Asset class for real estate

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Darkaegisagain
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Asset class for real estate

Post by Darkaegisagain »

When balancing your portfolio how should rental property be considered? Should the equity and income be considered separately?
dbr
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Re: Asset class for real estate

Post by dbr »

Darkaegisagain wrote:When balancing your portfolio how should rental property be considered? Should the equity and income be considered separately?
I don't think there is a theoretical construct for how assets in investment real estate can be integrated into the same structure of risk and return as we have for stocks and bonds (including cash). Probably it is possible to integrate some other assets, such as commodities, or to think of REIT stocks, for example, as an asset class. If you mean owning a few houses or an apartment building, or some such thing, I don't think you can position it (balance it, as it were) in liquid investment portfolio such as we discuss here. In any case income is not an asset although there are those who are tempted to capitalize income streams.

My answer is a very amateur one. Some other posters may have better suggestions.
steve_14
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Re: Asset class for real estate

Post by steve_14 »

I would not consider either directly, as neither is correlated to stocks or bonds. You could consider any mortgage a negative bond, optional. There are some indirect considerations, like the size of your "rental allocation" vs your stocks and bonds, and the fact that your rental income in the future may increase your nest egg, reducing your need to take risk.
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Darkaegisagain
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Re: Asset class for real estate

Post by Darkaegisagain »

Yes they are rentals, all positive income. To me its in the same class as fixed income assets would be so I have tried to balance out my portfolio with it in that class and which would allow me to add more risk to my portfolio, but that may be a naive position to take.
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Re: Asset class for real estate

Post by Alex Frakt »

Your allocation to stocks and bonds depends on your income needs in retirement. Rental income reduces that need. It's no different from Social Security or a pension.

For example if your remaining income requirements would be guaranteed by an 80% allocation to TIPS, they you'd probably want to do that. OTOH, if your rental income and SS and any pensions fully covered your income requirements, then you could reasonably go up to 100% equities if you are interested in trying to maximize your estate.

I will note that if you are planning on selling the rentals prior to retirement, you could consider your current equity in them (market value - cost of sale and mortgages) as part of your fixed income holdings.

Edited to reword previous sentence (edited section in italics).
dbr
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Re: Asset class for real estate

Post by dbr »

Darkaegisagain wrote:Yes they are rentals, all positive income. To me its in the same class as fixed income assets would be so I have tried to balance out my portfolio with it in that class and which would allow me to add more risk to my portfolio, but that may be a naive position to take.
To place these assets within the context of an investment portfolio, you would have to assign them an expected return and a risk, meaning the width of the statistical distribution of which the expected return is the average. That is a necessary first step to making any sense out of constructing a portfolio including those assets. It is also very difficult to compare the investment properties of investments that are not liquid with those that are.

I think what you mean is that they are like fixed income assets from the point of view of income stream analysis and risk to that income. That could be a useful, indeed a critical, analysis, but it has little to do with portfolio construction. Even so, I would not think rents less costs would have the kind of contractual certainty that the coupon on a bond has. In short, the "fixed" part of fixed income might not apply.

I doubt rental properties have much in common with fixed income investments. In essence a fixed income investment is a contract to pay you back a debt, and, in the meantime, to pay interest. A rental property has an asset value dependent on a market, and nowhere in there is there any contract to return your investment to you. In fact, rental property is a good paradigm for an uncertain investment depending on idiosyncratic risk in a volatile market that has liquidity issues. It is true that most property investors take out debt, a kind of negative bond, to invest, but that is a different part of the problem.

Probably the best model for holding rental properties is that it is a business that requires an equity investment and pays a dividend dependent on earnings. In this sense if there is any portfolio entity to which it is similar it would be investing in a single company stock, privately held, for which there is no ready market. Most portfolio theory assumes that diversifiable risk, which this business has in spades, has been eliminated, which would be the case for mutual fund investments, Treasury bonds, and so on.

This discussion is certainly open to other suggestions.
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Re: Asset class for real estate

Post by dbr »

Alex Frakt wrote: I will note that if you are planning on selling the rentals prior to retirement, I would consider the current market value as part of your fixed income holdings.
That is a good point. The question is how to take the possibility into account.

My vote would be to not consider the value as a fixed income holding now but to plan for one's future on the possibility that the liquidation could happen. At that time the assets actually become investable and one would devise a new asset allocation accordingly.

