DIVERSIFYING YOUR PORTFOLIO WITH REAL ESTATE

The decline of the stock market since early 2000 has taught many unseasoned investors a hard lesson: the value of diversification. This isn’t merely a matter of diversifying among stocks, though that’s important. It includes diversifying among asset classes, and one asset class overlooked by many investors is real estate.

Historically, real estate has not performed as well as stocks over the long haul. However, one benefit of real estate, like bonds and cash, is that it helps diversify a portfolio because it is not correlated with stocks. That is, real estate doesn’t go up or down necessarily at the same time or at the same pace as stocks or bonds.

A good recent example of this lack of correlation has been real estate investment trusts, or REITs. These investment companies buy and manage investment property such as hotels, apartments, shopping centers, business offices or mortgages. REITs performed poorly in 1998 and 1999 at a time when stocks were going through the roof. But in 2000, REITs returned nearly 26 percent while the S&P lost 10 percent and the Nasdaq lost 40 percent. REITs had returned nearly 7 percent this year through October, according to the National Association of Real Estate Investment Trusts (NAREIT), while the Dow was down 16 percent.

Clearly, mixing real estate with other elements of your portfolio can help smooth out the bumps. How much real estate you should incorporate in your portfolio depends on your individual circumstances, but most experts would keep it in the range of 5 or 10 percent. As to how you might invest in real estate, you have several choices.

Mutual funds. This is probably the easiest way. A real estate mutual fund typically focuses on REITs or real-estate related companies such as construction. Mutual funds provide the advantages of minimal initial investments, diversification, professional management and ease of liquidity.

REITs. One of the biggest benefits of REITs is that they kick out relatively healthy, steady income streams. The dividend yield on REITs as a whole has averaged nearly 7.4 percent the last seven years, with the lowest year just under 6 percent, according to figures from NAREIT. Price appreciation may add to their total return.

REITs are bought and sold like individual stocks, and that’s one of their biggest drawbacks for many investors. You have to research them as thoroughly as you would a stock, and many investors lack the time and expertise. Furthermore, because an individual REIT typically focuses on a specific type of real estate, often in a specific area, buying only one or two REIT issues provides no diversification. That’s why REIT mutual funds are often a better option.

Rental property. A more direct method of investing in real estate is through rental property such as a vacation home, homes, apartments, multiplexes and office buildings. You’ll likely need to borrow money to invest, and you’ll become a landlord with midnight calls for broken plumbing.

This is a complicated tax area involving depreciation, mortgage interest, management fees, sale and other issues. Tax rules are especially complicated for a vacation home, where you have a mix of personal and rental use. Investment risks include vacancy rates and weak or declining real estate markets. It’s difficult to diversify unless you can own several properties in geographically different real estate markets. Direct ownership also lacks liquidity compared with mutual funds or REITs. But it has the potential to provide fairly regular income, and price appreciation can be substantial if you’re in a booming real estate market.

Raw land. Buying raw land in anticipation of price appreciation resulting from future demand is considered among the most speculative real estate ventures. Financing can be difficult and you run the risk of changing zoning and land use laws. Patience is a virtue here, along with knowledge and luck.

Your own home. Investment experts continue to differ over whether a home should be treated as a distinct investment asset, though it commonly is the largest asset a client has and must be considered in overall financial planning. It can appreciate and you can use excess equity to help fund retirement, for example. However, a home is very undiversified by type and location, and a home carries a personal value that other types of investments typically don’t.

December 2001— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by McGuire & Co., LLP, a local member in good standing of the FPA.