Private real estate may be used as a hedge against the stock market due to its low correlation with stocks and bonds and its lagged rise and decline relative to the economy. Not only do well-selected properties tend to keep pace with inflation and maintain their value, but they also provide investors huge perks, such as large yields and tax benefits.
However, adding private real estate to a portfolio raises a crucial question: how much should be owned?
Yale University’s endowment, regarded as a worldwide gold standard for its extraordinary performance, has expanded from $5.8 billion to $27.2 billion during the last two decades, with the support of significant investments in private real estate, yielding a return of 12.1%. Lazard Asset Management says that the Yale endowment devoted 20 percent of its portfolio to real estate in 2013, compared to 10 percent during the fiscal year ended in June 2017.
A recent Tiger 21 poll quoted by Bloomberg found that 33% of the portfolios of high-net-worth individuals with $51 billion in assets consisted of private real estate investments. And a report from Urdang Securities Management quotes research by Stephen Lee of the Cass Business School in London that concluded: “Ideally, investors would allocate 26% of their portfolios to private real estate, but actual allocations are substantially lower owing to perceived risks and illiquidity.
When investing in private real estate, investors must remember that it is illiquid, meaning it may take several months to access their funds. Therefore, real estate is not a suitable investment for people who want funds immediately for living costs or college tuition. The optimal allocation relies on each individual investor’s condition, which is a function of their net worth and time horizon.
For instance, a $300 million family office may be happy investing more than 50 percent of its investable capital in illiquid assets, but an accredited investor with $1 million in investable capital may not be comfortable investing any money in illiquid assets. On the other hand, an investor may be OK with a substantial illiquid holding in their pension plan but not in their private savings account, which they may need to access quickly. Illiquidity is something that must be effectively controlled.
The issue is how much cash should be set aside in an emergency.
As long as an investor has sufficient money for emergencies, the illiquidity that comes with private real estate investment isn’t always a negative thing. One of the most frequent poor investment choices is triggered by panic when the market declines. The agony of a stock market fall is so severe that investors abandon the market at its lowest point, which is precisely when they should remain invested.
This argument is supported by evidence. Gary Belsky and Thomas Gilovich, co-authors of “Why Smart People Make Big Money Mistakes and How to Correct Them,” noted in their book “Why Smart People Make Big Money Mistakes, and How to Correct Them” that “by withdrawing your funds during short-term stock market declines, you risk missing the productive days.” Moreover, these fertile days add up. If you had passed over the 90 best-performing days of the stock market between 1963 and 2004, your average annual return would have reduced from around 11% to slightly over 3%.
This turns out to be a substantial sum of money. According to the estimates of the co-authors, “for a $1,000 investment, these varying rates of return result in a difference of $74,000 and $3,200 over four decades” It reminds us of another advantage of real estate investment: illiquidity might prevent panic-driven knee-jerk judgments.
The matrix below provides guidance for a future real estate investment allocation based on net worth and time horizon. Investing in fusing stocks, bonds, and private real estate may provide a greater risk-adjusted return and reduce volatility. However, each investor must choose how much to dedicate to longer-term private real estate depending on their short- and long-term objectives and requirements.
| Time Horizon | Net Worth | ||||
| $1 – $5M | $5 – $10M | $10 – $25M | $25M+ | ||
| Under 5 Years | 5% | 10% | 15% | 20% | |
| 5 – 10 Years | 10% | 15% | 20% | 25% | |
| 10 – 20 Years | 15% | 20% | 25% | 30% | |
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