Ever since Daniel Bernoulli made the first formal case for diversification in 1738, investors have understood the importance of diversification. We live in an uncertain world, and regardless of your conviction about investment, there is always a chance that that idea is wrong. Diversification protects an investor against errors. Despite this widely held view, many investors do not take the opportunity to diversify their investments in real estate. Here’s why you should.
Diversification Should Occur Across Assets
Diversification often means that an investment portfolio should have many investments of the same asset class. So, for instance, an equity investor will have a portfolio of stocks. However, this is very wrong. Diversification is a multi-dimensional concept. You have to diversify across geographic regions to avoid home bias, and diversify across assets to avoid suffering from a downturn in a particular asset class.
Often, people believe that if there is a downturn in the equity markets, they should cash out and sit on the sidelines, but that logic is flawed. An investor should always be invested in asset markets. Asset markets are like banks, and just as you wouldn’t withdraw your money and put it under your pillow, it’s foolish to sit on the sidelines of asset markets. The real question is the tilt of your portfolio at any given time. That means you need an investment portfolio with various assets: stocks, bonds, gold, and real estate, and if you don’t mind the volatility, cryptocurrencies.
Real Estate is a Source of Income
Some of the best equity investments are into companies that do not pay out any dividends. Management feels that the growth opportunities ahead are such that it can use the company’s free cash flow to create shareholder value at attractive rates. Many tech companies, for example, do not issue any dividends. Although you can rectify that by buying shares in dividend-issuing companies, given the need for asset diversification, getting a stream of income from real estate is extremely important in real estate’s favor.
The Housing Market is Going Upwards
Although the housing bubble has eased in recent months, housing prices are trending upward in the long run. Investing in real estate with a reasonable margin of safety is likely to be richly rewarded. Although the consensus in the wake of the Great Recession is that housing prices are linked to easy money policies, research by the St. Louis Fed shows that construction costs drive home prices. The chart below shows how new home prices have moved in tandem with construction prices over the last few decades.
Source: Federal Reserve of St. Louis
As we enter a period of inflation, this implies that housing prices will rebound as inflation takes hold. That presents careful investors with an opportunity to make some real capital gains.
Real Assets Do Well During Inflation
Inflation is the friend of owners of real assets, whether they are commodities, farmland, or housing. Not only is this because inflation, by definition, means that asset prices are rising, it’s also driven by the fact that during inflation, but investors are also under pressure to find investments that can beat the inflation rate. Given that real estate is relatively inelastic, the supply of real estate does not move much, at least in the near term, and farmland is a pretty finite and fixed resource. Investors such as Warren Buffett and Bill Gates have invested heavily in American farmland.
Food Shortages Are Here to Stay
Farmland is very attractive once you realize that food shortages are worsening, even as the global population grows. We are simply not producing enough food to feed the world’s population. Not everyone can buy acres of farmland, but you can invest in farmland through real estate investment trusts (REITS) that are listed on the stock market and give you fractional farmland ownership.
The Great Migration
According to the Census Bureau, in recent decades, Americans have been moving to the South and West of the country in search of better living conditions, bigger homes, and lower living costs. This migration was accelerated during the pandemic, where remote work allowed millions of Americans to leave metropolises in other parts of the country and move to the South and West. Much of the housing bubble was fueled by the demand for homes there.
An under-appreciated aspect of investing is that you also have to invest across different time periods, holding some assets for short periods because their value is likely to decay very quickly and others for an extended period because their value will last a long time. Even Warren Buffett, a long-term investor, makes many short-term investments, his most famous being his purchase of shares in PetroChina, which lasted just five years. Real estate provides an asset whose value creation occurs over a very long period.
Rents Will Go Up
As a function of rising real estate values, and migration patterns, you can bet on rising rents, at least in the South and West and in the suburbs. This means that investors will be able to counteract the influence of inflation with rising rental incomes.
Inflation Will Make Mortgages Cheaper
Finally, much discussion around mortgages has been about rising mortgage rates. However, as the European energy crisis deepens, the supply chain disruption continues, and the world drifts toward deglobalization, inflation is likely to remain a problem for several years, and the Fed will not be able to raise interest rates fast enough to counteract it. Runaway inflation will reduce the cost of mortgages, pushing real estate values up.
Real estate is a stable investment that will continue to grow in value. -It is essential to diversify your investment portfolio; real estate should be one of your choices. -There are many options when investing in real estate, so find one that fits your needs.
-Now is a great time to invest in real estate!
Don’t wait any longer; start investing today!