In this rather lengthy post, the following topics will be discussed:
- In what economical environments are real estate biased to perform well (economic growth and inflation)?
- Five ways of investing in real estate, regardless how much money you have
- How to adjust your balanced portfolio when including real estate – a template for adjusting portfolios regardless of new asset class
- A list of resources with some of the best books on real estate investing
Hi, I am so glad to have you back for another deep dive post – a kind of article besides my monthly updates, where I go in depth on a specific topic relating to investing or the asset classes in a portfolio. This time, I have been looking into real estate investing and how it fits in an All Seasons Portfolio or a risk-balanced portfolio. I hope you are in a comfortable place, because this post turned out a bit longer than I had first anticipated, but as I am very happy with the content and what different aspects I managed to cover. Enjoy, and let me know what you think in the comments!
There are numerous opportunities and strategies for making money by investing. The ultimate goal is always to achieve a combination of positive cash flow and value appreciation of your owned asset. It is just a matter of preferred strategy for the investor which dictates how you can grow your wealth.
With the All Seasons Portfolio strategy, you can achieve profits but with less volatility than on the stock market. This is achieved by having a balanced portfolio that is diversified between asset classes. Typically, those asset classes are stocks, long-term government bonds, inflation-linked bonds, gold and commodities, with the following allocation between them:
There are of course many more asset classes available than the five listed above. One extremely important such asset class is real estate, which is a popular investment object among investors. It is so attractive, because it offers profits in two ways: value appreciation of the property, as well as monthly cash flow from rental income.
In this deep dive article, we will be looking more closely at real estate investing – how you can get exposure to it and with how much capital – and how it fits into an All Seasons Portfolio. Let us first begin with the latter of these two topics by answering the question of what economic biases real estate have.
Where does Real Estate investing fit in a balanced All Seasons Portfolio?
As a quick recap on the All Seasons Portfolio strategy, it is a strategy built up by four sub-portfolios, each inclined to perform well in one certain economic environment. The four such environments are higher/lower than expected economic growth, and higher/lower than expected inflation. The total portfolio is then a risk adjusted combination of all such four sub-portfolios. You can read more about this in my first blog post named “Getting started with the all Seasons Portfolio“. What assets do well in each environment, or “season”, are set out by the below matrix.
Based on each asset class’ volatility (risk), your total portfolio will end looking similar to the one presented in the pie chart further above in this post.
But what if you want to add a new asset class, such as real estate, into this mix? What you will have to do first is to analyse where in the matrix real estate belongs, i.e. in what environments such investments perform well, and, on the contrary, not so well.
After that, you will have to decide on how much of your total portfolio you will have allocated in real estate investments and what to decrease. Only when you have found answers to these questions, it is time to decide on what type of real estate investments you will be making. This will all be covered in this post.
Let us begin with seeing where real estate belongs in the matrix and it what environments such investments thrive.
Real Estate and Economic Growth
Real estate is an asset that typically does very well in seasons of higher than expected economic growth. The main reason behind this is that when the economy is growing, people are accumulating more funds, and companies are expanding or more companies are being created. Thus, when growth is high, there are good opportunities to have your property rented.
At least for properties in attractive areas (the famous real estate mantra “location, location, locations”), in environments of high economic growth, there is little risk for vacancies. If a tenant decides to terminate the lease agreement, it should be fairly easy to find a new tenant when times are good. When demand for renting is high, there are also better possibilities to increase rent and thus your cash flow and profits.
When economic growth is high, you will not only be able to increase your cash flow, but also your balance sheet. The value of your property is likely to rise as well when demand for buying properties increases and more investors seek to invest on the property market to get access to the cash flow. Thus prices on property will rise in general, and that will also increase the value of your property.
If economic growth turns lower than expected, this is likely to have a negative impact of your investment in real estate. In a weaker economy, the demand for renting will decrease, which will deter new investments in properties. When it is harder to find tenants, it is more likely that rents will decrease, and when investors are turning away from the real estate market, the value of your property will go down as well.
Thus, real estate’s place in the Economic Growth part of the matrix is in the “Rising” box together with stocks and commodities.
Real Estate and Inflation
If it was easy to determine whether real estate investments a growth asset or not, it is not possible to provide a general rule for how your investment property will do as a result of changes in inflation. Whether investing in property is a protection against inflation depends on your leverage ratio, how the property is financed, and the terms of the lease agreement.
In principal, property is a real asset, and therefore, most investors believe that it is an inflation hedge.This is especially true when considering that a) land is scarce, b) it is difficult to develop new real estate in prime locations, and c) the lead time to have construction of a property completed is quite long.
