It has been three years since the Dow Jones Index was at its peak of over 14,000 points in October 2007. The last 36 months have been tumultuous for investors. Major institutions collapsed, some even disappeared.
During that time, portfolio managers kept having to adjust and shift, seeking safety in products such as fixed income instruments and sovereign bonds while shunning structured products, hedge funds and private equity.
Yet, from the second quarter of 2009, most were caught off-guard by the sudden strength of the equities market, or the sustained strength of commodities such as gold and oil.
Moving further back to mid-September 2005, the Dow was around 10,600 points, just below today’s level of around 11,000. Capital gains from investing in the Dow Jones Index have been zero over the last five years.
But the global real estate category presents a different picture. Real estate derivatives such as mortgage backed securities and mezzanine loans remain tangled between landlords, financiers, hedge funds and construction companies. Prices of real estate in major financial centres such as London, Tokyo, New York and Dubai are still on soft ground whereas prices in Shanghai, Seoul, Singapore and Hong Kong have trended up firmly.
It is a tough job for portfolio managers who are trying to balance their clients’ investments to minimise risks while going after maximum gains. In volatile and uncertain times, what is a ‘balanced portfolio’?
Modern portfolio theory prescribes diversification in investing. The aim is to maximise the returns of an investment portfolio based on mixing and matching several assets such that the overall portfolio has collectively lower risk than any of the individual assets.
Private banks and discretionary portfolio managers have a reference balanced portfolio which they will recommend to high net worth individuals (HNWIs). They tailor the portfolio to suit the client’s tastes, preferences and risk appetite. A typical balanced portfolio might comprise 25 per cent fixed income (such as bonds, interest rate products, fixed deposits), 40 per cent listed equities, and 35 per cent alternative investments (such as hedge funds, commodities private equities).
However, direct ownership of real estate is rarely included as real estate tends to be illiquid and difficult to value within a diversified portfolio.
An investment advisor in a local private bank recommends a balanced portfolio based on 55 per cent equities, 25 per cent fixed income, 10 per cent commodities and 10 per cent alternative investments. Any direct real estate investments or real estate derivatives (such as unlisted debt instruments or shareholdings in buildings and developments) are treated as private equity and classified under the alternative investments category.
In Singapore, with property prices the way they are today, investment in real estate starts from a minimum of $500,000 for a ‘matchbox-sized’ private residential unit.
A typical HNWI would own a residential unit with a value of, say, $4 million; this we exclude from the value of the total investment portfolio. This same investor might have another $1 million apartment purchased with $600,000 cash and financed with a $400,000 mortgage. Net equity at current valuation is $200,000. To have a balanced portfolio that included this investment property, based on 10 per cent allocation in a portfolio, the investor should have another $1.8 million allocated to equities, fixed income, cash and alternative investments.
Therefore, in Singapore, the minimum level of wealth required to even begin contemplating a diversified, balanced portfolio will be north of an investible amount of $2 million.
In the US, by comparison, a diversified investment portfolio can start from US$500,000 given that the median price of a single family home8 is less than US$180,000.
HNWIs have always been active in the luxury real estate market. What attracts them are the potential capital gains (often more than the steady rental income stream) and the perceived lack of correlation with the stock market.
Residential properties offer relatively high loan-to-value ratio of up to 70 per cent (for investment residential properties) in Singapore. With low mortgage rates, servicing interest costs is easy. And, even at the worst of the market in the first quarter of 2009, there was no mark-to-market, scarce cases of top-ups and few cases of margin calls as long as investors serviced their loans promptly. Real estate seems to be a favourite, especially among Asian HNWIs.
“The flip of the coin is the limited liquidity,” cautions Bassam Salem, Asia Pacific Head of Investment Advisory at EFG Bank. “Real estate capital gains are valid once the investor sells but when most investors want to sell, typically as prices start to decline, they find there are no buyers.”
Given the absence of an efficient pricing mechanism such as a stock exchange, property prices are indicative until a transaction takes place. As landlords turn sellers in an economic downtrend, buyers become more cautious, financing gets tougher, credit tightens and mortgage spreads widen as lenders price in increasing risks. This makes it almost impossible to sell under such circumstances (recall the period of fear from January to March 2009).
An alternative to brick-and-mortar investment is real estate investment trusts or REITs.
REITs are attractive for several reasons. They provide access to a diversified property portfolio but, more importantly, come with daily pricing on the stock exchange and immediate liquidity.
For investors with long-term horizons, in excess of 10 years, REITs provide an alternative to direct ownership and offer returns comparable to those of private property. However, for investors with a shorter time horizon, REITs have a higher correlation with the stock market.
Intuitively, the correlation between REIT returns and physical real estate returns should be high. The Urban Redevelopment Authority’s (URA) Private Property Index (PPI) rose from 115.5 to 184.2 points over the past five years — an increase of 59 per cent. This compares well with that offered by REITs, but the similarities end there.
The URA PPI does not capture monthly income returns nor does it account for geared returns and the costs of property and tenant maintenance. Furthermore, there are no residential REITs in Singapore to allow residential investors a proxy to measure their performance against.
Also, the mortgage against a property levers it such that during a downturn, investors could be holding on to paper losses or, worse, holding on to net debt where the outstanding mortgage is above the market value of the property. Investors in REIT units, even with margin financing, almost never step into negative equity because preset margin calls will be triggered and forced selling will take place.
I believe that the tangible nature of physical real estate is what makes it attractive. The property’s physical attributes, aesthetics, facilities, interior décor, ambience, location and monthly rental income tickle the fancy of investors.
There are emotional attachments even for many experienced real estate investors. And this is the Achilles’ heel of investments. Save for your own dwelling, any other investment into real estate should be based purely on facts, data and numbers. Let the numbers speak for themselves. Once emotions are involved — “if there are no tenants, I can stay in it myself” — judgement gets clouded and the returns objectives become unclear, both at point of entry and at point of exit.
We can find more examples of successful financial investors than real estate investors. Why? The reason is simple — it takes a lot more to get emotional over ticker symbols or fall in love with equities or, worse, to get excited over something as dry as an equity-linked note. We are able to objectively weigh the risks and returns of financial investments as our analyses are not clouded by emotions.
For those of us who love real estate, my advice is this — buy with your head, not with your heart.
8 The term ‘single family homes’ is used in the US and Australia and is equivalent to our landed properties, as opposed to ‘multi family homes’ which are apartments and condominiums.