with volatility of only around 7.28%. But the higher returns and lower volatility come mainly from the substantial (and very steady!) value of "imputed rent"— because the clients get to live in their house.
Real Estate as an Asset Class
Real estate is one of the four fundamental asset classes around which every portfolio should be built. Princeton professor Burton Malkiel, author of "A Random Walk Down Wall Street"—wrote that "basically, there are only four types of investment categories that you need to consider: cash, bonds, common stocks and real estate." Mark J.P. Anson, formerly the chief investment officer of the California Public Employees Retirement System, agreed: "Real estate is not an alternative to stocks and bonds—it is a fundamental asset class that should be included within every diversified portfolio."
David Swensen, the chief investment officer for Yale University and author of "Unconventional Success," went further by recommending a "basic formula" with one-fifth of the portfolio invested in real estate (listed real estate investment trusts, or REITs) and the remainder in stocks, bonds and cash. Listed REITs—real estate owned through the stock market—provide investors the combination of strong returns, moderate volatility, and portfolio diversification along with liquidity, scalability, and ease of rebalancing that clients need in their investment portfolios.
Getting back to the client's two questions, the answer to the first is twofold: First, the home shouldn't be considered part of the investment portfolio; second, the real estate asset class—listed REITs—should be part of it.
Since Q1'91, the total return on listed equity REITs has averaged 13.31% per year—much better than large-cap stocks (9.98% according to the S&P 500), small-cap stocks (11.39% per year according to the Russell 2000), international stocks (6.70% per year according to the MSCI EAFE), or owner-occupied housing (including imputed rent, between 6.81% and 10.78% per year, depending on the city).
Plus, REITs provide valuable portfolio diversification. Even though they're traded through the stock market, listed equity REITs have a low correlation with non-REIT stocks: just 0.58 with large-cap stocks, 0.67 with small-cap stocks, and 0.56 with international stocks. In contrast, non-REIT stocks move fairly closely together with correlations of 0.89 (large-cap with small-cap), 0.84 (large-cap with international), and 0.77 (small-cap with international).
Other Correlations