It is easy to reach the conclusion that if price levels in the economy goes up, it would automatically be beneficial for the owners of real estate. This is however only first-level thinking.
Most real estate is acquired using leverage. It is extremely rare that when you purchase real estate, that you do so with 100% equity. It is more likely, that you do so with 50%-75% debt financing. For that debt, you will pay interest to the bank or lender.
Falling inflation will cause lower interest rates as central banks try to increase inflation by stimulating investing. This will make real estate investing more affordable when the cost of your debt decreases. The ultra-low rates for the past decade has been the main driver for the real estate rally we have been witnessing, as debt is extremely cheap. Conversely, rising inflation usually corresponds with higher interest rates by central banks, making real estate less affordable, depreciating the value of your property.
As prices in general increase with higher inflation, you as a real estate investor may not be able to follow that increase right away. The bias of real estate to changes in inflation is largely dependent on the terms in the agreement made between the tenant and the owner. The leases may be long-term or short-term. The rent levels are usually fixed for longer periods (for example for a period of 1 year), which means that there will be significant lag between when inflation begins increasing and when the rent levels can catch up with the higher price levels. Shorter-term leases on the other hand provide no protection against lower inflation nor deflation.
In other words, there are several variables that impact the sensitivity of real estate to shifts in inflation. The net results are therefore mixed, why real estate is neither a rising inflation nor falling inflation asset class.
Only with a property financed with very low leverage and with flexible leasing agreements, can real estate be considered a an asset that does well in times of higher inflation. This is only true as long as you are not seeking to sell the property in such environment, as a potential buyer may not be able or willing to finance the purchase with low leverage.
This inflation concept for real estate investing is explained in further detail, along with the principles for balanced investing, in the recommended book Balanced Asset Allocation (from page 122) by Alex Shahidi.
The best inflationary environment for real estate is thus with stable low inflation with ultra-low interest rates, which is the environment we have been experiencing in both Europe and the United States for the past decade.
The asset class matrix above, can thus be completed with real estate as per the below:
How can you invest in Real Estate?
Despite the mixed exposure to inflation, real estate remains an attractive investment. It is a good investment for preserving value over longer terms and for achieving reoccurring cash flow (which is particularly interesting for the investor seeking financial independence).
While real estate is a growth asset, like stocks and commodities, it is an asset class that is much less volatile in price. This is due to real estate being a rather illiquid asset, where there are few potential buyers for each transaction, and each deal takes long time to settle.
Moreover, depending on how much capital you have at hand, it may be difficult to diversify your real estate investments properly with certain types of property investing. For example, if your total portfolio is worth €200,000 and you buy a rental property with €100,000 of your money, half your portfolio will be allocated to only one asset class (and only one property at that). This significantly increases your risk profile, and your net worth becomes dependent on what happens to that one property. A sudden water damage may thus have huge impact on your unbalanced portfolio.
Depending on your financial situation, there are always possibilities to get access to the property market, regardless how much you can afford to allocate to this asset class. We are here looking at five types of real estate investing that:
- Rental properties,
- Real Estate Investment Trusts (REITs),
- Real Estate Company Stocks,
- Real Estate Crowdfunding, and
- P2P Property Lending.
Regardless how much or how little you can invest in real estate to maintain a balanced portfolio, you can easily add real estate to your portfolio with any or multiple of these investment types. The most important thing is that your investments remain well diversified.
Let us proceed with looking at each of the five ways to get exposure to the real estate market.
1. Rental Property
One common hands-on approach to real estate investing is to buy and let a rental property. This is easily achieved by buying a second house and finding suitable tenant (it may be easier to find a decent property than a decent tenant though).
The positive side of buying a rental property is that you will have much control over the investment and be able to achieve a steady monthly income. During a climate of strong economic growth where demand for renting is high, this is a particularly good investment.
There are some negative aspects as well to overcome and be comfortable with before you buy your first rental property. There is much hands-on work involved and you as a landlord have obligations to maintain the property in decent shape. You also take on the risk of housing an unreliable tenant who may not have the same sense of care for the property as you do, which may impact your maintenance costs.
Moreover, rental properties require a high amount of capital, meaning that it is challenging to ensure that the property only makes up a small part (e.g. 5%) of your total portfolio value. This also has a direct impact on diversification, as much of your capital may end up being locked up in one rather illiquid property.
If you are looking to start a career as a real estate mogul, these are the three key aspects your property must tick off.
