from
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How to Enhance Portfolio Diversification Using Real Estate

All investment portfolios – even the strongest – are likely to hold
investments that will experience some periods of loss. However, by
diversifying your portfolio holdings, you can mitigate those losses,
which can boost your portfolio’s return potential. But not all
diversification strategies are created equal, which makes choosing the
right diversification strategy crucial to your investment success.

Most investors understand the risk that comes with investing in a single
stock, asset type, or industry. But what about the risk that comes with
investing in only one market? Many investors are diversified across and
within asset classes, sectors, industries, and more – but, usually all
within the stock market, which is a public market. With the public
market shrinking, and ownership of stocks becoming more consolidated,
investments traded in the stock market are becoming increasingly
correlated. With this, meaningful diversification is getting
increasingly difficult to achieve in the public market alone.

Wider accessibility to private market investments offers individual
investors new options outside of the stock market. Private market real
estate, in particular, is far more accessible now than it has ever been.
Easy accessibility, together with the benefits of low correlation with
the stock market, a history of long-term appreciation, and the potential
for regular income, can make real estate a powerful diversifier for your
portfolio.

Jump to
What Make an Investment Portfolio Diversified?
The 20% Rule
How Real Estate Can Enhance Portfolio Diversification
How to Diversify into Private Market Real Estate
Evaluating Your Options
What Make an Investment Portfolio Diversified?

Diversification is used to reduce the risk of loss, which ultimately can
improve the stability and return potential of an investment portfolio.
When risk is reduced properly though diversification, its volatility is
reduced. With lower volatility, an investment portfolio is more stable,
and its return earning potential more predictable. Rather than being
forced to ride the waves of market cycles, investors are able to enjoy
the peace of mind that comes with having their investments live on
quieter waters.

So, what does a diversified portfolio look like?

There are many diversification strategies to choose from, but strong
ones generally try to maximize a portfolio’s risk-adjusted returns. In
other words, you should try to invest in assets that offer the highest
possible return at your given risk level. By investing in assets with
low or no correlation, you can reduce unnecessary risk in your portfolio.

When investments are correlated, they share some or all of the same set
of risks. So, if one investment experiences a loss, then a correlated
investment is also at risk of loss. On the other hand, if your portfolio
holdings are spread across uncorrelated assets, the performance of one
or more investment could mitigate losses in your portfolio when another
asset underperforms. This is because uncorrelated assets are far less
likely to lose value in tandem than correlated investments.

The 20% Rule
The 20% rule is a leading diversification strategy, which was created by
the Chief Investment Officer of the Yale Endowment, David Swensen. The
20% rule aims to reduce portfolio risk and in turn maximize return
potential by allocating at least 20% of an investment portfolio toward
alternatives – an asset class with low or no correlation with
traditional, publicly-traded assets. Alternative investments are
investments that fall outside of the classification of traditional
investments, and are generally traded in the private market. Following
the 20% rule, private market investments are becoming increasingly
crucial to investment success. Institutional investors have a longer
history of diversifying into alternative with pensions and endowments
allocating 28% and 52% of their portfolios respectively to alternatives.

investment-portfolio diversification-20-percent-rule

How Real Estate Can Enhance Portfolio Diversification
The private market experiences very different buying and selling
dynamics than the public market. Let’s look at the attributes of private
market real estate and how this asset class can be a powerful
complementary diversifier for a portfolio of traditional investments.

Separate Markets with Low Correlation
The biggest difference between private market real estate and
traditional investments is that they trade in different markets.
Traditional investments, such as stocks, bonds, and commodities, trade
in the stock market, whereas private market real estate trades in, as
you may guess, the private market. Public market investments each have
their own individual sets of advantages and disadvantages, but because
they’re traded in the same market, they share the same marketwide
strengths and weaknesses. And, because private market investments are
traded in a separate market subject to different driving forces and
structural features, they don’t share the same wide risks as public
investments. Therefore, private market real estate has a low correlation
with traditional investments at the market level.

For instance, expectations of future interest rate hikes (or actual
hikes) typically cause the stock market to decline, because higher
interest rates can reduce both business and consumer spending.
Similarly, expected or actual rate hikes can have a depressing effect on
publicly traded real estate investment trust (REIT) share valuations,
because higher interest rates reduce the risk-free to capitalization
rate spread thereby driving down real estate values.

By contrast, expected or actual shifts in the interest rate environment
should have minimal impact on an investor’s equity stake in a commercial
real estate asset as long as the senior debt financing secured for that
investment is a long-term loan with a fixed-rate. In fact, an interest
rate hike could make the asset more valuable, because it now offers an
interest rate hedge, and stands to benefit from the likely positive
macroeconomic market conditions that typically precede federal interest
rate hikes.

Distinctive Investment Structures by Market
Coupled with low correlation at the market level, the performance of
private market real estate has a low correlation with the performance of
public market investments at the asset class level. Although real estate
is traded in the public market through REITs, private market real estate
investments are structured in a wholly different manner. REITs
themselves are structured differently in the private market, whether
private REITs or public non-traded REITs, which gives REITs different
diversification potential based on the market in which they’re traded.

In general, these different structures carry different sets of risks,
fee structures, return structures, and varying return potential.
Therefore the differences in investment structures between public and
private market vehicles further reduce the correlation between private
market real estate and traditional investments.

Differences in Access to Liquidity
One of the biggest benefits of public market investments is the high
level of liquidity that they offer. Shares of stocks and bonds can
easily be bought and sold on a daily basis. Because of this, public
market investments offer a high degree of flexibility.

However, it’s important to note that this access to daily liquidity
comes at a price. The liquidity premium is a built-in cost, which is
innate to public market investments. Investors pay whenever they buy an
investment. For long-term investors who follow the “buy-and-hold”
strategy, this can be an expensive feature that goes largely unused.
Those who are building a portfolio to support their retirement plan are
usually long-term investors, who should likely lean more toward
long-term investments. Avoiding costly features that go mostly unused
while building the most stable and reliable path to retirements saving
possible are key.

Private market real estate, on the other hand, is generally illiquid
with return potential maximized over time through rental income and/or
appreciation. Liquidity options for both public and private investments
each have their advantages and disadvantages, but their differences can
make private market real estate a good fit for long-term investors, as
well as powerful complementary diversifiers for investments with shorter
investment horizons.

Market Efficiency Mean a Lot for Investors
The public market is highly efficient with prices set by the market.
Information concerning public investments is widely disseminated, which
makes it difficult for one party to gain more information than the other
party on an investment. Transaction costs are also low, which results in
more frequent buying and selling. In fact, more than a billion shares
are publicly traded each trading day.

In contrast, the private market is highly inefficient. Buying and
selling private market real estate generally comes with higher
transaction costs, and with fewer buyers and sellers participating.
These differences in buying and selling dynamics in the private market
offer another diversifying element for investors largely invested in the
public market.