A Reuters’ poll in April this year suggested this won’t be changing any time soon. The survey of leading investment managers showed an average allocation of 53.5% to equities, 22.6% to bonds, 15% to alternative investments, 6.5% to cash and a meagre 2.4% to property. However, we believe these numbers should change.
Although commercial property has proved to be one of the more appealing asset classes of the early to mid-noughties, the UK’s residential market has been largely ignored by the professional investment world.
Despite showing the best long-term performance of the UK’s main asset classes (15.6% p.a. over the 40 years to 2011), it rarely, if at all, features in multi-asset portfolios. By comparison, the equity market (the multi-asset manager favourite and next best performer) recorded a total return of 12.7% p.a. ; this represents 2.9% p.a. of missed returns, and compounded over 40 years equates to a difference of nearly 300% between the asset classes.
Residential property has also proven to be one of the most reliable asset classes. Over the full 40-year period the standard deviation of total returns is significantly lower for residential real estate than for both UK equities and gilts. The total returns offered by residential have a standard deviation of 0.11 versus equities’ 0.30 and gilts’ 0.14. Only the standard deviation of cash returns is markedly lower at 0.04.
Combining risk and return numbers produces a fuller picture of how residential property compares to other asset classes. The Sharpe ratio shows residential property achieves the best risk-adjusted returns by a significant margin. Indeed, over 20 and 40 years, its Sharpe ratio is more than twice that of the next best performer, commercial property.
While risk and return of an investment are fundamental drivers of whether or not to include it in a multi-asset portfolio, it is also important to understand how the investment will relate to the portfolio as a whole.
Correlations can be used to examine the movement of returns for different assets to see whether, for example, losses in one asset class could be mitigated by gains in another. In other words, investing in asset classes with negative or weak correlations can be beneficial to the investor.
With data on asset risk and historical returns it is possible to calculate correlation and, using modern portfolio theory, the asset allocations that provide optimal returns for each level of risk. It is worth noting that for any chosen level of risk, residential property is a significant feature of the efficient portfolio.
While the efficient frontier calculation is illustrative, it is not realistic. Past returns are no guarantee of future performance and asset allocation is as much about predicting what happens next as analysis of what has gone before.
Such analysis suggests that adding residential real estate to a portfolio leads to a clear reduction in the weighted average level of risk. Its weak correlation to other asset classes and less volatile returns makes property a useful tool for portfolio diversification. The chart below shows how the Sharpe ratio of an average portfolio improves as the allocation to residential property increases from zero to 20%.
While an immediate and significant switch into residential is not realistic, the weight of evidence supporting its inclusion in multi-asset portfolios is becoming overwhelming. Already, international investment funds (e.g. Akelius) are moving into the market; and as demand in the private rented sector rockets over the next few years, residential will offer an increasingly reliable income stream.
Positive annual returns, together with low correlation to other asset classes and a low risk profile should see residential rightly becoming an integral part of multi-asset strategies. Surely, 40 years of missed returns is enough.