- Property in a growth location (area likely to grow in the future, with demand for living)
- Profitable budget, including planned maintenance costs
- Reliable tenants, both in terms of payments and care of property
If you do your homework properly and are comfortable with the extra time it takes to see after your own rental property, it may very well be a great investment.
if you do not want the hands-on work or do not have the capital required for a rental property, there are still many ways you could get access to real estate investing. Next, we will be covering to types of such investing that you can reach through the stock market. We will begin with Real Estate Investment Trusts, or “REITs” for short.
In short, a REIT is a company that owns, operates, and finances income generating real estate. They are similar to mutual funds where the REITs pool capital from numerous investors and use that to buy commercial property. REITs generate a steady income in the form of dividends derived from rental income, but less through value appreciation of your held unit.
Thus, you as an investor, when you invest in REITs, buy a share of an existing real estate portfolio.
Most REITs are traded on a stock exchange, which makes it a much more liquid asset compared to a rental property. You also need much less capital to get hold of units. As each REIT owns several properties, you moreover get instant diversification between properties (even though properties within one REIT could be in the same area or with the same focus such as offices, hotels, or care homes, etc.).
It is relevant to know that the REIT is an United States construction, and there are a set of rules and requirements for a company to be classified as a REIT. For example, at least 90% of the REITs taxable income must be distributed to its shareholders each year as dividends. This is what differentiates a REIT from just a normal real estate company. In the U.S. there are tax benefits for the REITs, why it is a common setup for investing in a pool of properties.
Because REITs are an American invention, a majority of REITs are located in the United States and investing on the American property market. This is not necessarily an issue, but you should have a clear view of what you are investing in when you buy shares in a REIT. You can find a directory of American REITs here (link to reit.com) for inspiration.
Lately, several European REITs have been set up, which helps you also get access to the European real estate market through a similar entity. REITs as such are not a concept in Europe or have any tax privileges, but are constructed as American REITs because that is a form that investors are familiar with, which is used as a tactic to attract investors.
Here you can find a list of 72 REITs traded in the UK, Germany and France. The lists does, however, not include REITs from countries like Italy, Spain or Sweden, why further research may be needed for the interested.
3. Real Estate Company Stocks
While a REIT is a special regulated entity type in the United States, there are of course other publicly traded companies that invests in real estate and that are not REITs. The main difference is that REITs in the United States benefit from other tax rules making the REIT a preferable structure for collectively owner property portfolios.
As special REIT legislation does not exist in Europe, it is hard to distinguish between what is a European REIT and what is just a publicly traded real estate company. For example, from the list over European REITs above, the biggest entity listed is Vonovia SE, which is not a REIT, but a real estate company.
The main difference between a REIT and a real estate company is that the latter does not have to comply with the same set of requirements to fit in a REIT category. For example, real estate companies do not have a requirement to distribute a minimum of 90% of its annual income, but has more freedom to reinvest that money into growing or improving its real estate portfolio.
When you look at companies to invest in, especially in Europe, you should thus consider if you are in fact investing in a real estate company, or an entity that seeks to mimic an American REIT structure. Neither is necessarily better or worse than the other, just different types of companies that give you good and diversified exposure to the real estate market.
The benefit of investing in listed real estate company stocks is that you get access to a diversified portfolio of properties and that your holding is very liquid. The real estate portfolio is moreover managed by a professional. On the other hand, you will have no control over the owned properties in terms of location or type, and will be exposed to stock market risk.
4. Real Estate Crowdfunding (Equity)
What if you want the benefits from a rental property, but want to commit less capital per property and be able to diversify more? This has become possible in later years with real estate crowdfunding platforms offering exactly that on the European market.
Crowdfunding as such has grown massively and gained a better reputation over the past 5 years. As of 2018, the global crowdfunding space had a volume of USD 305 billion. In 2017 (latest numbers now available) Real Estate Crowdfunding in Europe alone had a surprisingly great transaction volume of €258 million, and Property lending (discussed further below) amounted to €66 million. And the growth rate of crowdfunding is trending steeply upwards as it has matured as a financing opportunity.
As a footnote regarding my personal qualifications for crowdfunding, I have written both a my bachelor’s and master’s degrees about the legal aspects on investment-based crowdfunding, as well as the first book on the subject in Sweden in 2016. This is therefore my turf, so to speak. It is a brilliant way of democratizing investments and giving retail investors access to deals previously only available to those of high net worth.
Through crowdfunding, you can own just a part of a rental property and attaining attractive yield on your investment. Your investment in that property is then pooled with several money from other investors on the platform, and your share of the earnings equals your share of the ownership of the property.
Usually, the platform either manages the property itself, or makes sure that a professional property management firm looks out for the property. For this service, the property manager takes a cut of the profits, which is an identical setup as if you would hire a manager for a fully owned rental property.
