Managerial Finance and Financial Markets - Essay Example

Advice to the Board of Trustees: why commercial property should be included in the portfolio Introduction Although, traditionally, commercial property has not been considered an important portfolio holding, especially by individuals, in this paper I will discuss why this class of assets should be considered as a valuable, significant and a conventional constituent of an investment portfolio. I will outline, to the board of trustees, why inclusion of commercial property can be an effective supplementary investment, for example used to further diversity the current portfolio, which includes stocks (60%) and bonds (40%). The paper will, therefore, discuss how commercial property can be used as an alternative investment during periods of high inflation, which is possible because of its low correlations with bonds and stocks. More so, the inclusion of commercial property in the portfolio will offer regular streams of income, for example in form of rent, which can be adjusted periodically thus shielding the investor from the effect of high inflation. Diversification The force behind commercial estate returns, from macroeconomics viewpoint, is different from that of equity and bonds. In this view, commercial property is an ideal source of portfolio diversification. Furthermore, the commercial property is in itself diversified, hence its performance is very unique. Commercial property can be used to diversify unsystematic risk, but not systematic risk. The reason why it is difficult to diversify systematic risk is because it influences a large number of assets (Case, 2014). The diversification, in this case, depends on risk-adjusted returns, the investor’s horizon and correlations (as shown in Table 1). Some of the types of diversification that can be generated from commercial property include that between private and public real estate, between bonds and equity, by property type, by investment strategy, within domestic market (geographically), and between domestic and foreign market. International diversification, whereby investors venture into international real estates, is a potential means of reducing risk as it offers very low return correlations. For example, by investing internationally, investors achieve low performance fluctuations, in a manner that cannot be achieved locally (Hudson-Wilson, Fabozzi & Gordon, 2003). Return Enhancement Commercial property, relative to other asset classes, has been historically known to offer higher returns. However, in the long term, although commercial property is expected to generate a lower return compared to public equities, it is expected to perform better than bonds. Even though this relationship has been, somewhat, twisted by the effects of the global financial crisis, Figure 1 forecast shows that commercial property (REIT) is mostly expected to generate competitive returns than indexes such as S&P 500 and Russell 3000 (Bhuyan, 2014). Figure 1: Mark McAllister, http://www.advisorperspectives.com/newsletters12/Diversifying_Income_with_REITs.php Some of the reasons why commercial property is expected to yield competitive returns include the potential for capital appreciation, source of tax shield from depreciation, source of rent, reduction of tax liability due to carryover losses, and tax exchanges and credits. In addition, commercial property can be used as a shield against inflation, especially since its income streams is rooted from ongoing returns such as rent. Commercial property shields investors from the effect of inflation, also, because rents are expected to rise during such times, unlike fall in income experienced in bonds and equity. Moreover, the ability of commercial property in influencing performance is an important gain, which occurs because property such as real assets are tangible assets, which the investor can make some improvements thus increasing their value. Technically, the investor has a better control in influencing the performance of commercial property than other asset classes (Ferguson, 2014). An example of commercial property (REIT) outperforming other asset classes is shown in Table 2. Figure 2: Performance of S&P vs. REITs. Source: FactSet; Data period 9/30/94-6/30/14: As shown in Table 1, the commercial property has a low correlation to both equity and bond market, hence making it a potential source of diversification, as well as a source of risk-adjusted returns. The low level of correlation experienced is because commercial property draws incomes from ongoing streams such as rent which are hardly fluctuate as a result of economic shifts. As a result, commercial property offers a higher rate of return and less volatility than bonds and equity. In addition, in the case of commercial property such as real estates, they exhibit distinctive characteristics that influence the valuations, such as proximity to transportation, and property locations, among others. Inflation protection:  In the long term, commercial property is known to overcome the effects of inflation. For example, since real estate draws its income from rent charged from tenants, an investor can make adjustments by increasing it in order to adapt it to the changing economic conditions, such as increasing prices of commodity. Research has also shown that commercial property generates good returns during periods of high inflation (just as they do during periods of low inflation), while debt and equity-related indexes perform poorly during similar times (Ferguson, 2014). Other concepts Since both stocks and bonds are negatively correlated to commercial property, the resultant portfolio variance is a favorable effect of diversification. Correlation Matrix Asset Class Return Standard Deviation UK Stocks UK Bonds Property UK Stocks 12.0% 2% 1.00 UK Bonds 8.0% 10.5% 0.14 1.00 Property 12.0% 9.0% -0.04 -0.03 1.00 Table 1: Return, Standard Deviation, and Correlation Matrix of the portfolio The variance of portfolio returns after diversification is lower than what it would have been before diversification (Sullivan, 2003). The concept of variance shows how the actual returns of the portfolio rise and falls. In order to establish the covariance between