An investment portfolio can contain many types of asset: cash, stocks, bonds, funds, and of course, real estate. How much of your portfolio goes into each asset class is referred to as “asset allocation”. Optimal asset allocation depends on three main factors: your goals, investment horizon, and risk tolerance. Therefore, the answer to the question “How much of my portfolio should be in real estate?” depends on the person.
First, an investor must consider his or her goals. Maybe you’re planning to accumulate enough money for a deposit for a holiday home in 5 years. Or maybe you’re saving for retirement 35 years from now. Often, but not always, investment horizons and risk tolerances spring from goals.
Meet Noah. Noah wants to start graduate school for his MBA two years from now. Sure, he could pursue a different short-term goal, like buying a bright red sports car, but Noah is more sensible. This means that his investment horizon is short. The program costs a specific amount of money, and without that amount of money, he can’t attend. Therefore, his risk tolerance is low. Let’s say the program costs ¥4,000,000, and he has ¥7,000,000 saved. He has enough money to afford it, but just barely. If he loses too much money (say, 12%), it could spell disaster:
¥7,000,000 saved for his MBA program × (100% – a 12% correction in the stock market) = ¥6,160,000 to spend while he’s in grad school
If he takes two years to finish, he’ll have only ¥1,080,000 a year to spend on living expenses. If he ends up in that scenario, well…let’s just say “hopefully he likes cup ramen and nattō on rice…” In fact, a correction of 20% or 25% (not unheard-of) could make his plans virtually unattainable. Therefore, his risk tolerance is low. Noah should invest conservatively. Annualised volatility for the SnP500 is around 15%. Noah can’t afford that kind of risk (or worse); it could derail his graduate school plans two years from now. On the other hand, if he does nothing with his money for the next two years, then inflation will erode the purchasing power of that money. If he invests the money, in bonds/a bond fund (both of which are low-risk) at 5% interest a year:
¥7,000,000 saved for his MBA program × (100% + 5%)^2 years = ¥7,717,500 to spend while he’s in grad school
If that’s the case, then he can pay his tuition with ¥4,000,000. He’ll still have ¥1,858,750 a year left to spend on both necessary and discretionary expenses. That’s much better than ¥1,080,000 (or worse). Of course, that’s just Noah’s situation. Other even lower-risk (and lower-return) solutions include savings/money market accounts and CDs (Certificates of Deposit). Government bonds are lower-risk, lower-return, and corporate bonds are higher-risk, higher-return. That said, at present, because interest rates are at historic lows we are forced to re-consider the assumption that bonds are a low-risk investment…
Now let’s look at Jack’s situation. Jack loves his job and is in no hurry to retire. Jack’s goal: retirement in 35 years.
His time horizon is long-term. His risk tolerance is high because he has 35 years to recover from temporary losses. Jack starts from $0. Each year, he saves $10,000. If he invests in bonds/bond funds at 5% like Noah, after 35 years, he’ll have $903,203. By that time, inflation will mean that $903K won’t buy nearly as much as it does today. He might have an impoverished retirement if he lives for more than 15 years after he retires. Therefore, he needs to invest more aggressively. If he puts that money in stocks yielding 10% per year (on average), he’ll end up with $2.71 million. He could even use funds to diversify. Much better—plenty of money to treat his future grandkids to trips to the beach.
Therefore, asset allocation is different depending on the individual’s goals, time horizon, and risk tolerance. There’s no one-size-fits-all situation. Now, how does real estate fit into this? How much of your portfolio should be in real estate?
Well, financial planners generally agree that the bigger the goal and the longer the time horizon required. With a long investment duration there is also more time to recover from a short-term loss, so a higher degree of risk can be shouldered to produce higher returns, without adverse condequences. Some formulas exist to suggest good starting points for asset allocation. In these formulas, if someone is saving for retirement, the younger, the more aggressively he/she should invest. The older, the less aggressively he/she should invest. A formula like this is common:
Conservative investors: 100 – your age = what percentage you should have in aggressive investments (e.g. stocks)
Normal investors: 110 – your age = what percentage you should have in aggressive investments
For example, if you’re 30 years old, 110 – 30 = 80. You should have 80% of your money in aggressive investments, and 20% in conservative ones. However, if you’re 60, then you should have 50/50 aggressive/conservative investments.
