Why is Real Estate an "Alternative" Investment?

June 21, 2021
Categories: All Taxes

U.S. national debt held by the public recently rose to 100% of GDP, the first time since the end of World War II. While the amount of debt is staggering, those debt levels do not even include entitlements such as Social Security and Medicare.

At the same time, the spread between 2-year and 30-year U.S. Treasuries is steepening, which is a classic sign of rising inflation expectations.

Nearly unprecedented government spending combined with rising interest are compelling many investors today to look for alternative investments to protect capital while generating returns above the rate of inflation.

In this article, we'll take a closer look at alternative investments, including what they are and how they work, and explain why commercial real estate may be the best alternative investment around.

Alternative investments are used for diversification

What is an Alternative Investment?

Alternative investments are those that are not part of traditional investments such as publicly-traded stocks, bonds paying a fixed interest rate over a specific period of time, cash-equivalents such as a CD that can easily be converted into cash, or cash itself.

Examples of alternative investments include:

  • Real estate
  • Private equity
  • Private debt
  • Commodities
  • Precious metals
  • Cryptocurrency
  • Art and collectibles
  • Fine wine
  • Infrastructure
  • Structured settlements
  • Trade and marine finance
  • Litigation funding
  • Venture capital
  • Hedge funds

The alternative investments listed above can be grouped into two main types.

Alternative assets such as real estate, private equity, and private debt are less frequently traded and can be more complex to invest in than traditional stocks and bonds.

The second type of alternative assets, including venture capital and hedge funds, often operate in the traditional public markets but use less traditional strategies such as extreme leverage and short-selling to generate returns.

Alternative investments are used to diversify an investment portfolio and increase potential returns. However, they are not the right choice for every investor, because alternative investments may require a high tolerance for risk and may also be illiquid for long periods of time.

Many alternative investments require investors to lock up their capital for between five and ten years, and sometimes longer. During the holding period investors may not see distributions on their capital and may also find it difficult to sell shares as one would a publicly-traded stock or bond.

While there are some potential drawbacks, historically alternative investments generate greater returns than do the public equity markets.

For example, a recent study from Cambridge Associates reveals that private equity generated average annual returns of 10.48% over the 20-year holding period ending Q2 2020. Over the same time period, the Russell 2000 Index produced average annual returns of 6.69%, while the S&P 500 returned 5.91% per year.

Related: What Can You Expect With Your First Real Estate Investment?

Real Estate as an Alternative Investment

Real estate - including private equity and private debt - is arguably one of the least risky types of alternative investments, depending on the asset class invested in.

Single-family rentals, multifamily properties, and alternative asset classes such as self-storage can generate higher yields and stable incomes within a diversified investment portfolio, while historically providing downturn protection.

The advantage of investing in an alternative asset like self-storage is that it is "under the radar screen" of the general investing public compared to residential rental property. A niche asset such as self-storage can mean less competition from other investors, along with oversized returns.

The reason that real estate is a good alternative investment in general is that it checks all of the boxes that passive income investors are looking for:

Income

Real estate investments generate recurring cash flow from rents received from tenants and dividend distributions in private equity investments.

In fact, high-quality investment real estate is often described as having "bond-like" characteristics, only better. According to J.P.Morgan Asset Management, core real estate has high quality, relatively transparent income streams that are well above core government bond yields.

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Related: 3 Reasons Every Physician Should Consider Self-Storage as Part of Their Alternative Investment

Appreciation

Growth in rental rates and asset value is another reason why real estate makes a good alternative investment. In a commercial real estate investment like self-storage, leases are normally on a month-to-month basis.

This means that rents can be adjusted to match the rate of inflation and the demand for storage space in a specific market, unlike residential rental property that typically has 12-month lease agreement or other types of commercial real estate where leases of five to ten years are the norm.

Although most tenants rent self-storage space by the month, the storage unit rental duration is quite long. The average rental duration of a storage unit is about 14 months, with 42% of tenants renting for between one and ten years.

