Income Property Meets Portfolio Theory
Many stock market investors have become familiar with the work of Harry Markowitz in creating a methodology known as “Portfolio Theory” for managing equity investments. The fundamental premise of portfolio theory is to maximize the rate of return for a given level of volatility (risk) by diversifying with multiple financial instruments that are not perfectly correlated in the way that their prices move.Traditionally, portfolio theory bases all of its calculations on the ‘risk-free’ rate of return, typically assumed to be the rate of return from government bonds. By constructing a diversified portfolio of debt and equity investments of varying degrees of risk and return, the idea is to create a portfolio that approaches the ‘efficient frontier’ where an optimal trade-off is achieved between risk and return. In this way, an investor can reduce the impact of sector-specific market movements on their overall investment portfolio.
The thing to understand when evaluating investments is the impact of volatility on your performance estimations. Especially the impact of systemic volatility, which is a label that financial theorists give when disruptions in a particular market segment or of a particular variety impact ALL securities of a particular asset class. The most prominent example of this phenomenon is the financial crisis of 2008. When the financial crisis occurred, it had a large detrimental effect to large, medium, and small capitalization stocks, along with foreign and emerging market stocks. The massive market disruption cut through the portfolios that were diversified among financial assets alone and slashed values. This has caused some to question the value of portfolio theory and theorize that only ‘behavioral’ matters are important when making investment decisions. (‘Behavioral’ finance is based on the notion that people do not make rational decisions, and are instead driven by various heuristics or decision-making paradigms)
Our viewpoint is that both rational and behavioral matters are important. While it is certainly true that people do not always act in a manner that ‘we’ consider to be rational, it is quite true that people act in a way that ‘they’ think is rational. The ultimate effect of this is not that portfolio theory should be abandoned. Quite to the contrary, the quantitative models of Harry Markowitz are very important to long-term success as an investor. What we need to understand is the limitations of these models and the impact of events that are not contained within the bell-curve normalized statistics that are used to create the risk models.
A great deficiency of the financial industry is that it has limited itself to applying the fundamentals of portfolio theory to simple debt and equity investments. Since most of these investments derive their value from market value instead of cash flow, the prevailing financial models are based on volatility of market values, which are assumed to be continuous in both the up and down direction. Even with bonds, their market value fluctuates based on movements in the market rate of interest. As astute investors, we should seek to build investment systems that truncate our volatility so that our downside is limited, but the upside is large. This is very difficult to do with traditional financial instruments since stocks and bonds are necessarily bi-directionally volatile and option contracts incur transaction costs that require substantial rates of return just to cover your expenses.
The way that we use the fundamentals of portfolio theory to our advantage as astute investors is to build investments with multiple factors that have varying levels of (uncorrelated) volatility. One of the most efficient ways to accomplish this goal as an individual investor is through income property. The following is an analysis of the key factors specific to income property and the implicit volatility of each.
Income Property Factors:
Market Value:
The market value or price of income property is where most analysis begins and ends. It is the single factor that most people think of, and is the most volatile. For an all cash buy-and-flip investor, market value is the only factor that matters. For people who purchase property with financing, the effect of price changes are amplified, increasing the effective level of volatility. Uneducated investors will not beyond market value when assessing real estate and income property, but astute investors recognize that there additional factors in play.
Base Volatility: Low to Medium
Leveraged Volatility: Medium to Very High
Rent Income:
When a real estate investment is rented out to tenants, it becomes income property by nature of the rent income that it produces. The inherent volatility of rents vary drastically depending on the type of property you own. Generally speaking, residential income property near major employment areas have very low rent volatility. The ample supply of tenants make it relatively easy to fill vacancies at the market rate of rent. When a property is located in a vacation destination, rents will necessarily be more volatile since the rents come from many tenants and require constant marketing to find new renters. Similarly, if a property is located in an area facing employment and population decline, it may be difficult to find tenants with stable employment.
Volatility: Very Low to Medium
Mortgage:
One of the greatest gifts granted to income property investors is the 30-year fixed-rate mortgage. The reason for this is that it allows investors to lock in their cost of financing for three decades. In this case, your level of mortgage volatility drops to zero. This is extremely valuable for an income property investor, since the single largest cost for most property investors is the mortgage. If that cost can be fixed for three decades on a self-liquidating loan, it allows you to effectively plan for future rates of return with the main cost staying fixed. To the extent that adjustable rate mortgages are employed by investors, mortgage volatility can increase, but it is generally optimal for long-term investors to seek fixed-rate financing.
Volatility: Zero to Low
Tax Treatment:
Another tremendous advantage of income property investing is the highly advantageous tax treatment that real estate enjoys relative to other asset classes. Some of these tax advantages phase-out as investors reach higher levels of income, but most have been in place for a long time, and are expected
to continue into the future due to the extreme political unpopularity of taking away real estate related tax advantages since a very large number of politicians, voters, and key contributors hold significant real estate assets.
Volatility: Very Low to Medium
When these four factors are combined by an astute investor, they create a highly favorable blend of return generation and downside protection. By purchasing an income property where the market value is low enough relative to rent income such that positive cash flow can be achieved each month, it places you in a highly advantageous situation. The reason for this is because volatility in the market value is offset by the stability of fixed-rate mortgage payments that are paid by income received from renters. In this situation, if the market value shifts downward it does not need to distress the owner since rent revenue can ensure that the mortgage payments are still made while market values recover. If market values increase, the owner has the option to sell and re-invest the profits into new opportunities. In addition to this, the tax advantages of depreciation and tax-deferral of capital gains are continually present.
By intelligently combining these factors, it creates a ‘free option’ for investors where downside risk is truncated and upside opportunities are preserved. Furthermore, real estate markets are local and fragmented. This means that income properties diversified across multiple markets will not move up and down at the same rate. Each will perform based on the specific economics of its individual area.
Action Item: Organize your investment property portfolio so that the mortgage, tax treatment, and rent revenue protects you from downside volatility and provides the opportunity to benefit from upward value fluctuations. (Top image: Flickr | sherwoodrealestate)
The JasonHartman.com Team
"The Complete Solution for Income Property Investors"
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