After a decade of strong economic growth in the U.S., many investors are wondering how long the bull market can last. What follows the peak of the cycle is of even greater concern. The current cycle has been difficult to pin down due to the unusual combination of monetary and fiscal stimulus and risk factors such as trade wars and market share saturation. The uniqueness of this cycle renders historical comparisons less reliable and increases the range of potential outcomes. Instead of betting on a few definite outcomes of this cycle, capital allocations could be targeted towards mitigating the uncertainty and aiming for the best risk-adjusted return across an entire portfolio.
In a rising rate environment, short-term bonds in the U.S. and investment grade credit can act as a ballast to equity risk. Floating rate bank loans have an edge over high yield bonds. Yet, upside becomes restricted as capital is allocated into debt instruments and choosing to boost fixed-income returns can put high-yield bondholders at risk as rates rise and the probability of systemic shock increases. Is it feasible to decrease overall portfolio risk while still maintaining upside in the long-term? Yes and yes.
Ownership of tangible assets such as real estate could be the answer. Private real estate decreases overall portfolio risk due to its low or negative correlation with stocks, bonds and public REITs. Private real estate can also be a potential hedge against inflation, which is expected to rise, and offer a variety of holding periods and illiquid structures similar to bonds. Private funds that issue debt to developers with solid, long-term track records, decrease return risk through personal guarantees on the debt and return of principal dependent on refinancing rather than disposition of the property.
In the case of an equity market correction, the portfolio health of a relatively small-scale developer is unlikely to be affected to the point of default on a small portion of their overall debt load. The effect of a full-blown recession, though, can vary based on the location, size and asset category of the developer’s holdings along with the levels of education, human capital and housing price elasticity within and adjacent to the location. While direct investment in real estate can be luring, it also introduces new risks that are often only recognized with experience. Direct investments do not have limitations on loss or liability. Therefore, in order to protect against the risk of a full-blown recession, it is important to invest capital with those who have real estate fund management, underwriting and investing expertise and avoid a DIY approach.
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