Not only does real estate have a high risk-adjusted return compared to stock and bonds, commercial real estate also acts as an inflation hedge. The Real Estate Research Institute (RERI) recently published The Role of Commercial Real Estate in a Multi-Asset Portfolio.

The report observes that commercial real estate has a positive correlation with both anticipated and unanticipated inflation, and consequently acts as a hedge against inflation. In other words, real estate values generally increase faster than the rate of inflation.

Stability

Adding an alternative investment like real estate can also create a more stable, balanced portfolio for the passive income investor.

Bond-like yields from recurring rental income, asset value growth over the long term, and the inflation hedge characteristics of commercial real estate can provide stability and act as a safe haven to investors through all phases of the economic cycle.

As RERI's report suggests, direct investment in real estate outperforms stocks and bonds on a risk-adjusted basis for a long period of time. By including the performance of real estate in a portfolio optimization model, studies show that about 10% to 20% of a portfolio should be allocated to real estate.

growth in rental rates make self storage a good investment

Benefits of Alternative Investments vs The Stock Market

For generations, investment advisors recommended a 60/40 allocation of stocks and bonds. Today, it is increasingly unlikely that yesterday's allocation rules will provide the returns investors are looking for today and tomorrow.

Alternative investments such as commercial real estate can:

  1. Increase income levels in a portfolio
  2. Lower volatility
  3. Improve overall returns

According to BlackRock, the world's largest asset manager, there are several long-term megatrends that are driving investors to add alternative investments to their portfolios:

  • Technological innovation
  • Fast-growing cities
  • Government focus
  • Sustainability
  • Blending investment universe
  • Competition for prime assets

Because of these shifts in secular trends, alternatives may generate greater returns, reduce volatility, and improve overall returns in a portfolio when compared to a traditional mix of stocks and bonds.

Generally unrelated to the stock market ups and downs

Alternative assets such as commercial real estate generally have a low correlation to the broader stock market. This means that real estate values don't change as much relative to the ups and downs of the overall stock market.

One way to compare the performance of real estate to the stock market is by looking at publicly-traded REITs (real estate investment trusts). An analysis by the National Association of Real Estate Investment Trusts (Nareit) compared the REIT-stock correlation by property type between April 2008 and April 2018.

Their research discovered that property types such as data centers, infrastructure, and self-storage show the lowest historical correlations with the broad stock market. In fact, the average correlation of self-storage to the stock market was a little more than 42% over the 11 year period.

While REITs can provide a good barometer of stock market correlations, the drawback is that REITs are also publicly traded. Because REITs are more liquid than real estate that is directly owned, private equity real estate may actually have an even lower correlation with stock market ups and downs.

As an example, consider the pandemic-induced stock market crash of March 2020. During that time period, the total return index of REITs saw the same double-digit losses of the Russell 1000 and the S&P 500. In large part, the reason REITs stocks declined is precisely because they are so easy to trade.

On the other hand, the value of private equity real estate investments remained unchanged. In both cases tenants continued to pay their rent, but the illiquidity of a private equity investment worked in favor of investors who continued to collect passive income while the stock market sold off.

Direct ownership

Something that almost all alternative assets have in common is that represent direct ownership of the investment. Investments such as fine wine, gold coins, or rare works of art are all assets that can be seen, touched, and felt.

The same is not true for a share of stock. A quick look at the "Proving Securities Ownership" page on the U.S. Securities and Exchange Commission website explains how opaque stock ownership really is.

Real estate is another example of an alternative asset that is directly owned. For example, an investor who owns real estate directly or through a private equity real estate deal has direct ownership of the real property or the joint venture LLC that owns the property.

The same is true of private debt, such as a mortgage note. In exchange for lending a developer money, the investor receives a lien on the property (in addition to regular interest payments). If the project does not work out as expected, both debt and equity real estate investors have the real property as collateral.

On the other hand, shareholders of a publicly traded firm that files for bankruptcy are left with nothing but a loss.

Less volatility

Volatility in investing occurs when the price of an asset or the cash flow generated fluctuates significantly from one period to the next.