The benefit with real estate crowdfunding is therefore that you can get the perks of a rental property but with a) much less capital invested in the property (allowing you to diversify more) and b) much less hands-on work as a professional property manager ensures the function and service of the property.
The drawbacks are however that this type of investment is rather illiquid and it may be hard to sell your share of the property, even though most such crowdfunding platforms offer a secondary market function. Moreover, you will not be able to actively go and look for your dream rental property, but must stick to the opportunities vetted and offered on the platform. The supply of properties may therefore be limited, but this may not be a deal-breaker.
Here below, I am listing a few European RE Crowdfunding platforms where you can start your career as a property investor. They all have different niches and setups, so make sure to do your homework and get comfortable with the opportunities before committing your money.
- Bulkestate (Rental properties and loans primarily in the Baltic region)
- Brickstarter (Invest in primarily vacation homes in southern Europe; short term leases decrease tenant risk)
- BitOfProperty (Rental properties primarily in the Baltic region)
- Evoestate (Rental properties and loans from all over Europe; a one-stop-shop portal platform for multiple European Real Estate Crowdfunding platforms)
Make sure to register on these sites to discover the real estate investing opportunities they offer.
5. P2P Property Lending (Debt)
A rather similar solution to real estate crowdfunding is P2P property lending. This is a bit more detached way of property investing, as instead of owning the underlying property, you are lending money to the property developer. Interest rates are generally quite attractive at 8-14% annually, which should compensate for the risk of investing in small firms.
Structurally, lending is more secure than owning shares, as lenders always have better priority to the company’s assets in bankruptcy proceedings. This means that lenders must be paid in full first, before the shareholder can get any invested money returned.
Through P2P property lending, you can take advantage of the economic growth bias of the real estate market, but have no inflation protection (you should discount for expected future inflation in the interest when investing). Loans fundamentally react to inflation in the same way as bonds.
Make sure to diversify loans on several projects and borrowers, and to analyse both the deal and the borrower before investing. You should also always invest in secured loans only, i.e. where the financed property is pledged in favour of the lenders. This means that if the borrower defaults on the loans, the lenders may take over the property and sell it in order to get repaid.
With P2P property lending, you will have a certain counterparty risk against the property developer. Most commonly, the property developers financing through P2P Lending are smaller companies, which have smaller financial muscles than for example a publicly listed company. However, for secured loans, it is rare that all the invested money is lost, but in a hard recession, it may be difficult to sell a pledged property if the borrower defaults.
The benefits of loans are similar to the ones of real estate crowdfunding, but with some additions. Firstly, the illiquidity issue is partially solved, as your invested funds will be repaid at the end of the term (but with shares, you are invested until you find a buyer). Secondly, as mentioned, you as a lender are ranking higher up in the priority list over the assets in the case of a bankruptcy or default. The entry barriers are also low, as you need little capital to get started, in general only €50.
As with real estate crowdfunding, I have compiled a short list of well-renowned European platforms offering P2P property lending services where you can begin your research. Make sure to register as a first step, to get a full view of the platforms.
- Property Partner (One of the leading P2P Property Lending sites in the UK (which also is the biggest market in Europe))
- Bulkestate (Rental properties and loans primarily in the Baltic region)
- Evoestate (Rental properties and loans from all over Europe, including Italy, Germany, Spain, and Austria; a one-stop-shop portal platform for multiple European Real Estate Crowdfunding platforms)
- Estateguru (Property lending primarily targeting the Baltic countries and Finland)
- Rendity (Property lending site with access to German and Austrian real estate projects)
- Crowdestor (Business Lending site with global borrowers. Note that not all cases are property related)
- Lendsecured (Property lending opportunities which primarily originates from the Baltic countries)
It is time well spent to go through each platform in this list to begin to discover P2P property lending as a way to getting exposure to the European real estate market, with little capital allocation.
How to adjust your portfolio splits when adding real estate to your portfolio
Now you have been provided with some great examples of ways to get exposure to real estate in your investment portfolio. Now is a good time for you to properly go through each of these opportunities in depth and see if real estate investing is something for you.
The next step is then to find a place in your portfolio where real estate fits. As you recall from the beginning of this article, the typical All Seasons Portfolio is divided by stocks, long-term government bonds, inflation-linked bonds, gold, and commodities.
You should thus decide, a) how much of your portfolio to allocate to real estate, and as a logical next step, b) what other assets classes to decrease?
