Developing The All-Weather Real Estate Portfolio: Investing Personality and Risk-Adjusted Returns

Ray Dalio developed the all-weather portfolio strategy, which was inspired by the decision of President Nixon to take the U.S. off the gold standard. This historical event adds interest to the concept’s origins.

Our focus is on developing an all-weather strategy for real estate investors, which raises the question: how can such a strategy be created?

Can real estate investors truly create an all-weather strategy given the illiquid nature of the asset class and the potential for volatile swings in valuations?

While we do not have a clear answer, we aim to share our insights and essential considerations for developing a robust all-weather portfolio, particularly in the context of private real estate assets. This post will cover two crucial components: the investing personality and risk-adjusted returns.

Why are we only analyzing private real estate assets in our portfolio analysis?

• We can offer more actionable advice by narrowing our focus.

• Income producing assets are recession resistant and provide an anchor during economic downturns.

• Lower perceived volatility (private assets do not get marked-to-market daily) which leads to reduced panic buying/selling during market turmoil.

Understanding one’s behavior, specifically how they act versus how they should act, is a crucial factor in developing successful long-term wealth-building strategies. The concept of perceived volatility plays a key role in this, as it is a fundamental aspect of behavioral economics.

Investing Personality

Successful investors are characterized by discipline and consistency, which are essential for long-term wealth building. Warren Buffett, for instance, has emphasized that IQ is not the only predictor of success. Combining discipline and consistency sounds simple, but it is challenging to achieve. Nevertheless, a combination of these traits with emotional stability can produce remarkable winning streaks that defy mean reversion and efficient market hypothesis. A strategic plan that strictly adheres to one’s personality, underlying goals (financial and non-financial) and objectives is essential for maintaining discipline.

Leonardo da Vinci once said that there is no greater mastery than mastering oneself.

To begin the investment journey, it’s important to understand one’s investing personality which refers to the factors that influence an investor’s portfolio decisions. This term is not commonly used in finance, but it summarizes the key considerations that drive portfolio allocations. The CFA program delves into this concept through an investment policy statement (IPS).

1. Can you express your objectives in the short, medium, and long-term?

   • What is the ideal asset allocation?

   • What are ongoing and retirement requirements from the portfolio?

   • Are there sufficient liquidity reserves for major life events (first home purchase, college tuition, marriage)?

2. How much risk is the investor willing to tolerate?

   • This covers an investor’s willingness and ability to take risks. These are often at odds with one another.

   • How much of the capital is the investor willing to lose?

   • How does an investor respond to fluctuations in portfolio valuations?

   • Will an investor remain committed to the asset allocation during tough market conditions?

3. To what extent is the investor willing to sacrifice immediate rewards in terms of time, effort, and energy to attain their investment objectives?

   • Does an investor want to be active or passive?

   • Are they comfortable with a 3rd party managing their portfolio?

   • How much control are they willing to cede to their investment manager? 

Investors who are successful and experienced have gained a profound comprehension of their investing personality, which they use to their advantage by limiting themselves to areas they are familiar with.

Our recommendation for investors is to perform this exercise at least twice a year or annually. Similar to getting regular maintenance for a car, it helps in ensuring the portfolio is on track and aligned with the investor’s goals. As the old saying goes, “a stitch in time saves nine,” it’s better to be proactive than reactive in portfolio management.

Based on our experience, writing and rewriting answers is crucial. This is because the act of writing compels the writer to organize their thoughts systematically, as well as enabling them to objectively evaluate events without hindsight bias.

The ultimate goal is to establish a series of consistent systems and procedures that will enable investors to effectively screen and seize appropriate opportunities that align with their objectives and risk tolerance.

Novice investors may find it particularly challenging to invest in private real estate assets due to the need for extensive due diligence and patience, which is more complex compared to public securities. It is especially frustrating when capital is idle, and the investment process is slower.

It’s essential to keep in mind that the process of investing is just as significant as the ultimate outcome.

The fact that private real estate assets are illiquid and require a larger amount of capital to invest in also means that there is a higher opportunity cost associated with investing in them.

For instance, selling a publicly traded stock can be done quickly with minimal capital loss, even though it’s not the best scenario. However, in private real estate investing, one cannot easily exit an investment, which can lead to suboptimal decisions.

Investing in a syndication, on the other hand, typically demands a minimum investment amount of $50-100K and lacks easy liquidity options.

The first restriction serves to guarantee that it is worthwhile for the sponsor to collaborate with an investor. Working with smaller amounts of capital is usually less efficient and can consume valuable time that the sponsor could have spent optimizing the asset’s operations.

The second restriction exists because of the unique characteristics of the asset class. If an investor makes a sub-optimal investing decision, they may have to wait for a significant amount of time before they are allowed to liquidate their position.

In the real world, investors do not have the luxury of a complete set of opportunities with clearly presented risks and returns for easy comparison, unlike in business school case studies.

Investors, on average, face constraints in terms of capital and time, and every decision involves an opportunity cost. These constraints become more apparent for investors with smaller capital pools. On the other hand, investors with larger capital pools have more leeway, fewer restrictions, and more options available to them.

As an investor’s capital pool grows, their focus changes from accumulating capital to preserving it. This means that it becomes crucial to identify suitable investment opportunities that align with their investing personality at the right time, in order to establish a well-rounded portfolio that can withstand various market conditions.

Behavioral finance research has consistently shown that humans tend to make irrational investment decisions. Therefore, it is wise for investors to limit the number of decisions they have to make when deciding on what and where to invest.

One’s investing personality can be used as a foundation to establish an investing strategy, set goals, and maintain consistency even during tough times. This practice reflects two critical traits of success – discipline and consistency. Therefore, it’s important to have an accurate and comprehensive comprehension of one’s investing personality.