In the meantime one should estimate one's need and ability to take risk with liquid assets considering the presence of the investment assets. Keep in mind that it is not the market value but the net value that comes into play here. A real estate investor who is underwater on investment properties may be headed to bankruptcy and loss of all assets not otherwise protected. In any case the question of how to manage the debt involved in investment property mortgages is important, whether one likes the negative bond concept for this or not.
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Re: Asset class for real estate

Post by Alex Frakt »

dbr wrote:
Alex Frakt wrote: I will note that if you are planning on selling the rentals prior to retirement, I would consider the current market value as part of your fixed income holdings.
That is a good point. The question is how to take the possibility into account.

My vote would be to not consider the value as a fixed income holding now but to plan for one's future on the possibility that the liquidation could happen. At that time the assets actually become investable and one would devise a new asset allocation accordingly.

In the meantime one should estimate one's need and ability to take risk with liquid assets considering the presence of the investment assets. Keep in mind that it is not the market value but the net value that comes into play here. A real estate investor who is underwater on investment properties may be headed to bankruptcy and loss of all assets not otherwise protected. In any case the question of how to manage the debt involved in investment property mortgages is important, whether one likes the negative bond concept for this or not.
For clarification, while you were writing the above, I was revising the quoted part to:
I will note that if you are planning on selling the rentals prior to retirement, you could consider your current equity in them (market value - cost of sale and mortgages) as part of your fixed income holdings.
So the problem you outlined resolves itself if there's little equity :-)

But if there is equity, and you are planning on cashing in on that equity at some point, I don't see an issue with considering it part of your fixed income holdings. They are real assets that will be there when you require them. The underlying investment, the property, has an expected real return of around 0%, much like today's TIPS :shock:
dbr
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Re: Asset class for real estate

Post by dbr »

Alex Frakt wrote:
But if there is equity, and you are planning on cashing in on that equity at some point, I don't see an issue with considering it part of your fixed income holdings. They are real assets that will be there when you require them. The underlying investment, the property, has an expected real return of around 0%, much like today's TIPS :shock:
That sounds like a reasonable proposition for the return part. I wonder what the best estimate is for the risk part. Certainly in any local market real estate values are much more volatile than bond values. In short, how much should we question the statement that the real assets will be there when you require them?
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Re: Asset class for real estate

Post by Alex Frakt »

dbr wrote:
Alex Frakt wrote:
But if there is equity, and you are planning on cashing in on that equity at some point, I don't see an issue with considering it part of your fixed income holdings. They are real assets that will be there when you require them. The underlying investment, the property, has an expected real return of around 0%, much like today's TIPS :shock:
That sounds like a reasonable proposition for the return part. I wonder what the best estimate is for the risk part. Certainly in any local market real estate values are much more volatile than bond values. In short, how much should we question the statement that the real assets will be there when you require them?
How about we agree to put it in the junk bond part of your allocation? :-)
PacNorWest
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Re: Asset class for real estate

Post by PacNorWest »

Darkaegisagain wrote:When balancing your portfolio how should rental property be considered? Should the equity and income be considered separately?
Our financial adviser treats the income as part of our cash flow - as if it were social security.
When he "bucketizes" the liquid assets, he does not include the rental cash flow in any one bucket.
Only the liquid assets are considered for diversification and risk.

If we were to covert (sell) the rental then the cash would become part of the liquid asset pool.
The cash would then have to be allocated to one of the buckets.

So. . . equity is considered part of net worth but not as a liquid asset. Its treated as a bad relative.
Rental income is part of current income, like social security, pension or annuity income.
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Darkaegisagain
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Re: Asset class for real estate

Post by Darkaegisagain »

My current model doesn't include the rentals as part of my portfolio but it projects the rent out based on a 2.5% rate of inflation and a 3.1% on the value of the home (3.1% is the 100 year average). I then use the rent modeled out to retirement minus the fixed cost of the mortgage as part of my retirement income.

At some point my portfolio assets start to converge towards zero but the equity of the rentals has ballooned and they are paid off at which time I plan on selling them back into the portfolio. In reality the tax benefits really diminish a few years before the full equity has been reached so I would consider converting them into some equal asset.

I guess I will stick with the current model, I could probably take more risk in the equity markets because the rentals sort of skew my asset allocation for retirement. In the end I need less to retire on but it complicates things and I get different answers from financial planners so I came up with my own modeling system as income / equity.

Thanks!
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Re: Asset class for real estate

Post by malloc »

You seem to equate rental income with bond income.
I certainly do not think of them as equivalent - I consider rental income and rental expenses as more volatile, and hence I am perhaps a bit more conservative than you.

