The practice of diversifying assets in a portfolio to mitigate the effects of market volatility is as old as investing itself. When it comes to hedging against volatile equity markets, real estate can be a smart alternative to add to a portfolio, particularly in light of current market conditions.
The fundamentals of the U.S. economy remain strong: The economy added 128,000 jobs in October and 325,000 Americans decided to re-enter the workforce from unemployment to look for work. As a result, the unemployment rate rose slightly to 3.6% from its 50-year low. That being said, some signals indicate the possibility of a slowdown or recession in the future, including the current trade war with China, weaker economic growth in Europe and Asia and movements in the U.S. bond market.
When it comes to stock market performance, 2019 reversed the losses experienced in the fourth quarter of 2018, which proved to be one of the worst quarters in recent memory for the market and caused the major indices to finish in negative territory for 2018. In fact, the S&P 500 was up about 37% as of this Christmas Eve versus where it was after the 2% drop experienced last Christmas Eve. While the market rallied through much of 2019, signs of slower growth are starting to show up in the data. The Congressional Budget Office projects that 2019 GDP growth will slow to 2.3%, down from 3.1% in 2018, “as the effects of the 2017 tax act on the growth of business investment wane.”
Despite a spectacular 10-year bull run in the equity markets, recent volatility and the persistent inversion of the yield curve — a predictor of past recessions — has many investors and observers concerned. A National Association of Business Economics poll revealed that 60% of economists believe there will be a recession by the end of 2020.
Single-Family Real Estate: An Uncorrelated Asset With Income Potential
Investors skittish about a potential downturn are increasingly looking to new investment vehicles to diversify their portfolios. I know firsthand why residential real estate is such an attractive asset — the properties are historically uncorrelated with stock market volatility.
Investors’ confidence in real estate is at a high. Nearly one-third of Americans believe real estate is the best way to invest money for the long term, according to a recent Bankrate survey. Younger millennials are even more bullish on real estate as a means to build wealth. Among 23- to 28-year-olds, 37% rank real estate above stocks, bonds, gold and savings accounts as their preferred investment for money that they wouldn’t need for 10 years or more.
Millennials’ confidence in real estate matches a strong market that is trending steadily in favor of buyers. The Federal Reserve has made several interest rate cuts of late, which is keeping borrowing costs relatively low. While the federal funds rate has dropped, mortgage rates have fallen even further. According to Freddie Mac, rates are holding steady at around 3.7%, which is a significant drop from the highest point in 2018 when rates reached 4.94%.
It’s an attractive time to buy real estate, particularly in markets with lower housing costs. This trend is reflected among our firm’s users: When surveyed, 82% said they plan to purchase real estate in the next 12 months while only 28% plan to sell properties. This enthusiasm to buy is undeterred by a cautious economic outlook.
Not all property types are created equal. When investors are eyeing potential real estate opportunities, single-family rentals have an opportunity for a significant upside. Holding SFR properties as investments gives owners the opportunity to be cash-flowing and recoup monthly rental income for tenanted properties. Rental prices are historically resilient in times of market turmoil. According to John Burns Real Estate Consulting, rent growth has remained positive since the mid-1980s, including during recessionary periods. Some experts predicted this year’s rent increase could average 5%–7% and that real estate investments will outperform stocks.
One of the challenges for investing in SFRs historically has been access. Let’s face it: Buying a stock is a lot easier than buying a house, and for this reason, many shy away from buying property. The good news is that over the past decade, it has gotten a lot easier to diversify into real estate, as new technologies and business models are breaking down the barriers to investing in property. If you are looking to get started, there are a few basic questions that can help narrow your options and begin to define a strategy.
First, decide whether you want exposure to a particular region or you are location-agnostic. I tend to encourage investors to look at markets where they don’t live so the returns are not correlated to their home market.
Second, be clear about your objectives from the investment as it relates to income, growth or capital preservation. Some investors just want to generate income and may flock to promising cities in the South and Midwest like Birmingham or Indianapolis. Others want to invest in growth markets like Austin that have low yields but have strong growth prospects. Others don’t care about yield at all and want to own property in a specific city, like Palo Alto, with constrained supply and global demand. Determine the path that fits your specific goals.
Third, think about the level of risk you are prepared to take. With SFRs, similar to bonds, those with the most return potential generally carry the most risk, and along with the increased return opportunity, you will be assuming more volatility, or variability, of potential outcomes.
Economists are divided about when a market downturn will hit, but experts are in agreement that the good times can’t keep rolling forever in the equity market. Investors who maintain a diversified portfolio featuring uncorrelated assets can reduce feelings of fear and anxiety during turbulent periods in the market. Incorporating real estate into an investment portfolio provides a hedge against stock market volatility. Rental properties give investors an added boost: an extra stream of income with the attractive potential for long-term growth.