Risk-Adjusted Returns and the Fallacy of Chasing IRR

It is common to hear investors express a specific minimum required return when evaluating investment opportunities, such as saying, “I only consider deals with an IRR of at least 18%.”

This approach has become commonplace, particularly among novice investors, but it is not the right way to go about things.

The advice given by experts is typically to follow a certain formula: choose a desired return, evaluate potential investments, and only consider those that meet the minimum return threshold.

As a consequence, many investors purchase Class D properties and end up regretting their decision for a long time.

We understand that obtaining a 15% return in a Class B location is more favorable than achieving the same return in a Class D location.

Why?

We can understand on a basic level that higher class areas typically involve less risk. All other things being equal, an investor should opt for less risk when seeking the same level of income.

Before making purchase decisions, it is important to have an understanding of the interplay between risk and return, or risk-adjusted returns.

When it comes to commercial real estate, evaluating risks involves subjective judgement calls based on perceived risks. The level of risk an individual is willing to take depends on their tolerance for various types of risks involved in a deal. Therefore, it is crucial for investors to have a clear understanding of their investing personality.

To understand risk-adjusted returns, it is important to start with the concept of risk-free return, which is the theoretical rate of return for zero risk. While there is no such thing as zero risk in the real world, sophisticated investors use U.S. Treasuries as a proxy for the risk-free return.

To provide context, a holding period should be determined for real estate ownership, which typically lasts between 3 to 7 years. To compare, the current U.S. Treasury yields for the same duration range from 2.65% to 2.83% as of July 3, 2018.

One way to begin would be to take the average of this range, which is the midpoint, and consider the risk-free rate to be 2.74%.

Using our established risk-free rate of 2.74%, any annual returns exceeding this percentage point involve a level of risk. This relationship can be illustrated graphically as follows:

The risk curve shows that generally, venturing into higher levels of risk is associated with the possibility of greater returns. This means that each successive step taken towards more risk should result in a corresponding increase in potential returns.

For instance, an investment in low-risk, unleveraged, Class B multifamily properties located in a thriving sub-market in Dallas would carry a lower risk profile, which would correspondingly limit the potential return. On the other hand, a highly leveraged investment in a Class C asset situated in a declining market in the Midwest could have a much higher level of risk associated with it but also the possibility of greater returns.

Therefore, it is important to consider the balance between risk and return when making investment decisions. While higher returns are attractive, they must be carefully weighed against the potential risks involved to avoid losses.

An alternative way to understand the risk-return relationship is to consider the red line, also known as the “fair value” line, as representing the optimal balance between risk and return.

Looking at the chart, we can see that the red line shows a gradual increase in potential returns as the level of risk increases. This suggests that at a certain point, the level of risk may become too high, and the potential for returns may not be worth the additional risk.

In terms of returns, the ideal investment would be one that offers the same level of returns as another investment, but with a lower level of risk. This is depicted on the chart as a point that is located below the red line. By identifying such opportunities, investors can maximize their returns while minimizing the associated risk.

From a risk perspective, it can be said that the better investment option would provide a higher return for the same level of risk. This means that by identifying investments that offer higher returns while maintaining a similar level of risk, investors can optimize their portfolio and achieve their investment objectives.

The chart illustrates that the optimal balance between risk and return is represented by the red line, with each point on the line indicating the level of return that can be expected for a given level of risk. If an investment opportunity lies above the red line, it implies that it carries a higher level of risk for a given return, making it less attractive.

Therefore, investors should seek opportunities that lie below the red line as they offer the potential for higher returns for the same level of risk. By carefully analyzing the risk-return relationship, investors can make informed decisions that will help them achieve their investment goals.

Why would anyone be willing to assume more risk to obtain the same return or accept lower returns for the same level of risk?

NOBODY!

It’s generally easier to comprehend the concepts of returns compared to risk scenarios. Evaluating risks requires a level of finesse and sophistication, and it involves creating a “stack” of elements to estimate risk accurately.

To estimate risks effectively, investors must first have a basic understanding of the common mistakes made during due diligence and the sources of risk in real estate investment deals.

Crowdstreet has provided a helpful example of the risk “stack” referred to in the previous paragraph. I have taken their example and made some modifications to improve clarity.

We can rank two competing assets by assigning a score of 1-10 to each attribute and aggregating the numbers to obtain a total risk score. While this is a straightforward example, it offers an initial insight into a basic ranking methodology that investors can use to evaluate and compare different real estate investment options.

The key takeaway is that risk can be quantified by establishing individual opinions on how to rate the various risk attributes or factors. By comparing risk scores and known target internal rates of return (IRR), we can create a graph to illustrate the relationship between the two.

Based on the graph provided earlier, it appears that the multifamily investment offers a better risk-adjusted return, according to the investor’s preferences in the example. This is because, in order to achieve an additional 14% annual return, the investor would have to take on an additional 21% risk score. Assuming that the weighting and score of each factor are acceptable to the investor, they now have a measurable basis to argue that the proposed retail investment poses an excessive amount of risk relative to its potential return.

The above example presents a basic framework for how investors can compare competing real estate investments. Ideally, investors should look for real estate investments that offer higher returns for the same level of risk, or the same returns for lower risk. This concept aligns with modern portfolio management theory, which advises against loading a stock portfolio with high-risk, speculative companies. Similarly, investors should avoid taking on unnecessary risks in real estate investments.

Despite the fact that the real estate market has been steadily increasing for almost a decade, it is important to remember that all real estate investments are not created equal. Projected returns are meaningless if they are not adjusted for risk. As Warren Buffet famously stated, “Don’t confuse luck with skill.” Investors must take a nuanced approach to evaluating real estate investments, carefully considering the risks and potential returns associated with each option.