Yes I do estimate what I expect and hope the income will be - but I try to be diversified to the point where I do not rely on that estimated income for survival.
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Re: Asset class for real estate

Post by Clearly_Irrational »

I use a meta-model of which financial assets are only one component. There are only four ways to make money: Wages, Rent, Interest & Profit. Generally I would like to have roughly equal amounts (by income stream) as they'll each have their own risks, rewards, tax structures, etc. Stocks & Bonds fall under the interest section, while rentals fall under the rent section.
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Re: Asset class for real estate

Post by Saving$ »

So for a beginning Boglehead, really trying to keep things simple with the three fund portfolio, would it be reasonable to allocate equity in investment real estate to 50% against equities (due to volatility) and 50% against bonds (due to inherent income stability)?

I've really struggled with this in trying to set up my AA. For purposes of my own AA, I keep primary residence equity out of the equation and am very conservative in my equity valuation of the investment real estate. Regardless, if it is a very significant portion of assets, it can have an enormous impact on AA, and thus it does not seem prudent to ignore it when determining AA.
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Re: Asset class for real estate

Post by Alex Frakt »

Saving$ wrote:So for a beginning Boglehead, really trying to keep things simple with the three fund portfolio, would it be reasonable to allocate equity in investment real estate to 50% against equities (due to volatility) and 50% against bonds (due to inherent income stability)?

I've really struggled with this in trying to set up my AA. For purposes of my own AA, I keep primary residence equity out of the equation and am very conservative in my equity valuation of the investment real estate. Regardless, if it is a very significant portion of assets, it can have an enormous impact on AA, and thus it does not seem prudent to ignore it when determining AA.
You shouldn't ignore it because it impacts your allocation requirements. But there is no simple way to plug it into stocks and bonds. Perhaps it will help to think of your investment real estate as a business. Because, after all, it is. If you owned another type of business -say (looking out my window) a dental practice or pizza place or gas station - would you spend your time trying to figure out whether it was a stock or bond? Probably not. Instead you'd look at the expected cash flow and how it will affect your income needs in retirement. Or if you don't want to run the business in retirement, how much equity you'll be able to pull out when you sell it off.
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Re: Asset class for real estate

Post by dbr »

Saving$ wrote:So for a beginning Boglehead, really trying to keep things simple with the three fund portfolio, would it be reasonable to allocate equity in investment real estate to 50% against equities (due to volatility) and 50% against bonds (due to inherent income stability)?

I've really struggled with this in trying to set up my AA. For purposes of my own AA, I keep primary residence equity out of the equation and am very conservative in my equity valuation of the investment real estate. Regardless, if it is a very significant portion of assets, it can have an enormous impact on AA, and thus it does not seem prudent to ignore it when determining AA.
What do I know? - - but my thought process is that your investment real estate is absolutely not a stock or a bond or any kind of mixture of those.

Your assets allocation is (for example) 35/35/30 stocks/bonds/real estate. There is nothing wrong with this. There are people that hold portfolios that are 25% gold and gold is gold and not a stock or a bond, and so on.

I do agree that this forum doesn't really have the tools to look at the portfolio you would have in the kind of detail that people apply to stock and bond portfolios. I'm not so sure the forum does any better looking at gold either, for that matter.

I also agree with the comments of the just prior poster.
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Re: Asset class for real estate

Post by Saving$ »

dbr wrote:Your assets allocation is (for example) 35/35/30 stocks/bonds/real estate. There is nothing wrong with this. There are people that hold portfolios that are 25% gold and gold is gold and not a stock or a bond, and so on.
.....
I also agree with the comments of the just prior poster.
So if I look at it as a business, and do the above allocation as you propose, how should the investment real estate business affect my stock/bond AA, if at all? In the example 35/35/30 example you gave, the stock / bond allocation is 50/50 of the stock/bond subtotal. Based on common wisdom of this forum of age in bonds-10, that is about right for someone who is 60. Do I just subtotal the assets available to invest in stocks and bonds and do the traditional AA, without letting the real estate business affect the stock/bond AA?
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Re: Asset class for real estate

Post by Clearly_Irrational »

