Last Updated Oct 15, 2010 4:09 PM EDT
It's 2007 and for the past several years, Bob had been reading about how hot the national real estate market was. He had also observed that prices of homes and apartment buildings in his hometown had been rising rapidly. When Bob learned an apartment building in an attractive part of town had recently come on the market, he decided to speak with his accountant, Paul, about this opportunity before taking a serious look at the building as a potential investment.
Bob called Paul and set up an appointment for the following day. He began by explaining why he was excited about this opportunity. He asked Paul for his thoughts and advice. Paul began by explaining that one of the issues he was most frequently asked to opine on was related to investing in individual real estate properties. Just like Bob, most often the individual was considering the purchase of a local apartment building that was for sale. However, he also pointed out that in some cases he was asked about an office building or a warehouse. But almost always he was asked about a local property.
Paul went on to explain there are numerous reasons, all based on the principles of prudent investing, why he doesn't recommend purchasing these types of investments. The main reason is that by purchasing a single piece of property an investor is taking what economists call uncompensated risk. The risk of owning a single investment, be it a property or a stock, within an asset class is called uncompensated risk because the expected return of any one investment is the same as that of all investments with similar risk characteristics. By owning just one investment, or a small group of similar investments, you are taking risk that can be diversified away. Because the risk can be diversified away, the market does not reward you with any extra return for taking that risk.
Risk that cannot be diversified away, like the risk of owning real estate (or stocks) in general, is called compensated (or systematic) risk. Because that type of risk cannot be diversified away, the market must reward investors with higher expected returns for accepting the incremental risks.
The bottom line is there are two types of risk: the good kind (compensated) and the bad kind (uncompensated). Effective diversification results in the elimination (or at least reduction) of uncompensated risk. Paul went on to explain that by purchasing a single property Bob would be undiversified not only as to geography, but also by property type. Within the asset class of real estate, there are many different types of properties - apartments, warehouses, hotels, offices and so on. Paul also explained that the most effective way to diversify this type of risk is to own a passively managed real estate fund that owns all types of properties and is broadly diversified in terms of geography. He gave Bob some examples of what he believed to be prudent investments in real estate: DFA's Real Estate Securities Portfolio, Vanguard's Real Estate Fund and TIAA's Real Estate Account (which he explained was only available on their retirement platform and only to qualified participants).
Tomorrow, we'll more from Paul about what to consider when investing in real estate.