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Why investors should add property to their investment portfolio

Even after multiple investment options and tools are available, real estate will never lose its shine. It is said that a perfect investment portfolio is a balanced mix of different investment vehicles, and not to mention real estate or property is always an essential part of it. 

Buying property and adding to your investment portfolio should be your priority when planning funds for your retirement. 

Explore how a property fits into investment portfolios and why some properties may be better than others for a portfolio.

The key is that the risk of buying a property on its own is higher than the risk that property adds to a portfolio of investments.

Grow your investment portfolio by investing in real estate

Key Takeaways

  • Investors may choose to add properties to their portfolios for several reasons, including diversification and the potential for higher returns.
  • Attribution analysis can be used to identify which factors have contributed to the performance of a portfolio.
  • Investors can use property derivatives to hedge against these risks or take advantage of opportunities in the market.

What is an investment portfolio?

Investment portfolios are a medley of investment vehicles, including stocks, bonds, mutual funds, and real estate. The idea is to have a diversified mix of investments to minimize risk while still achieving investment goals. 

You can plan individual investment portfolios such as Real estate or property portfolios. 

Aggressive, defensive, income, speculative, and hybrid are 5 types of investment portfolios.

Investment portfolio

What is a property portfolio?

A property portfolio is a group of commercial or residential properties owned by an investment company, individual, or family. 

The purpose of a property portfolio is to generate income through rental payments or to appreciate over time so that the properties can be sold for a profit.

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Why do investors include properties in investment portfolios?

The primary reason to include properties in an investment portfolio is regular rental income and long-term capital growth. Both of these elements will likely offer long-term protection against price inflation. 

The income and capital gain are usually less volatile than shares but more volatile than interest-bearing securities like bonds and deposits.

Returns on real estate are different from the returns on stocks and bonds. This is a good reason to hold some income-producing real estate as a diversified investment portfolio. 

There are many benefits of adding real estate to your investment portfolio. 

  • It can act as a hedge against inflation because the value of real estate usually rises along with inflation. 
  • Real estate investment can provide a fixed income stream because rental income from tenants typically remains stable, even during economic downturns.
Investors include properties in investment portfolios

Private investors

Many Australian private investors have one or two investments in their portfolios apart from the family home. 

Investors should build a diversified profile that matches their risk tolerance or risk profile. Their risk tolerance is sometimes used to recommend portfolio mixes.

Whether you are a conservative, balanced, or aggressive investor, the guideline below helps you create personal investment portfolios.

Guidelines for personal portfolio weights

  • Cash means deposits that pay interest and can be withdrawn quickly. 

Investors need a cash reserve in case of an emergency. 

  • Bonds include government or company bonds, debentures, and other securities, most of which have fixed interest rates. 

Since interest payments come first over returns to stockholders, these are usually low-risk investments and make up most of the conservative portfolios. 

  • The property includes direct purchases and property funds holdings, which come with a wide range of risks

Real estate is usually only a small part of a portfolio, but investors willing to take on more risk may put more money into property. 

  • Shares range from moderately risky investments in "blue chip" companies to very risky investments in small companies that just went public. 

Shares dominate aggressive portfolios.

Institutional investors 

Superannuation funds are the leading institutional investors in real estate in Australia (known in other countries as pension funds).

The purpose of all superannuation funds is to provide members with retirement income. 

Most superannuation funds have some "exposure" to the property because it is a long-term investment that gives regular income (to pay pensions) and capital growth (to build up while the members are working).

Almost all superannuation funds start the investment process by setting broad goals for how much of each asset class they want to hold. These goals help the fund and its members reach their long-term goals. 

Most funds put 5 and 10% of their money into real estate. Larger funds put more money into real estate, but most retail funds put less. 

In the past few years, the average target weighting for property in industry-based pension funds has been 10%.

These long-term strategic goals don't stop funds from taking advantage of rising returns in one asset class by making tactical decisions to become overweight in that asset class for two or three years. Fund managers sometimes call these tactical moves "tilting" the portfolio.

When asset managers suggest a property to buy (or sell) to their boards or executives, the choice is almost always limited by the target asset mix and the selection criteria.

The manager will have to show that the property has a good chance of making more than the benchmark rate of return set by the board or executive. The fund manager's main job is ensuring all the "due diligence" steps are taken and negotiating a good deal when a suitable property comes up for sale. 

This is because buying property requires large payments only rarely. This process can take up to a few months. 

The managers of property portfolios also look at how well their current properties fit their needs based on past and future returns. Then, despite the high transaction costs, they may suggest getting rid of properties that are getting worse and pose more risk to the fund.

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How to measure the performance of a portfolio? 

You can reduce real estate investment risks by including properties in a portfolio with other investments. 

If the property's performance is not good, the owner can still get the returns from another property, shares, bonds, or other investments in their investment portfolio. 

Even though the asset mix in institutional portfolios and their property sectors is a hard decision, it is often made easier by looking at past returns to see how diversification has helped. 

You can identify it with the modern portfolio theory using a mean-variance framework. The mean and standard deviation of past returns can be used to examine the effects of building an investment portfolio or adding a property to an existing portfolio. 

Steps to measure the performance of a portfolio

Measuring portfolio return

When you add a property (or any other asset) to an investment portfolio, its weighted return is added to the portfolio. 

The return on a portfolio is the weighted average of the returns on each asset. We can calculate the weight by dividing the asset's share's value by the portfolio's total value.

Measuring portfolio return

Attribution analysis

It is often helpful and sometimes required for funds to compare the return on their portfolio to a benchmark, such as a market or property index. 

If the returns of the index's parts are known, the fund's over- or under-performance can be analysed. There are two reasons why funds did well or poorly in the past compared to a benchmark portfolio. 