In my simple example here, I have decided that I want to allocate 5% of my wealth into real estate. I would suggest that you refrain from letting that number take up too big of a portion of your balanced portfolio. In that case, you should also invest in real estate in a way that suits your wallet, for example on the stock market, or by crowdfunding / P2P property lending.
Remember the pie chart from earlier with the portfolio splits? This will of course need to be adjusted to now fit in our 5% of real estate. But how should we adjust it?
The first thing to consider is to determine what biases real estate has. Based on the discussion of what seasons real estate are biased to perform well in, we must make sure to keep our sub-portfolios balanced (cf. the seasons matrix) to ensure risk parity. As a reminder, we concluded that real estate does well in an environment of increasing economic growth, but has no inflation bias. Therefore, to adjust our holdings, we must primarily decrease other assets that do well in an environment of economic growth (with neutral impact on inflation).
As a result of this, we will add real estate into our portfolio, and at the same time decrease stocks and commodities (remember the seasons matrix). This suits us quite well also on the inflation side, as these assets are on the opposite sides of the inflation bias matrix, meaning that we will easily achieve the mixed bias of real estate in our portfolio.
But how should we allocate that 5% increase between stocks and commodities? Here I have considered the relative volatility between stocks and commodities. In simple terms, commodities are 4x as volatile as stocks. This is evident also on the splits in the balanced All Seasons Portfolio, as we have four times as much money allocated to stocks than commodities. Therefore, to keep the portfolio balanced, we will decrease the stock component with 4 times as much than the commodities component.
This adjustment leaves us with a portfolio comprising of 26% stocks (4%-points less than the original 30%), 6.5% commodities (1%-point less than 7.5%), and 5% real estate. All other asset classes remain unchanged. See the updated pie chart below to the right for reference.
Remember that this is only a simplified example of allocation and reasoning. Make sure to make a proper assessment on your own before investing.
Real Estate is an attractive asset class from which you can profit in two main ways: appreciation of the value of the property and by monthly rental cash flow. It is an asset class which is biased to perform well in environments of high growth and low interest rates. As for inflation, there is no clear answer and very much depends on how the property is financed and by the rental agreement.
There are five main ways for retail investors to get access to the real estate market. These are by investing in a Rental property, REITs, stocks in publicly traded real estate companies, Real Estate Crowdfunding (investment through owning together with other investors; property is managed by a professional third-party), and P2P Property Lending (investment through lending to property developers). For well-renowned crowdfunding/P2P lending providers, see the lists further up.
When including real estate in your portfolio, you must decide on a) how much of your capital shall be allocated to real estate (5% in our example), and b) how to adjust other assets in your portfolio. You should decrease other assets performing well in a growing economy to compensate for the real estate exposure, i.e. stocks and commodities.
The property market is a very attractive and well-used investment space. As an investor, there are no real reasons not to stay outside this asset class, as long as it fits your strategy and investment philosophy.
Resources and further reading
I hope that you have found this article useful. It has been my intention to give you a fundamental understanding of how to think when introducing additional asset classes to your balanced portfolio. I find that real estate is also deemed an attractive asset class that no investors should neglect. It is thus important to understand how this asset class behaves in different environments, so that you do not unwillingly and unknowingly throw off the balance in your portfolio.
If you look for further reading on balanced portfolio investing, and investing in real estate, I have compiled a short list of great books to get started with. I have tried to cover all types of real estate investments that were covered in this article, so that you can learn more on the investment type that best suits you. I recommend that you start by picking up a few of them to better understand real estate as an asset class.
- Balanced Asset Allocation by Alex Shahidi – The best book I have read about diversified investments between asset classes, which also covers real estate and other types of assets.
- Rich Dad Poor Dad by Robert Kiyosaki – The go-to-book for readers looking for advice on personal finances and with basic thinking of cash flow and property investing.
- The Book on Rental Property Investing by Brandon Turner – A detailed and practical book on how to start making money with rental properties
- The Intelligent REIT Investor by Stephanie Krewson-Kelly and Brad Thomas – The best guide and resource available for REIT investing
- Mastering the Art of Commercial Real Estate Investing by Doug Marshall – A book with a somewhat different perspective than “The Book on Rental Property Investing”, as it covers other aspects on property management and cash flow. Well worth the read.
- Peer-to-Peer Lending and Equity Crowdfunding by Kim Wales – One of the better books ever written that explains investment-based crowdfunding (P2P Lending and Equity Crowdfunding). I recommend this for anyone interested in alternative finance.
Are you already investing in real estate, or do you plan to do so in the future? Do you think it fits into your balanced portfolio? Let me hear your thoughts on this in the comment section below. I make sure to answer all comments.
Thank you very much for your attention,