In the wake of the Property Investor Show at Excel in London recently it seems apposite to look at how the serious real estate investor should be creating his/her portfolio and what issues need to be incorporated into the decision making process.
Portfolio theory and its relevance
We all know that investing in bricks and mortar is not the same as buying stocks, shares or bonds but that doesn’t mean the theories applied to stock market investing are wholly irrelevant. Sure, property is less liquid and tends to be less volatile in terms of price movements and it is less sensible to use debt when buying shares. Nonetheless, portfolio theory still has some useful aspects for the property investor.
Just to summarise (rather swiftly) on the basics of portfolio theory: each asset (share, property, classic car, etc) will experience price fluctuations in line with two distinct influences. The first is referred to as market risk, the risk that affects all assets in the particular asset class concerned. So, for example, if the general market view on shares in UK entities is negative (bearish) then all shares on the UK market will be subject to that mood – this is not the same as saying all shares will fall in value but even a share experiencing upward motion in such conditions will find that upward momentum slowed by the market sentiment.
The second influence is called specific risk and expresses the notion that an asset has its own risk features which are independent of the market and will put pressure on the asset to increase or decrease in value irrespective of what general market sentiment is. So if the classic car market is growing and sentiment is positive (bullish in stock-market jargon) but E-Type Jaguars are out of fashion this specific risk will hold their values back in comparison to the rest of the market and may even mean E-Types fall in value whilst the rest of the market grows. Clearly, specific risk is where one makes (and loses!) the greatest amount of money as this risk is generally far higher than market risk.
By measuring these risks it is, theoretically, possible for a portfolio manager to match the risk profile of any given portfolio to the risk profile of the person who owns it – an individual needing his pension from the portfolio will want to get rid of specific risk far more than someone who is looking to achieve relatively short-term growth. For the former the number of assets within the portfolio needs to be greater than 20 and to be well-spread as this largely eradicates specific risk.
Portfolio theory and property investing
The same principles outlined above should also be applied by the serious property investor by asking a few basic questions and then constructing the ideal portfolio based on the answers:
• What risk profile am I looking for from this portfolio? If it is the primary source of your future pension you want a well diversified portfolio. If, on the other hand, you want quick returns you will need to focus more of the invested cash into higher risk/higher return products;
• Where do I feel are the riskier and less risky areas/products/types? This will assist you in developing the portfolio to match the profile you have selected;
• How much gearing (borrowing) am I prepared to use? The more money you borrow, the more you can buy but a small drop in the value of the assets can quickly leave you in negative equity, wiping out any benefits of owning the properties;
• How long do I want to hold the assets? Again, stocks and shares can (at least in theory) be sold easily and quickly – they are what is termed “liquid”. Properties take a lot longer to turn into cash so if you are likely to need money sooner you may be better investing through a fund such as this one or some other financial instrument rather than in the underlying assets themselves.
Rather than get into too much detail on the theories here it may be worth looking at a few potential portfolios that you could construct. I have, therefore, chosen to create them on the following basis:
Portfolio 1: a lower-risk portfolio designed to generate consistent if unexciting returns over a 15-20 year period and well diversified to reduce specific risks associated with particular markets and products;
Portfolio 2: a medium risk portfolio designed to generate good, healthy underlying returns but with some higher risk products bought with plenty of debt to benefit from potential growth in value in more dynamic markets. These latter products will need to be monitored and maybe switched more frequently within the life of the portfolio but give an upside and downside exposure that adds that bit more risk and chance of greater returns;
Portfolio 3: really designed for a short-term gain which should be cashed in within 3-5 years and re-invested in another portfolio at that time. Borrowing to finance this portfolio is essential really to maximise the returns but this portfolio has a much greater exposure to losses as a consequence of its profile.
I have only selected 5 products for each to give a snapshot of the sort of thing one might include and because not many property investors will have the capacity to make more than 5 purchases within the next 9-12 months.