For a fund to be successful, it must have either put a lot of money into asset classes or industries that do well or bought assets that did better than those in the benchmark portfolio.

There are different ways to do attribution analysis that show various aspects of the properties and sectors in the portfolio.

When applied to a property portfolio, attribution analysis shows whether a fund's success (or failure) to outperform a benchmark portfolio is due to its choice of sectors or properties.

Measuring the risks in a portfolio

You can use the standard deviation of the portfolio to describe the risk of the portfolio. It is the standard deviation of each asset in the portfolio, reduced by the benefits of diversification.

In contrast to the portfolio return, which is the weighted average of the returns from all its assets, a portfolio does not include all the risks of each asset unless they all respond exactly the same way to every stimulus.

The square root of the portfolio variance is the portfolio standard deviation. 

The portfolio variance is the sum of the variances of each asset and the covariances between them, weighted by each asset's value.

Here's how to figure out the standard deviation of a portfolio with n assets.

Standard deviation with n assets

Property derivatives 

Property derivatives show the rise or fall of defined property markets or stock exchange-listed property trusts. A derivative security is a financial contract giving the right to a return from another investment or commodity.

The return depends on the change in value or income from assets that the trader of the derivative security does not own. The rights are set when the financial instruments are made, but the returns aren't decided until later. 

The instruments could be certificates, bonds, futures, options, or swaps, and their value and returns could depend on a property index, a pool of properties, or a listed property fund.

Except for a few trials and private contracts, the only property derivatives traded in Australia are those based on the major Australian Real Estate Investment Trusts (A-REITs).

Different types of property derivatives

Different types of property derivatives

Property certificates or bonds

People who own property certificates, bonds, or structured notes are entitled to receive income regularly or when the income has built up to the end of the instrument. 

The returns depend on a property index or the average returns from a large portfolio of properties with different types. You can buy the certificates from a broker or the company that made them. 

There isn't much demand for these certificates unless there is a reliable secondary market where investors can sell them back to the issuer or a third party.

"Short-selling" can be done with property certificates or bonds. This means that investors can sell certificates before buying them, hoping to make money if the value of the certificates goes down.

When an investor sells something they don't own, they must leave a deposit with the issuer to cover any rise in the price of the certificates.

Future contracts on a property index

As the name suggests, a futures contract is a deal to buy or sell investments or goods at a specific time in the future. 

In a futures exchange or an "over the counter" trade, the price at the settlement date is set by competitive bidding today.

Most likely, these futures contracts would not be carried out (or "delivered"). Instead, any profit or loss would be paid on the settlement date, or the contracts would be "closed out" by a reversing trade before the settlement date.

Before the settlement, the futures contract can be closed out for a profit, similar to the property index change. However, the property index and futures prices will not change similarly.

A contract to sell an index of future property prices can protect against a drop in property values until the contract is settled.

The futures contract protects against the effect of property prices going down. If the price of real estate goes up, the fund's properties will be worth more, but it will have lost money on the futures contract.

This short hedge reduces the fund's property risk until settlement.

Property swaps

A property swap is an agreement to swap rights to income and capital gain from properties or a property index for rights to some other return. 

The other income could come from other properties or investments, or it could be a fixed rate. The owner still owns the properties but agrees to temporarily give up their rights to rental income or capital gain. 

Most swaps depend on the property index's performance rather than the performance of a property portfolio that one of the parties owns. 

Swaps based on the performance of a property index keep the counterparty from having to research the portfolio of properties on which the returns are based. 

Swaps are usually worked out between two parties individually, with the help of investment banks who bring them together. This kind of trading is called "over the counter," and each deal is made privately instead of being traded in multiples set by the market-maker.

There may also be the possibility of swaps between parties who trust each other. These swaps could depend on one party's properties, with the returns from those properties swapped for the returns from another part of that party's portfolio, probably fixed-interest securities. 

People who know how to buy and manage real estate could sell the rights to a portion of the income from their property portfolio in exchange for similar rights over other assets or cash.

Bottom line

Real estate investment is a great way to diversify your investment portfolio and generate income. However, it's essential to research before investing and consider both commercial and residential investment properties. You may also want to invest in a property syndicate.

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FAQs

What is portfolio Diversification?

Diversification is the process of spreading your investment dollars across a number of different asset classes in order to reduce risk. By investing in a variety of assets, you reduce your exposure to any one security or market sector that may underperform.
For example, if you invested all of your money in stocks, there is a good chance that you would lose money if the stock market crashed. But if you spread your money across several different asset classes, like stocks, bonds, and real estate, then it is less likely that you would lose all your money if one of these investments performed poorly. This way you will have a diverse portfolio.

What are some of the profitable real estate investments for a portfolio?

Commercial property investments are a great way to diversify your portfolio and generate consistent income. Commercial real estate can be leased out to businesses, which will provide a steady flow of rent payments. Additionally, the property value of commercial real estate appreciates at a slower rate than residential property, making them a more stable investment choice.

Another option for profitable real estate investing is purchasing rental properties. Rental properties can provide you with regular monthly income as tenants pay rent, and they often appreciate in value over time as well. It’s important to screen potential tenants carefully and make sure you have good property management in place so that you can maximize your rental income while minimizing any associated risks.

Should you include REIT in your portfolio?

It depends on your risk tolerance and investment goals.
Real estate investment trust or REIT is a type of security that invests in real estate. Some people include them in their portfolios because they offer a high level of income and stability, as well as the potential for capital appreciation. However, real estate investment trusts are also considered to be more volatile than other types of investments, so you need to weigh the risks and rewards before including them in your portfolio.

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