different asset classes, the following formula is used: Covariance = Covariance (Stocks vs. Bonds) = 0.14*0.02*0.105 = 0.000294 Covariance (Stocks vs. Property) = -0.04*0.02*0.09 = -0.00007.2 Covariance (Bonds vs. Property) = -0.03*0.09*0.105= -0.0002835 The above results shows that stocks and bonds moves in tandem, while stocks and property as well as bonds and property moves in different directions, which explains why property plays a critical role in diversifying the portfolio. Although the analysis of portfolio risky as measured by standard deviation is important in hedging diversifiable risk, it is imprudent to ignore the market risk, which is measured through a tool called beta. This measure shows how closely a certain asset class tracks to the market, which is very essential in risk control. Unease with the validity of the expected return and risk for commercial property Because of the differences between commercial property and stock markets, the potential benefits of the inclusion of commercial property in the portfolio can be question. These differences mainly arise because, as regards commercial property, it is essentially not possible to hold the assumptions of capital markets theory; for example that markets are efficient. Therefore, as much as inclusion of commercial property in the portfolio is highly supported as explained, there are several risks that emerge as a result of the very nature of commercial property. Some of these are exceptional to this assets class, while others are general risks common with any other asset class. For example, it is very complicated quantifying returns to private commercial property investment, because most of such property is highly heterogeneous and illiquid. Although most investors commonly include commercial properties such as international real estate assets as a means of geographical diversification, Chau, Wong, and Yiu (2014) have, however, explained that such methods are sometimes challenged. In the event that an investor wishes to exit from a venture in the commercial property, the cost of doing so is significant because of the illiquid nature of this asset class. For example, exit from a real estate investment involves sales negotiations, market exposure, and pricing, which can extend for years on end. Therefore, if the investors are not in good liquidity position, it is advisable to avoid investing in direct commercial property such as the real estate. Nevertheless, the investors with liquidity problems can still consider venturing into indirect commercial property investments, such as REITs, which are relatively liquid. The other risks of investing directly in commercial property are the need to possess specialized knowledge, especially of the asset type, the local market, and the market trends. This means that, if the investor will decide to invest in real estate, for example, they must be ready to undertake rigorous property management, which is sometimes very complicated because different asset types require different management skills. Nevertheless, some of these challenges can be overcome by contracting real estate professionals. Even when it comes to REITs (indirect investments), most investors experience challenges because they do not possess adequate knowledge; though professional managers and advisors are helpful in managing indirect commercial property. Other potential risks, which are especially common in direct commercial property investments, include depreciation of some assets, incontinences experienced during renovations of property, and the risk of damage, among many others. My role as an investment manager As an investment manager in an efficient market, I will be charged with the responsibilities of planning the investments in a manner that maximizes the returns while minimizing the potential risks. These responsibilities includes all tasks associated with the management of the portfolio, such as purchasing and selling stocks, and performance of risk measurement, just to mention but a few (Cummins, & Nye, 1981). Conclusion As discussed, inclusion of direct or indirect commercial property, such as REITs and rental buildings, would improve the portfolio by reducing risk and enhancing return. Nevertheless, the choice of the most suitable type of commercial property will depend on the investor’s risk profile and type of exposure they are seeking. Although commercial property will offer competitive returns, sometimes more than equity and bonds, this asset class has distinct characteristics that come with both advantages and disadvantages. The most notable benefits include diversification, inflation-protection, risk reduction, and returns enhancement. Unlike bonds and equity, investing in direct commercial property offers investors the potential for influencing the performance of their assets. On the other hand, some of the potential pitfalls for commercial property include its exit complexity, the need for management knowledge, huge initial investment, and illiquidity, among others. References Bhuyan, R., Kuhle, J., Ikromov, N.and Chiemeke, C., 2014. Optimal Portfolio Allocation among REITs, Stocks, and Long-Term Bonds: An Empirical Analysis of US Financial Markets. Journal of Mathematical Finance, 4, p. 104. Bodie, Z., Kane, A., and Marcus, A., 2010. Investments (9th ed.). New York: McGraw-Hill Irwin. Case, B., 2014. “Diversification Benefits” in H. Kent Baker and Peter Chinloy (Eds.), Public Real Estate Markets and Investments. New York: Oxford University Press. Chau, K. W., Wong, S.K. and Yiu, C.Y., 2014. “International Real Estate Markets” in H. Kent Baker and Peter Chinloy (Eds.), Public Real Estate Markets and Investments. New York: Oxford University Press. Cummins, J. D. and Nye, D. J., 1981. Portfolio optimization models for property-liability insurance companies: An analysis and some extensions. Management Science, 27(4), pp. 414-430. Hudson-Wilson, S., Fabozzi, F. J., & Gordon, J. N. (2003). Why real estate?.The Journal of Portfolio Management, 29(5), pp. 12-25. Sullivan, A., Steven, M. and Sheffrin, 2003. Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 273 Ferguson, M. A. (2014). AREIT sector review and outlook for 2014. Equity,28(2), 6. Read More