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Diversifying Your Investment Portfolio With Real Estate

Having a steady stream of passive income to maintain a certain lifestyle after retirement is probably on most, if not everyone’s mind.

Historically, the four main asset classes have been equities (stocks), fixed income (bonds), cash equivalent or money market instruments, and real estate. Modern times, most investment professionals also include commodities, futures, other financial derivatives and even cryptocurrencies to the asset class mix. Each asset class reflects a different risk and return investment characteristics and perform differently in any given market environment. Different asset classes have different cash flows streams and varying degrees of risk.

Investment advisors will advise investing in several different asset classes to ensure a certain amount of diversity. And diversification reduces risk and increases the investor’s probability of making a return.

In a country with high home ownership ratio like Singapore, real estate probably forms the largest part of a Singaporean investor’s portfolio. And real estate fits really well because it has several qualities that can enhance the return of a larger portfolio, or reduce portfolio risk at the same rate of return.

Why We Should Diversify Investment Portfolio With Real Estate ?

Some benefits of adding real estate in your portfolio are:

  1. Diversification benefit – Real estate returns have relatively low correlations with other asset classes (traditional investment vehicles such as stocks and bonds).
  2. 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, real estate income tends to increase faster in inflationary environments, allowing an investor to maintain its real returns.
  3. Ability to influence performance - An investor can do things to a piece of property to increase its value or improve its performance. Examples of such activities include replacing a leaky roof and improving the exterior to lease the property to higher quality tenants. An investor has a greater degree of control over the performance of a real estate investment than other types of investments.

Some considerations include:

  • Real estate can be costly to buy, sell and operate - Transaction costs are significant when compared to other investment classes. Real estate can also be costly to operate because it requires ongoing maintenance to extract the best value.
  • Real estate requires management - Real estate requires ongoing management to deal with the day-to-day operation of the property. Management comes at a cost; even if it is handled by the owner, it will require time and resources.
  • Real Estate can be difficult to acquire - It can be a challenge to build a meaningful, diversified real estate portfolio. Purchases need to be made in a variety of geographical locations and across asset classes, which may be out of reach for many investors.
  • Real estate market is cyclical - Not unlike other asset classes, real estate is cyclical. Real estate has two cycles: the leasing market cycle and the investment market cycle.

Real Estate Capital Appreciation Vs. Rental Yield Return 

The leasing market consists of the market for space in real estate properties, and the conditions of the leasing market are dictated by the supply side, which is the amount of space available (or vacancies), and the demand side, which is the amount of space required by tenants.

If demand for space increases, then vacancies will decrease, and the resulting scarcity of space will cause an increase in market rents. The real estate investment market moves in a different cycle than the leasing market.

On the demand side of the investment market are investors who have the capital to invest in real estate. The supply side consists of properties that are brought to the market by its owners. If the supply of capital seeking real estate investments is plentiful, then property prices increase. As prices increase, additional properties are brought to market to meet demand.

Although the leasing and investment market have independent cycles, one does tend to influence the other. For instance, if the leasing market is in decline, the decreasing rental growth may lead real estate investors to view real estate prices as being too high and hence may stop making additional purchases. If capital seeking real estate decreases, then prices decrease to derive equilibrium.

All being said, investing in properties is in the blood of every Singaporean investor. If managed well, investing in real estate can be an effective way of financial planning. Rents provide passive income and capital appreciation offers a bumper return upon exit. It is thus prudent to add real estate into one’s portfolio. It will also be prudent to remember real estate is a lumpy asset with a high cost of entry, is relatively illiquid, and can be expensive to transact. The duo benefits of its ability to generate passive income and appreciate capital over time may be a boon to many investors, it is not an asset class for an investor with liquid needs.