Aggressive investors: 120 – your age = what percentage you should have in aggressive investments
“115 or 120 – your age” is becoming more common. This is because, for most demographics, life expectancies are going up.
There’s a need to update your profile as your goals, time horizon, and risk tolerance change. This is “rebalancing”.
Is Real Estate A Conservative Or Aggressive Investment, Then?
First of all, for our purposes, we’re not going to refer to your home as an investment. “Real estate investment” here, according to financial planners, means property aside from the home that you yourself live in.
That depends on what kind of real estate it is. If you invest in a five-year-old building in downtown Tokyo, that’s a very conservative investment.
First of all, tenancy in downtown Tokyo is over 95% (特別23区, Tokubetsu 23 Ku, 23 Special Wards). Unless you’re asking outrageous rents or key money, you will fill any vacancies quickly. The average return on investment (ROI) in downtown Tokyo is 5.5% on average. Second, the building is relatively new. The government expects you’ll be able to use it for another 42 years, but actually, that’s probably an underestimate. You may be able to use it decades beyond that.
Is there aggressive, riskier real estate, then?
Oh, yes, there sure is! Imagine that you buy a one-room apartment in an outlying area of Tokyo for ¥2,000,000. The building dates back to 1970, so it’s now 50 years old. Most tenants are elderly. They may stay there for many more years, or they may move into a nursing home/in with their families. Rents in the building are ¥30,000 a month (¥360,000 per year). If you have a tenant, your ROI will be incredible: 18%!
However, if the unit is vacant, you’ll make nothing. If you have a long time horizon, perhaps the ROI will even out to a higher ROI than the downtown Tokyo property. Maybe it’ll be occupied ⅔ of the time, vacant ⅓ of the time, and your average ROI will be 12%—an excellent ROI.
However, in any given year, the ROI could be as little as 0%. Second, you have to consider the lifespan of the building. At 50, the building could have another 50 years of life left in it. Or, the owners’ association could vote to tear it down sooner.
Therefore, consider using formulas like 120 – your age, 110 – your age, or 100 – your age. However, rather than just plugging in stocks and bonds, figure out whether your property is lower-risk/higher-risk. Classify it as the “aggressive” part of your portfolio or the “conservative” part of your portfolio accordingly.
A Few Other Notes About Real Estate In One’s Portfolio
- It has low correlation to stocks and bonds. For example, The Great Recession had a huge impact on the stock market. However, the impact on housing prices and rents was more subtle.
- It is a lagging economic indicator. Often, the effect of an economic crisis doesn’t show up in the real estate market.
- Owning your own building is great, but you don’t have to to cash in on real estate. You can also buy a REIT (Real Estate Investment Trust). It’s like a mutual fund, but composed of properties instead of stocks.
- You can use Japanese real estate to diversify (avoid putting all your eggs in one basket). If most of your assets are in the US, the UK, etc., Japanese real estate is great for geographic diversification and currency diversification. If you already have many stocks and bonds, it can help you with asset class diversification. You can also buy a property at specified intervals moving forward for periodic diversification.
How Much Of My Portfolio Should Be In Real Estate? The Bottom Line…
Funds, CDs, stocks, bonds, and real estate are all popular asset classes. Your portfolio should contain more than one type of them. Your asset allocation should depend on your goals, time horizon, and risk tolerance. These typically change as you get older. Therefore, the older you get, the more conservative you should be with your investments. Conservative real estate investments include, for example, real estate in the 23 Special Wards of Tokyo. Riskier (but potentially higher-yield) real estate includes real estate in older buildings, in outlying areas, etc. Allocate your assets relative to your goals, and rebalance from time to time to ensure that you stay on track.