With a publicly traded asset like a stock, prices can be highly volatile, going up or down based on the whim of the market and the investing community. Real estate that is privately held for the passive income the property generates can be much less volatile, with lower volatility leading to higher returns.

Let us look at a simple example of how lower volatility works in the favor of the private equity real estate investor.

We'll assume that both assets have a beginning market value of $500,000 and an ending market value of $750,000 at the end of a 10 year holding period. Asset #1 yields a periodic cash flow that increases by 3% each year, while the returns from Asset #2 are much more volatile.

At the end of the holding period, the IRR (internal rate of return) is higher with the less volatile investment than the one that has significant swings in income from one period to the next, even though the returns from Asset #2 outperform the returns from Asset #1 in some years:

Period Asset #1 Asset #2

1 $30,000 $30,000

2 $30,900 $5,000

3 $31,827 $40,000

4 $32,782 $10,000

5 $33,765 $50,000

6 $34,778 $15,000

7 $35,822 $60,000

8 $36,896 $20,000

9 $38,003 $70,000

10 $39,143 $25,000

IRR 9.879% 9.355%

real estate performs better than the public equity markets

Other Types of Alternative Investments

Commercial real estate is the most common alternative asset for investors seeking risk-adjusted returns with a low correlation to stock market volatility.

Investing in real estate can increase overall income levels in a portfolio, lower volatility, and improve overall returns because real property is an alternative asset that acts as a hedge against inflation.

For investors who are willing to accept more risk in exchange for potentially higher rewards, other types of alternative investments to consider include:

Hedge funds

A hedge fund is an investment pool limited to high-net-worth accredited investors with a net worth of $1 million or an annual income of $200,000 or more. The goal of a hedge fund is to maximize returns while minimizing risk.

Investment strategies of hedge funds come in all shapes and sizes, including macro hedge funds, long/short hedge funds, and distressed hedge funds. The compensation model of most hedge funds is based on the 2 and 20 scheme, which means that the hedge fund manager receives an annual fee of 2% of the value of the assets under management, plus 20% of the profits each year.

Although the goal of a hedge fund is to maximize returns for investors, over the last several years hedge fund returns have averaged about 10%, about the same as the broader stock market and less than many private real estate investments.

Private equity

Private equity is capital that is invested directly in a privately held company, versus a publicly-traded stock. Investing in private equity generally requires a long holding period, and higher level of risk in exchange for a potentially greater reward, with ownership share percentages negotiated with the business owner.

Three of the most common types of private equity investing strategies are leveraged buyouts (LBOs), distressed funding, and "funds of funds."

Examples of recent private equity investments include Apollo Global Management providing billions of dollars in rescue financing to companies such as Airbnb and Expedia Group, and the sale of mortgage-software company Ellie Mae Inc. to the owner of the New York Stock Exchange.

Venture capital

Venture capital investors provide startup financing for companies and businesses in exchange for a percentage of ownership, oftentimes with the goal of eventually going public.

Venture capital funding is provided in rounds, including pre-seed funding, seed funding, and Series A through C funding. As the business grows and becomes more viable, the amount of venture capital funding expands and increases until the company can be taken public.

Although the failure rate of venture capital investments can be high, investing in a winner can more than make up for any losses.

Some well-known examples of companies that were funded by venture capital before being acquired or going public include Amazon, WhatsApp, Facebook, Twitter, Uber, Airbnb, GitHub, Spotify, and Dropbox.

Conclusion

The biggest variable in stock market returns is the volatility in the broader market. While it is good to have some investments that can easily be turned into cash, liquidity can also be a double-edge sword when too many investors decide to sell all at the same time.

Alternative investments such as commodities, precious metals, and art and collectibles act as a store of value over time, but do not generate recurring income for the investor over the holding period.

One of the biggest differences between investing in real estate as an alternative asset and virtually any other type of investment - alternative or traditional - is that real estate investors generally have a good idea of the amount of money they are likely to make. Returns in private real estate investments come from income, appreciation, and hedging against inflation.

Related: How to Start Investing in Commercial Real Estate