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Using Real Estate as Diversification in Asset Allocation

By: Jon Galane

IRA Insights

By: Jon A. Galane

The ghost of business past

Through the last three decades, “financial planning” has developed from non-existent to hot button marketing for hundreds of firms. The barrage of terminology that has developed over this time has led to confusion by investors of what “financial planners” are advising their clients.

Let’s start with the 1990s. The financial services industry changed more in the 1990s than it had since a group of men with government bonds began trading under the buttonwood tree on Wall Street in 1792. There really was no such thing as a “financial service industry” before 1990. Prior to  this there were four heavily armed camps, each occupying different sector war zones: banks, insurance companies, stockbrokers and real estate brokers.

Banks took deposits and made loans; insurers insured life and health and sold fixed annuities to the terminally chicken-hearted; stockbrokers sold stocks and bonds and did marginal business in a wimpy little product called mutual funds; real estate brokers sold homes to the American family, raw land to speculators and incomeproducing properties to investors. Each combatant spent tens of millions of dollars every year telling the public that the other guy’s products were carcinogens.

With the advent of the wild bull market starting in 1982, stockbrokers began taking market share from both banks, through money market funds, and life insurers by licensing their reps to sell insurance/annuity products. Given the nature of this greatest of bull markets, stockbrokers’ essential marketing message—“risk is good”— had turned out to be right, just as banks’ and whole life insurers’ message—“risk is death”—was seen to be wrong. On the outside looking in were real estate brokers whose major business was homeowners and only a select, elite few were part of the  investment side of real estate.

By the early 1990s, the three major financial services combatants were all in the same business. Real estate was still left on the outside looking in. The private placements and highly leveraged limited partnerships of the mid 80s had left them bloodied and bruised. Real estate was still looking for a way to attract the average investor.

The three financial arenas had joined forces as uneasy allies when they turned together to face a new and impeccable enemy: the “no-load” fund. They now faced a foe who said, “You’d be better off not paying any of ‘em.” Real estate still on its own and able to sell their product on the value of tax deductions, depreciation and write offs, continued to develop their marketing to investors. The ability to invest real estate in IRAs, although around as long as IRAs, was not being marketed by real estate agents or reps of the financial industry like it was by banks, insurers and stockbrokers.

At best, the advent of REITs was the answer of stock brokerage firms to gain market share in real estate.

Now, with no-loads banging away at the ability to “do-it-yourself,” investors’ eyes were opened to the fact that they could make their own decisions for investments and retirement planning. Unfortunately for real estate agents, they never thought that there might be a way to assist in educating their clientele in do-ityourself real estate buying. This led to the advent of “for sale by owner.” Only now in the 21st century, with loss of market share, do we see real estate agents starting to educate themselves on “do-it-yourself” retirement planning through IRAs. This  awareness gives value added service to the client they may previously have lost because those investors could not see the value of their real estate broker.

Diversification and Asset Allocation

Not a day goes by when the media isn’t discussing the terms diversification, asset allocation, asset class. What exactly do these terms mean? Are they interchangeable? How does someone practice this art themselves?

Where does real estate fit into the modern portfolio theory of asset allocation?

One of the most ridiculous statistics I have ever heard is one delivered with an astoundingly straight face by some professional financial advisor types (including me at one time) that 87% or 90% or whatever of your total investment return comes from asset allocation of your portfolio rather than from the selection of individual investments within an asset class. Let’s take a look at
the index returns of the 3 major financial asset classes: stocks, bonds and cash, per Ibbotson Associates 1925- 2005.

Looking at various indices for real estate, which is more vague, you can find conclusive historical returns using JMB Institutional realty Corp and others as a cross section from 1974-2005:

Real Estate 8.2-12%

An investor may infer from this that the more assets in the things that returned 8-12% as opposed to the things that returned 5.7% and 3.7% the higher the portfolio return would be.

Asset allocation as defined by William F. Sharpe, the inventor of the Sharpe Ratio which measures reward to risk, concluded that, “investors can allocate their money among three major asset   classes-stocks, bonds and cashand numerous subcategories within those asset classes.”

