Real Estate vs Stocks & Other Asset Classes

August 5, 2020
By EQUITYMULTIPLE Staff

Most investors begin their investing journey with allocation into public stocks. As soon as you put money into a 401k, you attain some exposure to public equities, i.e. the stock market. Many investors heed conventional wisdom and next allocate to bonds, allocating more of their portfolios to fixed-rate bonds and money market vehicles. Real estate presents an opportunity to capture the income potential of the stock market while investing in a tangible asset. This article takes a close look at private real estate vs. stocks, as well as some of the key benefits of CRE versus other major asset classes.

Key Takeaways:

  • Private real estate can provide numerous benefits as compared to other major asset classes.
  • Equity crowdfunding and REITs should not be confused with platform-based, passive, private real estate investing.
  • A diversified approach may include passive, private-market real estate assets, and other forms of real estate investments, alongside traditional assets.

As we will discuss in our Alternative Asset Theory series, real estate and other alternative assets may be wise supplements to a traditional portfolio of stocks and bonds. 

Merits of Real Estate vs. Publicly Traded Stocks

Here are the main reasons institutional and experienced investors are drawn to real estate, as compared to publicly traded equities:

Consistent cash flow

Many private real estate investments will target regular cash flow, often paying monthly or quarterly distributions. This cash flow may be paid out of NOI from rents or ancillary revenue sources, from an interest reserve held by the Sponsor, or some combination thereof. In the case of a senior debt or preferred equity position, the cash flow from a real estate investment will be senior to all equity holders, adding a cushion against adverse circumstances. 

Dividend-paying stocks also offer regular cash flow, but the typical yield ranges from just 1.5% to 5%¹, with yields exceeding this range often subject to heightened volatility. By comparison, EquityMultiple’s senior debt investments target annual returns of 6-11%*, and preferred equity investments target current preferred returns in the range of 7-12*.

Tangibility & Intrinsic Value

The stock market, with its high degree of liquidity and responsiveness to the news cycle, has exhibited higher volatility than private real estate: in the 20 years from 1999-2018, the S&P 500 exhibited volatility nearly four times greater than private real estate². The volatility of public equities markets appears to be the new normal – as geopolitical tensions and coronavirus drive negative economic news, the VIX (the primary measure of investor trepidation) has reached all time highs.

Private real estate, conversely, offers tangibility. Whereas negative macroeconomic news can precipitously hurt the value of a stock, valuations of individual real estate assets are a function of real in the built environment, reflecting demographic trends and microeconomic factors. Fundamentally all humans need a place to live, and our economy needs places to congregate and do business. The essential nature of real estate provides a hedge against volatility. Because private real estate assets are transacted in inefficient, illiquid markets, savvy real estate investors are able to time exits to maximize value.

Downside protection

Real estate investments are often structured to mitigate worst-case scenarios. This may take the form of contractual measures to insulate certain investors against bad actors or adverse economic conditions. EquityMultiple seeks ot build in such protections on behalf of investors [link to downside protection article] The lead investor — or sponsor — of a real estate investment typically considers a worst-case scenario on a unit basis (what is the least favorable price per square foot I could sell or rent this property for to break even). 

Again, the tangibility and necessity of quality real estate assets means that sponsors are typically able to manufacture some form of exit that mitigates loss, even in the case of unexpected adverse conditions.

Low Correlation with Public Markets

Not only has private real estate exhibited less volatility than public equities markets (see above), but performance of the asset class also correlates less closely with the stock market than do other major asset classes.

More on this topic in our series on Alternative Asset Theory.

Tax Benefits

Passive real estate investments generally offer the potential for passive income, which can be offset for tax purposes by passive losses. Many private-market real estate investments are also eligible for depreciation, providing a potential added boost to post-tax returns. 

Aside from these general benefits, certain types of private real estate investments offer additional benefits that are established in federal tax code. 1031 Exchange and Qualified Opportunity Zone investments allow for deferring and, in the latter case, potentially reducing capital gains tax on realized profits from a real estate investment.

Strong Historical Returns

In the past several decades the stock market has had plenty of good years and some not-so-good years. Private real estate markets have had down years as well, but aggregate average returns have generally shown more stability with downswings of lesser magnitude (part and parcel of historically lower volatility, see above). Private real estate has also exhibited stronger average returns in absolute terms than the stock market in the twenty years from 1999-2018: 9% versus 5.1%. 

When assessing real estate vs. stocks with respect to risk-adjusted returns, private real estate far outperforms. Let’s now turn to other major asset classes. 

