It is no surprise that October was a terrible month for the markets. Fears of slowing growth, the looming trade wars with China, and higher interest rates sparked major volatility across the largest North American indices. The S&P 500 lost nearly 7% (which was the worst month since September 2011), the NASDAQ was down 9% (largest monthly drop since November 2008), and the DOW lost 5% (worst month since January 2006).
“A man should always place his money, one third in the land, a third in merchandise, and keep a third in hand.” – Babylonian Talmud.
This 1500-year-old investment advice highlights the importance of diversification in one’s portfolio of assets. Diversification, put simply, means one should spread their capital amongst different investments and investment asset classes in order to disperse the risk of relying on one investment or investment asset class to generate all the portfolio returns. Those who held all their investments in public equities in the North American markets in October, had very few places to hide from the turmoil. The key benefit of diversification is to help minimize some of the risk of loss – the only free lunch.
Kismet Asset Management recently launched an investment fund focused on passive real estate investment. Real estate offers competitive risk-adjusted returns, attractive income streams and can also enhance a portfolio, by lowering volatility through diversification. Pooled investments in real estate can provide more liquidity, and shorter-term investment horizons than investing in a real estate portfolio directly. Whereas all stocks of a particular type in a specific company are identical and most publicly traded equities have some level of correlation, and all bonds of a particular issue suffer from the same potential interest reinvestment risk and default risk from the cyclicality of the economy, no two real estate properties are the same. Even structures that are constructed identically with the same types of tenants and similar duration of leases will be at different locations with different land values. Buildings and dwellings differ in their intended use, size, location, age, type of physical construction, and building quality. These factors all contribute to the potential diversification benefit of adding real estate investments to a traditional portfolio.
As is it often a lot of work, and can tie up an investor’s liquidity needs, active/equity investment in real estate can be burdensome and costly. Diversification into REITs still bears some of the market correlation with stocks as diversifying into other publicly traded companies. On the other hand, pooled mortgage lending involves less risk than equity investment or unsecured lending and the mortgage pool has a priority claim on the real estate used as collateral for the mortgage. Additionally, a MIC’s return does not fluctuate with changing market interest rates because of the alternative financing market that they serve and therefore, has a lower correlation with the stock market– adding further diversification benefits than traditional public investments. The difference is that their income streams are secured on real estate assets, which means that the risks are default risks linked to the performance of the real estate assets and the ability of mortgagees to pay interest. Lower investment amounts, zero carrying cost, and no personal liabilities (which are present through purchasing real estate personally) further provide an attractive avenue to bulk up diversification in one’s portfolio and get that free lunch.