Real Estate

The reason I've seen is that most homeowners already have a significant holding in real estate. For example, if you have $100,000 in stock/bond/mutual-fund investments and live in a $200,000 house,

2/3 of your "portfolio" already is in real estate. Adding more would simply decrease your diversification.

If you are not a homeowner, then you could increase your real estate- related investment holdings, but it might be better to become a homeowner. This is a lifestyle choice, not an investment decision.

Dave

Because one industry should not dominate your portfolio. This goes for any single industry, not just real estate.

Hi Dave,

Thanks for your response. Owning a home means you have a stake in a single piece of real estate. If you own a real estate mutual fund [for example], you have an ownership stake in hundreds of properties, spread across the country or the world - and across the commercial and residential sectors. So it seems that a fund offers much more diversification than owning a single home. I tend to think of my home as a place to live, rather than an investment.

But I follow your thinking.

-JJ

estatestocks, etc] should account for no more than 5%-10% of one's

Trade that $200,000 house from my previous example for $200,000 in a real estate mutual fund and you have increased your diversification, not across the economy, but within one sector of it. Keep your house and replace a growth stock mutual fund with a real estate fund, and you have decreased your diversification.

Dave

That is true if you paid cash for the $200,000 house. But if you made a downpayment of $20,000 and took a mortgage for $180,000, the comparison with stocks or mutual funds is not quite the same. Your $20,000 downpayment on the house gives you control of an asset that could appreciate and eventually return as much profit as the entire $100,000 in stocks.

Swenson (Yale endowment manager and author of several investment books) recommends 20%+ real estate. There's a few other authors that also recommend higher real estate allocations so it's not a totally crazy idea. To be honest, it doesn't matter that much whether you decide 5% or 20%. Whether 5% or 20% will do better in the future, who knows? The most important thing is once you decide on some percentage, you stick with it and don't flip-flop trying to performance chase.

Or as some people have learned recently, your asset could depreciate and your $20,000 down payment could be lost entirely, or worse.

Dave

I'll have to change the numbers to make my point, but from a portfolio composition point of view, what is the difference between

1. having a 0,000 mutual fund portfolio and a house with a 0,000 loan against it, and
2. having a 0,000 house and a mutual fund portfolio with a 0,000 loan against it?

Either way, you are 50-50 with a large debt.

Dave

Dave,

I agree with that statement.

Peter

Surely, real estate holds a special place in portfolio theory versus most other specific industries - but I understand your point. But that reasoning, why specifically invest in real estate? Isn't it represented in the typical stock mutual fund - just like other sectors?

-JJ

That is true. But everybody knows that, over long periods, stocks on average increase in value despite temporary ups and downs. The same is true of real estate. The main question is: Are your chances of eventual gain or loss with $100,000 in stocks more or less than your chances with $20,000 in real estate? And to make the comparison fair, you have to consider what you do with the other $80,000 that you did not put into real estate.

Yes, that seems like a good comparison. But one point: For a small investor with limited assets it is possible to obtain a $180,000 mortgage to buy a house but not a $180,000 loan against mutual funds.

Maybe not from a bank, but just ask dad! :-)

Dave

It's mainly a matter of diversification. Real estate stocks represent only a small percentage of the available equities, so you should feel well represented at that level investment.

Real estate does represent a high proportion of the equity of American families, and a house probably is all you need for real estate exposure.

Owning rental properties is an attractive way to go if you have a high income and can take advantage of some of the tax benefits. Others who are willing to maintain their own units can also do well in the rental market. I have heard that 8 rental units are needed to make a rental operation start to pay off.

-- Ron

Ron,

I think there's a difference between how much real-estate you "need" versus how much might make sense in your portfolio. For example, a real estate fund generally invests in commercial property. I think owning commercial property around the country or the world can be a significant diversifier above and beyond owning a single home in a single location. In addition, you cannot sell a portion of your home [or buy a little more] to rebalance your portfolio. Thus, your home cannot particpate in the Efficient Frontier.

I can state with certainty that over the past 5 years, having some real estate in my portfolio [20%] has significantly boosted returns and reduced volatility. Going forward - one can never say?