Real Estate vs Bonds and Other Fixed-Rate Vehicles

While the stock market and real estate investing offer the potential for appreciation and current yield, bonds and other fixed-rate vehicles offer lower-risk, lower-return investments for preserving wealth. Indeed, most institutional investors allocate between 10 and 20% of their portfolios to bonds and other fixed-rate vehicles. Robadvisors and 401Ks will often start investors in this range, and ratchet up allocation to bonds and other fixed-rate instruments as the investor nears retirement age. 

From CDs to treasury bonds to unit investment trusts to utility stocks to fixed annuities, these options offer low risk and require very little knowledge or upkeep, but limited annual returns of between .5% and 5%. With the advent of direct real estate platforms like EQUITYMULTIPLE, commercial real estate debt has emerged as a higher-yield alternative. Like these other vehicles, investing in commercial real estate debt targets stable, fixed returns, but with a significantly higher range of returns – between 6% and 11% APR*. High-yield commercial real estate loans like this are typically short in duration (6-18 months) and offered by private lenders instead of banks. (For more on how rates on such loans are determined, see this article).

However, fixed-rate real estate debt investments secured by the underlying property still come with attendant risk, namely the potential for the borrower to default. Government bonds, while offering lower rates of return, are often referred to as “risk-free” because of the extremely low potential for the government to default.

Private, Passive Real Estate vs. Equity Crowdfunding

The JOBS Act opened the door for individuals to access private commercial real estate investments. It also created the opening for early-stage startups (from tech to ecommerce to biotech restaurants and breweries) to raise capital, and hence new opportunity for individuals in “equity crowdfunding”. Platforms like SeedInvest, MicroVentures and EquityNet now allow individual investors to operate as small-scale venture capitalists, buying shares of promising growth-stage companies.

As you might imagine, this form of investing carries great potential for return, but enormous risk: while some startups strike gold, the majority do not, and these investments have a far greater potential for 100% loss of principal than do real estate, stocks, or other asset classes. Established venture capital firms wield enormous stores of capital, expertise, and analytic acumen, and still expect to lose on the majority of investments they make. As such, individuals should approach this new investing channel very carefully. Even proponents of the young industry seem to agree.

As with any real estate investing platform, investors should look carefully at the vetting measures of any startup equity crowdfunding platform they consider investing with. (More on EquityMultiple’s underwriting practices can be found here.)

Real Estate vs. Stocks & Other Asset Classes:

Passive real estate investments behave differently from REITs, and direct ownership of property.

Private real estate investments behave differently from REITs, and direct ownership of property. When real estate is talked about in the context of other asset classes, people are often referring to REITs (real estate investment trusts) or direct ownership of property. While both of these investment vehicles may be viable alternatives to stocks and bonds, it’s important to keep in mind that passive private real estate investing differs substantially from public REITs or direct ownership of property:

  • Unlike publicly traded REITs, passive online real estate investments are not subject to market swings and do not correlate heavily to public markets. In other words, for an investor already exposed to stocks, passive real estate investments in distinct properties provides superior diversification benefit and downside protection than publicly-traded REITs. 
  • Meanwhile, private, nontraded REITs typically carry high management fees (often 10% and up, as opposed to the 0.5-2.5% annual fees usually associated with online platforms like EQUITYMULTIPLE).
  • Direct ownership of real estate has the potential for significant appreciation, but comes with a host of potential headaches and drains on time and capital. Like any business venture, real estate investment and management benefits from experience and scale, and individuals looking to allocate into real estate for the first time may not have the requisite experience to buy, manage, and sell commercial real estate to a favorable ROI. 
  • Furthermore, committing large amounts of capital to the purchase, management, and improvement of one or two properties may preclude substantial diversification. Conversely, EquityMultiple allows for passively investing as little as $10k in a diverse range of commercial assets.

Conclusion

Private real estate assets are tangible, essential, and provide a natural hedge against economic shocks. The asset class has empirically shown less volatility than stocks and other major asset classes. 

Of course, real estate vs stocks or any other asset is never a binary decision – a strong portfolio will exhibit diversification across asset classes, and within asset classes. We will speak more to this in a subsequent article on modern portfolio theory.

 

¹https://www.thebalance.com/the-basics-of-investing-in-dividend-paying-stocks-416832

² Volatility as expressed by standard deviation of annual returns. Sources: https://www.macrotrends.net/2526/sp-500-historical-annual-returns, RECREIF Index

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