How real estate debt affects asset allocation

Real Estate Issues, Dec 1997 by Rutledge, John K

Real estate leverage generates results not expected or understood by the typical investment professional. It distorts the performance of the bond portfolio and corrupts the carefully planned asset allocation of the total portfolio.

Investors and real estate investment managers commonly use the term "leverage," or mortgage financing, in discussing real estate investment. Known in certain other systems as "gearing," leverage is simply the use of borrowed money in association with the ownership of an asset. In the investment setting, mortgage debt is commonly nonrecourse, meaning that the lender may claim the property following the borrower's default, but may not recover from other assets of the borrower. The borrowing may occur to fund the acquisition, or at a later date, borrowing could provide funds for capital or operating requirements or for distribution to the owners. Both tax exempt and taxable investors use leverage to improve yield and gain control of property for which capital is not otherwise available, and taxable investors may also use debt to multiply tax benefits.

Consumers typically use mortgage financing in the acquisition of a home because of the lack of otherwise available capital for the purchase. Traditionally, homeowners celebrate the day they pay off the mortgage. Many home buyers would pay cash if it were available. (The argument that mortgage debt is desirable because of the tax shelter benefits is specious. It takes a dollar of interest payment-real money-to save $.28 of tax at a 28 percent marginal tax rate. The borrower is still out the other $.72.)

Real estate investment managers acquire property on behalf of institutional and private investors which have allocated a portion of their total portfolio to real estate for three principal reasons: 1). they seek to minimize the impact of volatility of performance of specific asset classes; 2). to hedge against inflation; and 3). to generate attractive levels of current income. These managers may use debt to acquire specific assets or may pledge a group of assets to obtain financing to augment the equity available for real estate investment. If these managers represent only the property component of a portfolio, they are likely to be uninformed about the other components of the institutional portfolio.

Background - The Construction of a Portfolio

A professional portfolio manager carefully constructs the investment portfolio to achieve certain objectives consistent with the needs of the owner of the portfolio. For example, the manager of a pension portfolio strives to assure the payment of accrued benefits to current and future retirees. The manager allocates assets to reflect the ages and years of service of the personnel who will receive pensions. From the individual perspective, a wealthy family may seek capital growth for the next generation, while a retiree may require high current income to cover living costs. Institutional investors generally recognize asset allocation as being much more important than individual issue selection in achieving portfolio objectives. For example, the selection of an individual stock will be far less significant to the success of the portfolio than will be the decision concerning the proportion of the portfolio allocated to the stock market.

A carefully allocated portfolio typically contains stocks, bonds, and cash equivalents. It may also include real estate, venture capital investments, oil and gas interests, distressed securities, and other asset classes. The stock or equity component may include subsets such as small capitalization stocks and international stocks. The international component may include securities of established firms located in developed countries as well as stocks in new ventures in emerging nations. The opportunities and their combinations are endless.

Each asset class in a portfolio is there for the benefits it imparts. Because each asset class has different characteristics and impacts on the portfolio, the mix of assets chosen to comprise the portfolio represents an optimization designed to achieve the objectives of the investor.

The asset allocation process is technically complex and highly sophisticated. Most institutional investors engage specialized consultants to advise on asset allocation and investment manager selection. This manuscript does not address these issues.

The allocation process views unleveraged real estate as an asset class with unique investment performance characteristics. (This is consistent with the reporting practices of the National Council of Real Estate Investment Fiduciaries (NCREIF), the recognized leader in the publication of real estate performance data, which reports on real estate as if it carries no debt.)

This manuscript examines the impact of adding debt to the capital structure of otherwise unleveraged real estate. A property can be viewed as a business enterprise appropriately capitalized like any other business with a mixture of debt and equity. Perhaps real estate should be capitalized differently from other enterprises, since unlike a service or manufacturing business, real estate is relatively more dependent on fixed assets (bricks and mortar) and less dependent on working capital and managerial and operating structures.