-JJ

I've seen this rule of thumb many times but never seen it attributed to existing home ownership (as it has been in some of the above posts). I have to ask, if home ownership is the reason for the rule, how much should a renter have invested in real estate? Still 5-10%? And how do we vary our plan for a 0% equity home owner as opposed to a

100% equity homeowner. I have never seen that distinction made in regards to asset allocation. With reverse mortgages, post-retirement downsizing, etc, etc.. becoming more popular it seems that residences may begin to play a larger part in portfolio development. Traditionally they have not, nor do I believe this is the primary reason "they" recommed 5-10% (but perhaps it will be some day or should be now).

The essence of the "rule of thumb" is to reduce non-systematic risk through diversification. Diversification relies upon the intermingling of NON-CORRELATED assets, not just having a bunch of funds/stocks. As PeterL said, the rule is not specific to real estate. Its a general rule used for lots of sectors to help assure non-correlation. Its also the reason many of us use index funds and ETFs. By getting broad exposure to the entire market, non-correlation is most efficiently achieved. Focusing a large % of assets in one sector, even if you have a large number of funds, may still result in a high correlation and little diversification. Imagine if an investor had "diversifed" by only buying a bunch of different tech stocks in 2000-2001.

JJ, without knowing specifically what you're looking at it's hard to say, but I'd be wary of any rules of thumb about asset allocation. Some people don't even consider REITs to be a separate asset class, for example, so they might say 0% is appropriate. Others might be relying on historical models over time periods where REITs performed extremely well, and weren't highly correlated with other asset classes, using that as a justification for a high investment in them. Just looking at the numbers you can find periods that would justify allocations higher than

20%...they've outperformed US stocks over quite a few time periods.

One rationale for keeping it small is that it is, as another poster mentioned, a relatively tiny part of the public equities market, based on total market capitalization. It's a small subset of the Russell 2000, really. Commercial real estate may have a lot of value associated with it, but a small percentage of properties are owned by REITs. So I question the capacity of existing US REITs to absorb a 20% allocation by the "typical investor"...that'd be too much money chasing too few stocks. There was some commentary about this after REIT gains earlier this year; some blamed institutional dollars that were tied to investments in the 200-odd public REITs that are members of the major US REIT indices.

I don't know how relevant home ownership is to a REIT allocation -- as you said, they're really different things. To some extent there may be correlations in value but even that strikes me as tenuous. And as you said, one's an investment, the other is the place you live.

-Tad

Don't confuse the size of one's mortgage with the amount of real estate one has. The 0% equity guy happens to be short a bond which happens to have the same value as his house. But they are both subject to the rise and fall of the real estate market, in term of impact to their wealth.

Having no intention to use my home's value to retire (e.g. no particular plan to downsize and take money from the house to invest) I don't count the house as part of my 'portfolio'. Not like I can withdraw 4% each year at retirement. I think there's little to be gained in overweighting real estate in one's portfolio. Chasing sectors to me is a form of market timing, isn't it?

JOE

I think what I am asking is IF one were to consider their home as part of their portfolio does the "rule of thumb" change based on equity ownership? Renting or 0% equity means you actually have no real estate position. You may in the future (by paying off your mortgage) but if you liquidated all your holdings today and headed to beach, you'd get nothing for your "holdings". 100% equity would be a different scenario. It just so happens that I don't count my residence in my portfolio so this is a moot point for me.

Agreed. I wonder if the practice of not including it will change as underfunded retirement plans, unsustainable defined benefit plans, and reverse mortgages become more common?

I also don't recommend my clients take a large RE position (usually

4-7%). I am a buy and hold investor so I don't care how the RE market does. I'm gonna rebalance and keep'em in that range regardless. Using ETFs also helps in that with 1 or 2 funds I can obtain well diversified positions for my clients.

I'd think not. $200K House $200K mortgage $400K Stock

is not much different than; $200K house no mortgage $400K stock $200K margin loan

Of course the dynamic is different, a drop in house prices doesn't force a margin call, just hinders one's ability to refinance. And the margin loan tends to be at higher interest rates, and variable. Both people above have $200K RE, $400K stock, -$200K cash. JOE