How To Bulletproof Your CRE Portfolio Against Volatile Markets
Some new investors look at the stock market and tend to assume that everything, from GDP to commercial real estate values, track closely with its overall performance.
That is, if the stock market is up, then commercial real estate is up. Likewise, a bearish stock market should also correlate with a downturn in fortune in commercial real estate.
Investors naturally use stock market performance as a blanket metric for a particular sector because the status of the equity market indicates the aggregate business mood of all investors.
Though, depending on several factors, their collective sentiments could alternate between confidence and doubt at any given moment. This sudden shift in their investment outlooks is at the heart of market volatility.
In this article, we’ll show you how to bulletproof your portfolio against volatile markets and why the risk factors for real estate are completely different from those for stock market and bond investing.
The Risk Factors for CRE, Stocks, and Bonds
Volatile markets are especially dangerous if you make poor decisions as a result of them.
Some often seen examples of uninformed investment decision-making include liquidating all assets even though the fundamentals are still sound, funding investments with too much leverage in an effort to time the market, and hoarding an unsustainable amount of alternative investments as a contingency.
Though risk is a natural part of a boom-and-bust cycle, the factors that drive the stock market down don’t always affect commercial real estate.
In research published in the Pension Real Estate Association magazine, Greg MacKinnon analyzes how six common risk factors, including GDP growth and change in bond spreads, have different correlations with various asset classes. MacKinnon writes, “How much of the real estate market is driven by the stock and bond markets?“
Using quarterly returns from Q2 1984 to Q2 2018, MacKinnon shows that only 2.3% of the variation of real estate returns is associated with the fluctuation in bond market returns — and only a minuscule slice (less than 0.5%) is associated with the variance in the stock market.
What does this mean for you as a commercial real estate investor?
Securities have very little correlation to the commercial real estate industry, despite the widespread conviction that the two are intrinsically linked.
Diversify Your CRE Holdings with REIT ETFs
Diversification is a strong motive for many investors getting into commercial real estate in the first place. If you’ve allocated your funds across multiple industries, your CRE portfolio might already be more “bulletproof” than you think.
A myriad of uncontrollable factors can put a real estate project in the red: shifting migration patterns resulting in decreased demand, natural disasters destroying businesses and homes, and more.
Picking successful individual commercial real estate projects is sometimes just as difficult as picking successful individual stocks.
One way to overcome the volatility is REIT ETFs — i.e., investing in a fund that purchases real estate across many markets and areas. As an example, Vanguard’s REIT ETF has averaged roughly 9% since inception (and a whopping 34% YTD).
Essentially, REIT ETFs allow you to hold on to a lot of different real estate assets without having to take on as much risk as buying a single property. In other words, you’re spreading your capital and risk across a variety of assets in different markets and geographic areas.
Even with this investment vehicle, you’re still exposed to the real estate market, but your investment is easily liquidated in the event that you find a project you want to pursue.
Invest in What You Know and Take a Long View
If you know your market, if you collaborate with partners you trust, and if the fundamentals of your investment are sound, you will very likely make money in even the most volatile markets.
And if you take a long-term view on the market — i.e., you don’t drop your assets in a recession — you’ll rarely lose money in CRE. Invest in assets that you understand and pay attention to the direction of the market to select assets and strategies that fit.
Then, when the market is pulling back, avoid short-term buying and flipping approaches and hold on to your CRE portfolio till the weather clears. CRE, like residential, consistently appreciates over the course of decades and, in the long-term, compensates for even severe market swings.
If your returns are falling and it really is the time to exit but you’re facing prepayment penalties on your conventional debt, consider defeasance as a strategy to replace the underlying collateral and stabilize your portfolio with Treasury bonds and other securities.
Hone your insight
The risk factors for stocks, bonds, and real estate do not precisely track with each other. And research demonstrates that the stock market is not an indicator of the commercial real estate industry’s performance.
To keep your CRE portfolio humming throughout your investment lifecycle, hone your marketing insight, diversify your portfolio, and look past the horizon in planning your exit strategy.