Saving$ wrote:So if I look at it as a business, and do the above allocation as you propose, how should the investment real estate business affect my stock/bond AA, if at all? In the example 35/35/30 example you gave, the stock / bond allocation is 50/50 of the stock/bond subtotal. Based on common wisdom of this forum of age in bonds-10, that is about right for someone who is 60. Do I just subtotal the assets available to invest in stocks and bonds and do the traditional AA, without letting the real estate business affect the stock/bond AA?
I use a meta-model. There are only four ways to make money: wages, rent, interest & profit. In general I want roughly equal amounts of rent, interest and profit. (wages I just try to maximize and use my surplus to buy the other three until such time as I have enough to not need to work) So the idea would be to balance the equity of your real estate holdings vs the market value of your portfolio vs. the sale value of any businesses you own. This is not a standard Boglehead setup and it's definitely less passive, but in my opinion it diversifies you against a wider variety of risks and gives you more flexibility as well as better tax treatment.
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Re: Asset class for real estate

Post by Alex Frakt »

Saving$ wrote:So if I look at it as a business, and do the above allocation as you propose, how should the investment real estate business affect my stock/bond AA, if at all? In the example 35/35/30 example you gave, the stock / bond allocation is 50/50 of the stock/bond subtotal. Based on common wisdom of this forum of age in bonds-10, that is about right for someone who is 60. Do I just subtotal the assets available to invest in stocks and bonds and do the traditional AA, without letting the real estate business affect the stock/bond AA?
Age in bonds (or age up to +-10 in bonds) is a reasonable guideline, especially for those in the early or middle working years, but it should not trump looking at your individual situation. The question as you get closer to retirement becomes "How much income does my portfolio (stocks and bonds) need to produce in order for me to live comfortably?"

Let's take a couple of examples. If you are making enough from your income properties to cover your income needs, then any allocation is appropriate, it just comes down to you deciding how much risk you want to undertake in an attempt to maximize your estate. OTOH, if you determine that you have just enough to produce a borderline sustainable withdrawal rate (say 4%), you may want to move to a very conservative allocation like 80% bonds 20% stocks because otherwise a single sizeable market correction would result in your falling short.
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Re: Asset class for real estate

Post by dbr »

Saving$ wrote:
dbr wrote:Your assets allocation is (for example) 35/35/30 stocks/bonds/real estate. There is nothing wrong with this. There are people that hold portfolios that are 25% gold and gold is gold and not a stock or a bond, and so on.
.....
I also agree with the comments of the just prior poster.

So if I look at it as a business, and do the above allocation as you propose, how should the investment real estate business affect my stock/bond AA, if at all? In the example 35/35/30 example you gave, the stock / bond allocation is 50/50 of the stock/bond subtotal. Based on common wisdom of this forum of age in bonds-10, that is about right for someone who is 60. Do I just subtotal the assets available to invest in stocks and bonds and do the traditional AA, without letting the real estate business affect the stock/bond AA?

Note: Please realize that you are now reading the comments of an amateur who has never owned investment real estate. I would hope others will continue to chime in as much as possible. This is not a combination of circumstance that seems to be addressed in the run of the mill investing books.

The numbers I used were purely an example. Stocks/bonds were 50/50 for simplicity. I do not believe in applying formulas to this.

The whole purpose of asset allocation is to make a choice where on the continuum of return and risk you want to position your investments. That has to be done by considering the whole picture. The problem that arose initially is that it is very difficult to compare the risk and return of investment real estate to the same properties of stocks and bonds. What that means is that you are going to have to think through how much risk to take with the stocks and bonds allowing for the fact that you have the real estate investments. Does that mean you are more wealthy and have large income streams so that you don't have to take risk with stocks and bonds? Does that mean that you have enough wealth and income in real estate that you can dedicate your stock and bond portfolio to a risky future hoping to benefit heirs or institutions to whom you might give money? Is your real estate investment a very small part of your retirement resources? Is your investment real estate at risk and you had better think of building a stock and bond portfolio you can rely on if the real estate investment fails? How possible is it that you could be exposed in real estate to more than 100% losses, driving you into personal bankruptcy? All of this needs to be considered. There is no formula, but only good judgment.

An advantage of considering real estate investment as a business is that it dumps the whole calculus into the future income camp rather than the portfolio camp. Then you can determine what risk and return you might need from stocks and bonds allowing for the total effect of the future income stream. This can also allow that at some time in the future you might liquidate your real estate and add to the stock and bond portfolio. Many of the financial planning tools have data entry that include lump sum operations like that along with step changes in income and expenses.

I would think a large driving factor would be the magnitude of the investment. It would be quite different to hold a few millions in real estate with a couple hundred thousand in investments, vs the opposite or something like an even split.

That's the best I can do, because I don't know any more about it than that.
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Re: Asset class for real estate

Post by abuss368 »

I prefer the beauty and simplicity of REITS.
John C. Bogle: “Simplicity is the master key to financial success."
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