Over the past six months, Wealthfront has given a seminar on how to invest well to more than 50 Bay Area-based companies, including Facebook (FB), LinkedIn (LNKD) and Yelp (YELP). The seminar helps the audience learn how to use Modern Portfolio Theory to better manage investment portfolios. (Here’s a link to our slideshare presentation covering some of the same ground and to our seminar page)
As you might expect, we talk about the idea that investing in individual stocks actually hurts portfolio returns over time.
At almost every seminar, we get a question from the audience related to how someone should think about investing in real estate – not the home in which a person lives, but real estate rental properties. The more the Bay Area property market booms, the more seductive the prospect of owning rental property seems to become. Some people get sucked in, too, by the idea that they can invest using borrowed dollars.
We always answer the question the same way, though. You should think of a physical real estate investment the same way you should think about an investment in a particular stock: As a big risk. You are unlikely to outperform the market unless you have an information advantage (which you are unlikely to have unless you are a real estate professional or are willing to put lots of time and energy into finding the property).
You can reap some of the benefits of owning real estate – an asset class that traditionally is thought of as a hedge against inflation — by owning a diversified collection of residential and commercial properties in the form of an ETF. The Vanguard REIT ETF, VNQ, which Wealthfront recommends for its clients, owns shares in Real Estate Investment Trusts including Simon Property Group, which owns retail properties, Ventas Inc., which owns healthcare properties, and Vornado Realty Trust, a big commercial office building REIT.
A real estate ETF, owned as part of a broadly diversified portfolio, is likely to lead to better risk-adjusted returns.
Many people are interested in owning real estate for the consistent income. REITs by law must pay out 90% of their income, so their dividends should address those income goals.
The idea of trying to choose the “right” individual property is alluring, especially when you think you can get a good deal on the property or buy it with a great deal of leverage. That strategy can work well in an up market. However, 2008 taught all of us about the risks of an undiversified real estate portfolio, and that leverage can work both ways.
The bottom line? Unless you are an incredibly savvy real estate investor, you are probably better off owning a real estate ETF as one of the six components of a diversified portfolio.