Have you ever sat down with a stock broker to review a stock or bond portfolio? Chances are that they plopped a chart that looked like a mountain range that was intended to impress upon you that the market, although it might have a few bumps along the road, always ends up positive if you sit tight and don’t panic in bad times. It’s also likely that they asked you several questions about how you tolerate risk and then put a colorful pie chart in front of you detailing how your investment portfolio should be spread out to provide for proper diversification. This exercise is to determine how to allocate your investment dollars to different “Asset Classes”.
Simply put, an Asset Class is a group of investments that look and behave in a similar manner to one another. For instance, stocks of large companies that tend to pay dividends are in the Large Cap Value asset class where bonds would be members of the Fixed Income class.
Why is this important and why do we need to spend time on this when we are discussing real estate-backed investments such as mortgage loans and rental property? A fact that many seem to forget is that real estate (including real estate-backed loans) is, itself, an asset class. Contrary to popular belief, real estate does not always appreciate. It acts similarly to how other assets classes work, therefore, looking at how asset classes function is critical to building a strong, healthy portfolio.
In 1952, economist Harry Markowitz penned an essay that introduced the world to his research and something he called Modern Portfolio Theory. With MPT, Markowitz tried to mathematically show what the ideal portfolio mix was by allocating a portfolio’s assets into asset class buckets in pre-determined, supposedly optimized percentages. The theory has its detractors, but it won Markowitz a Nobel Prize and it’s the basis of allocating assets for pretty much every stock brokerage in America, if not the world.
Stock brokers often ignore Real Estate and Real Estate-Related assets as part of a strong portfolio. The asset class should certainly be allocated a sliver of the pie, but many investors struggle to allocate the appropriate percentage of real estate-related assets to their portfolios. Many ignore the class all together while others insist on holding only real estate-related assets. The appropriate balance will vary from person to person, but real estate-related asset should certainly be considered for a portfolio.
I often reference my days at Wachovia and what happened when they acquired World Savings and it’s $122 billion in “Pick-a-Pay” loans. With the PAP loan, borrowers could choose to pay less than the interest due each month and add the remaining interest to their loan balance creating a “negative amortization” or a situation where the loan balance increases rather than pays down. The theory behind allowing this was the erroneous belief that “real estate will always go up!” That, of course, is a crazy notion, but to people in the early 2000s, it seemed completely logical. They failed to remember previous real estate market corrections, recessions, and outright crashes. I assure you, people will forget the bad times again.
The truth of the matter is that Real Estate and Real Estate-Related Assets like mortgage loans are an asset class. They will steadily progress over time and then snap back a bit. They will then inch forward and crash before bouncing back. It is inevitable just as the Sun rises in the East. Although Real Estate tends to be a more stable asset class than many others, it is still an asset class and it will act accordingly.
Understanding this truth will help you avoid the pitfalls that regularly doom investors. With the Pick-a-Pay product, loan balances increased and, when the market corrected, borrowers found themselves with loan balances higher than what their homes were worth. This upside-down situation caused many to walk away from their loans leaving the lenders to have to resort to costly foreclosure actions and losing millions and millions of dollars in the process. This is what eventually sunk Wachovia, one of America’s largest and strongest institutions prior to purchasing the company that held more than $100 billion in these negatively amortizing loans. They lost sight of sound underwriting principles and it cost them their bank.
Another very important take away from studying asset classes and Modern Portfolio Theory is that MPT encourages investors to “spread the risk”. Often times real estate investors will go all in on a single asset and stretch outside of where they normally would go. This was the case with one of my biggest mistakes in portfolio management.
I was speaking at a conference in Dallas when a principle of one of my old business ventures called to tell me about a property he had found. He had put down a $10,000 non-refundable deposit on a property that was considerably outside of our normal scope. It was much more expensive than anything we had undertaken but it was in a fantastic location. When I returned from the trip, I analyzed the deal in detail and my first reaction was to walk from the $10,000. There were many red flags with the project and it was a situation where many of our resources were being allocated to one deal. I should have listened to my gut, but I had a delusion of grandeur that we would be able to make a silk purse from a sow’s ear. In the end, we took a bath on the deal, it stunted that entity’s growth, and ultimately contributed to the breakup of that investment group. I’ve not made the same mistake since. I knew better, but I forgot the lessons that I learned through years and years of building portfolios.
The study of real estate behavior over time has shown us that real estate does not always appreciate in the relatively short run. Like other assets classes, it does tend to bounce back over time after a correction, but if you are operating a real estate or loan-based fund, investors will not usually wait for the market to bounce back. Keeping your ratio of your investment to the real estate value is just as critical as avoiding overextending for any one deal. Being a good steward of your portfolio’s assets means that you must remember these basic truths if real estate-related investing. In the end, real estate is simply another assets class. Treat it accordingly.