Leverage and Diversification ConjoinedApr 5, 2023
As your Real Estate Philosopher I don’t see my job (if it is a job in the first place) to always spout out advice. My stated purpose is to think of provocative ideas for dissemination or, said, another way, to stimulate thought and ideas.
I lead with that preamble as I am being – perhaps too honest – in saying I am really not sure I am onto something in this article. It is either a great revelation or – perhaps – something that doesn’t quite work.
Okay here goes……
I started some deep thinking about what I should do as an investor – or what my real estate friends should do as investors/owners in the real estate industry – since there is so much perceived turmoil going on right now in the markets. This turmoil includes, without limitation:
- Interest rates – going up, going down, staying the same
- The debt ceiling – is anyone wondering about that
- Politics and divisiveness – with an election in full bloom a year early
- Global uncertainties – too many to mention
- Recession concerns
- A banking crisis – or maybe not
- And probably a bunch more
All of this offset by a general boom in the world’s largest economy that, so far, seems to take negative hits as minor speed bumps.
After a lot of thinking, I came to two conclusions that seemed contrary:
First – it seemed like I should be conservative in a time of uncertainty. Among other things, it seemed obvious that I should have as little leverage as possible since outcomes are murky and leverage is a wonderful servant but a terrible master. Indeed, if prices of real estate drop having a lot of leverage is pretty awful.
Second – it seemed like the foregoing was missing the boat. I mean I have no more ability to predict that this is a time of uncertainty than I did a year ago to predict that that was a time of stability. There is no crystal ball at any given time – although we all may think we have one that lulls us into being aggressive when we should be conservative and conservative when we should be aggressive. So, if this thinking makes sense, I should be investing aggressively – on amazing terms that I would never have gotten a year ago – and leveraging up like crazy.
So as I was about to despair that my thinking had led me into a corner and – like probably everyone else – I had no particular idea what to do – so I should just diversify my investments as much as possible and hope for the best – and then this thought came to me, which, as noted above, might be a ground breaker in its novelty….
The idea is that maybe there is a way of thinking about diversification that is different from what we have thought before……
Diversification – generally – is thought of as diversification among asset classes with the theory – that I think was (mostly) proved mathematically a long time ago by the famous mathematician John von Neumann – that diversification is an optimal investment strategy over a long time period. Most parties think of diversification as allocation of assets among asset classes such as the following:
- Fixed Income
- Commodities (including gold)
- Real Estate
- Some additional non-correlated asset classes like art
- And (for some intrepid souls) adding in Bitcoin and things like that
And this makes a ton of sense and is probably a wise investment strategy. In this vein, I think the heart of diversification is an acknowledgement that there are variables one simply cannot quantify or assess – such as the directions of markets or interest rates – so one accounts for these known unknowns by a diversified basket that will do “okay” no matter what happens.
But how about adding this into the mix:
Applying this to just real estate (for now), this would mean that you would -- also -- diversify your real estate investments among differing leverage levels. Some investments would be with very low leverage and some with very high leverage and some with medium leverage.
So now apply this to the unknowable future….
For example, if the US debt ceiling blows up and – God forbid – the US actually defaults on its debt, do you know what would happen to US real estate? Well, I don’t have a clue. Maybe hard assets would be just the thing and real estate would rocket up in price while interest rates plummet in a panic – and highly leveraged assets would be a fantastic deal for the owners of them. Or maybe the other way around, and it would be an unholy disaster that inflation would go crazy and interest rates would go through the roof and low leverage would by the thankfully best place to be. Or maybe neither of the foregoing would happen.
Since I don’t know, nor does anyone else, I wonder if leverage diversification -- just like other diversification in concept -- is a way to optimize one’s investment profiles and synthesize these unknowns.
I admit I cannot tell whether this is a brilliant idea – or the complete opposite of a brilliant idea. It feels like I am onto something but I am not sure. I certainly haven’t heard this before.
If you think I am right – or wrong – or something else – I would love to hear your feedback if you are so inclined.
Best of success to all my real estate industry friends.
Bruce aka The Real Estate Philosopher