Stock Plunge Highlights the Importance of Diversification

The sharp drop in equity values in the stock market on Friday, February 2, 2018, and then again on the following Monday, reminded us as investors of the importance of prudent risk management.

A portfolio of stock investments does not provide sufficient diversification.  Diversification across asset classes is important.

The yields on government bonds have been artificially depressed by the Federal Reserve’s aggressive Quantitative Easing program, with many investors choosing to underweight government bonds as an asset class so that returns are not dragged down by the depressed current yields on these bonds.  Corporate bond values are dependent on the same cash flows that drive corporate equity valuations, reducing their effectiveness at diversifying one’s portfolio.

Adding real estate to an investment mix may increase the diversification of one’s overall investment portfolio. A number of studies have found some evidence that private real estate indices correlate only weakly with equities and bonds (although results vary over time and investment horizons), and in recent periods has itself exhibited less volatility in total returns.  The tax law was generally friendly to commercial real estate.  In this note, I would like to focus on the potential impact for of the changes in the tax code that were just passed by the congress and signed into law by the administration, and by demographic changes as millennial start forming households at rates closer to historical norms to the commercial multifamily apartment asset class.  Let’s analyze each of these factors separately.

 

Tax Reform

The tax reform passed by Congress and signed into law by President Trump encompassed several changes that reduces the implicit subsidy for owner occupied housing directing demand towards rental housing.  The standard deduction for a married couple was almost doubled to $24,000 from $13,000, the deductibility of state and local taxes was capped at $10,000 and the deductibility of mortgage interest was capped at $750,000 in principal balance.  Congress’ Joint Committee on Taxation estimates that, due to these and other changes in the tax code, 94 percent of taxpayers will choose to take the standard deduction, up from 70 percent in 2016.

Tax payers taking the standard deduction eliminate any implicit subsidy towards a purchase of an owner-occupied house, as they will get the same standard deduction if they choose to rent.  These changes will push demand towards rental housing.  On the operator side, interest expenses, taxes, and depreciation continue to be deductible, and the tax reform plan provides operators with a potential reduction in tax rates on taxable rental income for pass through companies.

 

Multifamily

With the forecasted move toward rental properties, RealtyShares recently completed a study of apartment equity returns. The study demonstrated that historically non-major metro / middle market investments can provide higher returns over the long run than returns in major metro-market institutional sized deals.

 

Millennials

On the demand side of the equation, it appears that millennials are finally starting to form new households at rates similar to older generations.  This generation had put off establishing families and setting up households longer than previous generations, opting to live with parents longer, deferring marriage, and doubling up with roommates.  The homeownership rate has finally begun to tick up, and the tax law changes we discussed above are likely to divert a larger fraction of these young household forming families to the rental sector relative to what would have happened under the previous law.

Together these factors provide support to the idea that one should consider middle market / non-major metro apartment buildings as an alternative asset class with the ability of providing additional diversification to stock-heavy portfolios.

 

Neither RealtyShares, Inc. nor North Capital Private Securities Corporation, as institutions, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied.  Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.

Arash Sotoodehnia on Linkedin
Arash Sotoodehnia
Arash Sotoodehnia
Chief Credit Officer
Arash has over 20 years of risk management experience. He started his career at Fannie Mae primarily responsible for developing Fannie’s multi-family guaranty fee models. He then moved to RFC/GMAC/Ally where he held various risk management roles. Prior to joining RealtyShares, Arash was Head of Risk Policy and Controls at CitiMortgage. Arash holds an SB in electrical engineering from MIT and a PhD in economics from JHU.
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