Over the past decade, “main street” investors have awakened to the power of illiquid alternative assets. Alternative assets are loosely defined as types of investments that transact on private markets. In other words, not the stocks, bonds, and exchange-traded funds that transact virtually real-time, and make up the bulk of most investors’ portfolios.
“Traditional” assets, like the stocks that comprise the S&P 500, can be bought or sold at any time through any number of platforms. The barriers to entry are miniscule, the liquidity is nearly instant. That’s why traditional assets are a great place for any individual investor to begin their journey, and why a “70/30” or “80/20” stock/bond portfolio is where most investors begin as they find themselves with surplus capital in their 20’s or 30’s.
When it comes to a long-term investing strategy, though, illiquidity is a feature, not a bug. Savvy investors are supplementing traditional assets with alternatives to achieve balance, diversification, and long-term portfolio stability. Real estate crowdfunding, in particular, is a great place to start for any investor looking to diversify into illiquid alternatives.
Why Invest in Alternatives?
Precisely because they are illiquid, and transacted through private, inefficient markets. Because of this, alternatives can provide both a strong complement to public markets and a risk/return profile that stands above what traditional assets can provide.
Institutional investors like the Harvard Endowment have made alternatives like private real estate a fixture of their portfolios for decades. Individual investors now have a new level of access to close the allocation gap.
Here are three major, interrelated advantages of investing in private-market alternatives:
As of Fall, 2021, the stock market has generally had a good recent run. But it wasn’t so long ago, in late 2020, that the S&P 500 tumbled 10% in just a few days. Swings of more than 2% are far more common now than in prior decades. Volatility has become the new normal precisely because of the liquidity of public markets, and due to the velocity of information in an increasingly connected world. Anxieties over viruses, geopolitical tensions, and even internecine corporate politics can all trigger price dips. Because alternative assets are not traded on public exchanges, their pricing tends to move more slowly in parallel with underlying economic conditions. Over time, adding alternatives to an investment portfolio can potentially help to reduce the overall volatility of the portfolio.
Mitigating Cross-Asset Correlation
In crafting a long-term asset allocation strategy, investors can potentially reduce the volatility of the portfolio by minimizing the degree to which assets in their portfolio move together. Historically, private-market real estate values correlate less tightly with pricing in the stock market than other asset classes. While bonds bear a 0.25 correlation vs. stocks, and public REITs bear a 0.31 correlation with public stocks, private real estate has exhibited only a 0.07 correlation with stocks. In other words, private-market real estate bears less than one-third the correlation with stocks as bonds; and less than one-quarter as public REITs do.
Pursuing an allocation of less correlated asset classes means that an investor will potentially be less vulnerable to market swings and mitigate the risk of losing major portfolio value closer to retirement.
Potential to Realize “Alpha”
Values of stocks can move, sometimes precipitously, with market sentiment. Values and cash flow from alternatives (like commercial real estate) depend on the skill and competence of individual operators — e.g., the investment firms, developers, and property managers realizing value from these “hard assets.” Hence, alternatives have the power to deliver “alpha”: returns specific to a given asset and driven by quality management. Diversifying into investments with the potential to deliver alpha can potentially increase a portfolio’s overall potential for appreciation and cash flow.
Why is Real Estate Crowdfunding the Place to Start?
Investors can now tap into a wide array of alternative asset classes, including farmland, fine art, rare wines, and even collectibles like sports cards and memorabilia. This is a good thing, as investors can tap into an even wider array of return profiles (and have some fun along the way).
But real estate remains the tried and true “next step” for investors looking to diversify beyond a traditional portfolio. Here are just a few of the reasons:
Many shapes, sizes, and return profiles
Real estate generally offers a great combo of tax advantages, low volatility, appreciation, and cash flow potential. Through real estate crowdfunding, investors can also access a broad range of return profiles. The real estate crowdfunding industry has crystallized around a handful of quality platforms that specialize in different types of real estate investments. Different property types (apartments versus industrial warehouses versus office space), different geographies, and different strategies (buy-and-hold vs. value-add vs. ground-up development) all offer different types of return profiles.
EquityMultiple, for one, offers commercial real estate investments across the “capital stack,” from senior debt, offering a flat rate of return over a relatively short term, to opportunistic equity investments that target higher upside over a longer duration, while also prioritizing interim cash flow from property rents. Most platforms offer investments at a minimum check size much lower than historically have prevailed in private real estate investing (EquityMultiple, for example, starts at $5,000). These low minimums help investors diversify not just into real estate, but across different profiles of asset to further spread risk across their portfolio and pursue a variety of channels for passive income and appreciation.
Among these more tangible asset classes, it’s the most tangible
Classic cars, fine art, fancy wines, and rare baseball cards are all real objects. But as an investment asset they are not tangible in the way that real estate assets are. Collectible cards and art, for example, are as valuable as people think they are. No one would deny Picasso’s genius, but one of his great works does not provide an essential good; it’s at the top of the hierarchy of human needs. Real estate assets, quite the opposite, provide value that society cannot do without. No matter what else happens in an economy, or which way the cultural winds blow, all members of society will still need a place to live (and generally, also need places to congregate and do business).
Due to this intrinsic worth and essential nature of real estate, it can be considered perhaps the most stable asset class, as evidenced by the low historical volatility of the sector.
It is in the best position to deliver cash flow
Fine wine may have the potential to pay huge dividends when it’s sold, and wine has a proven record of appreciation over time. However, a bottle of wine sitting in a climate-controlled cellar does not have the ability to issue monthly payments to investors. In fact, trophy assets of this sort may carry negative cashflow due to ongoing maintenance and insurance costs. Real estate, on the other hand, has the potential for positive NOI (net operating income) from rents. Depending on the structure of the investment, passive investors may be entitled to regular cash flow, which can free up capital for other purposes, reduce liquidity risk, and help to produce compound return effects.
Allocating to alternatives is a critical step for investors. Due to the tech-driven expansion of investment options and relatively low minimums, it has never been easier for self-directed investors to not only find alternative investment opportunities, but also to build a diversified portfolio of alternatives. Real estate crowdfunding provides a logical first step for investors who are seeking to go beyond a traditional portfolio of publicly traded assets.
1Source: U.S. 2018 Insights on Wealth & Worth
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