What we don’t see in any model of asset allocation or diversification within those models is real estate. It has been conspicuously left out of the mix. Is this because the major financial institutions have not been able to figure out how to control the independence of real estate ownership, possibly?

Is it perhaps because of the extra effort and work it takes for an investor to identify and  consummate the real estate transaction? But, the real question I have is, “Why wouldn’t the real estate industry embrace the incredible tools available to them to assist investors in using
real estate in their retirement planning through IRAs and qualified plans?”

Well, let’s look at what professors really mean by asset allocation—the “moving into, out of, and among stocks, bonds and cash at just the right times.” What we have here is an academic theory that is of no practical utility what so ever. This is the same as saying, “the key to superior returns is to be able to consistently time the markets.” That’s terrific in a computer model and completely impossible in real life. If you simplify that argument even further, you realize that reduced to its essence, the asset allocation theory just says:

“The higher your equity exposure as a percentage of your total assets, the better your overall return.”

Why then has the financial services industry made virtually a secular religion out of “asset allocation”? If you believe in the myth of “higher returns with lower risk” that by some mixture of stocks bonds and cash you can somehow magically get higher than 10.5%, then there is nothing I can say to help you understand a better model. “Higher returns with lower risk isn’t modern portfolio theory, nor even ancient portfolio theory. It’s voodoo portfolio theory. It defies both logic and arithmetic.”  Nick Murray, The Excellent Investment Advisor, 1996. At best, all an investor can ask of asset allocation is to forgo some of the permanent ups so you can miss some of the  temporary downs. The question is why would anybody want to do that? The answer is nobody would— if the investor really believes that downs are temporary.

The other real life problem with asset allocation as it is defined is that stocks and bonds correlate quite positively with each other. When one is taking on water in a hurry, the other usually is too, and for the same reasons. I would like to propose a theory of total market asset allocation that simply states, “Allocate your assets between separate but equal returns. Consider using equities from the business world and real estate from the hard asset world causing your portfolio to create ‘higher returns with different market risks.’”

I have coined this theory as, “independent asset allocation.” It’s simple and obtainable.

An individual can take more control over their future and direct their retirement plans towards things that are concrete and graspable. Separate your funds into 2 areas, 50% equities, diversified into five areas of the stock market, and 50% real estate.

If real estate debt for income is a goal, then look at first trust deeds. These give higher income that can give an investor the 6-12%% area of return, equalizing it with the overall return of a stock portfolio. If an investor wants real estate equity to maximize capital appreciation, they could look at the possibility of raw land. If equity diversification is a goal, large dividend paying stocks and funds could be allocated to an income producing property. And certainly, any bond or bond funds
could be self-directed to income properties to satisfy income needs while giving the investor the opportunity of growth, stripping the direct relationship between bonds and stocks that quite frequently move in the same direction.

“Things in life will not always run smoothly. Sometimes we will be rising toward the heights----then all will seem to reverse itself and start downward. The great fact to remember is that the trend of civilization itself is forever upward: that a line drawn through the middle of the peaks and valleys of the centuries always has an upward trend.”---Rev. Endicott Peabody, headmaster of Groton, quoted by his former student, Franklin D. Roosevelt, in FDR’s last inaugural address, January 20,
1945.

Dr. Peabody’s permanent uptrend line—“drawn through the middle of the peaks and valleys of the centuries”— is mirrored in the long-term behavior of both equity and real estate prices. It is the permanent upward bias of the trend line, not the jagged slopes between peaks and valleys, of which you should be most concerned with as you make your investment decisions within your self directed IRA and other qualified plan accounts.

Jon A. Galane is a investment advisor with 23 years experience with fortune 500 companies and is currently licensed in life, health, variable annuity and both general security and general supervisory securities licenses through AIG Investments and CEO of MountainWest Entrust IRA, serving Idaho and Utah. Nothing in this article is intended as tax, legal or investment advice.

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