Real Estate – a Refuge from Unnerving Stock Markets?
The recent sharp drop in equity values in the stock markets has shattered what had been a lengthy period of low volatility and a mostly uninterrupted climb for equities. After months of unusual calm, fear has raced back onto Wall Street in dramatic fashion. The VIX index of market volatility spiked by a record 116% to the highest level in more than two years on Monday.
The heart of the stock market sell-off seems to be about inflation. More specifically, it seems to reflect a fear that wages and prices are going to rise faster than expected, and that the Federal Reserve is going to fumble its attempts to keep inflation in check.
“When inflation is very low, rising inflation has a positive impact on equity valuations,” said Michael Wilson, chief U.S. equity strategist at Morgan Stanley. “But with the equity risk premium now close to full/fair value, rising inflation expectation may no longer be a positive for stocks, especially if markets start to think inflation is coming ‘unhinged.’”
Inflation Risk – Is It Real?
Moderate inflation is a healthy component of an economy. But markets currently seem to fear inflation could quickly grow overheated. Should that happen or even appear to be a real risk, the Federal Reserve would probably raise interest rates, a move that could dramatically slow the economy or even contribute to a recession.
“The employment report on Friday showed wages are growing at the fastest rate since the recession,” said Torsten Slok, chief international economist at Deutsche Bank. “Investors are waking up to the fact that we won’t have low interest rates forever.”
“There is not a high chance of a recession,” Slok said. “There is a high chance of the economy overheating. The market is reacting to good news, not bad news.”
Real Estate Markets Have Been Relatively Stable, Despite Economic Headwinds
As we’ve earlier noted, one of the characteristics of commercial real estate is that it can act as a potential hedge against the cycle of the stock and bond markets.
Some key reasons to consider RealtyShares and commercial real estate investing in times of instability can include:
Income-generating potential — Our mix of debt and equity real estate investments should allow us to provide current income to our investors. Debt investments should (unless there are defaults) produce periodic interest income, while equity investments may produce some periodic income derived from a property’s rental revenues in addition to the potential future gain or loss in the form of price appreciation, or depreciation, that may be realized upon the sale or refinancing of a property. .
Asset class diversification, with potential reduction of a portfolio’s volatility — Adding real estate to your investment mix may increase the diversification of your overall investment portfolio. A number of studies have found that private real estate indices correlate only weakly with equities and bonds, and in recent periods has itself exhibited less volatility in total returns.
Potential hedge against inflation — Real estate has the potential to act as a hedge against inflation because property values and rents have historically been positively correlated with growth in inflation. Appreciation in property values can be a significant part of the returns on an equity real estate investment. Property rents are typically tied to inflation, and a property’s value is generally tied to its rental income, so as inflation drives up rents, the value of the underlying property may increase as well. Inflation also generally makes new construction more expensive because the cost of building materials rises, and the resulting fewer competing properties tends to support the value of properties already in operation.
Potential tax benefits of common equity investments in commercial real estate — Common equity real estate investments can, if structured through pass-through investment vehicles, typically benefit from deductions related to depreciation, interest expense, and other items help to defer taxes on cash distributions. The reduced tax rates applicable to many investors in commercial real estate that resulted from the Tax Cuts and Jobs Act of 2017 may serve to amplify these potential benefits compared to those available in past years, although every individual’s tax situation is different.
Commercial real estate is the third largest asset class (excluding cash) in the United States for institutional portfolios, and institutional investors generally target a 9-10% allocation to real estate. No investment is guaranteed, of course, and a commercial real estate investment can lose value just like any other investment class. It can have default risk, liquidity risk, market risk and interest rate risk, among others. Commercial real estate has unique characteristics, however, and its ability to provide cash flow, low volatility (for private real estate), a hedge against inflation, diversification, tax benefits, and its nature as a hard asset all potentially argue for its inclusion in an investment portfolio.
RealtyShares offers securities through North Capital Private Securities Corporation, member FINRA/SIPC. Neither RealtyShares nor North Capital, as institutions, provide tax, legal or investment advice, and this article should not be construed as such. Before making any investment, investors should consult with their own attorneys, accountants or other investment advisors.