CONTRIBUTORS
Tony Davidow, CIMA®
Senior Alternatives Investment Strategist
Franklin Templeton Institute
Priya Thakur, CFA, CAIA
Analyst
Franklin Templeton Institute
Preview
A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.”
Whether intentional or not, Nobel Laureate Harry Markowitz—the father of Modern Portfolio Theory (MPT)—acknowledged its limitations. The bottom line: Stocks and bonds alone are incomplete tools in building diversified portfolios. We experienced this lesson in 2022, when both stocks and bonds were down double-digits.1 Fortunately, through product innovation and the willingness of institutional-quality managers to bring products to market, advisors now have access to a broader set of alternative investments to help clients achieve their goals.
Over the last several years, there has been a broader acceptance of alternative investments as tools to provide potential for incremental returns, alternative sources of income, and diversification relative to traditional investments. These broader tools may be more responsive to the contingencies that Markowitz was referring to—changing interest rates, inflation, increased correlation and market shocks.
Commercial real estate (CRE), also known as private real estate, is the most mature alternative investment. While real estate ownership is generally understood and broadly available, CRE debt is less well-known. It is often imbedded in a real estate fund and not always viewed as a stand-alone investment. We believe this is about to change. CRE lending and financing is of critical importance; however, traditional banks may be hesitant to lend given the collapse of Silicon Valley Bank (SVB) in 2023. The CRE debt market could be facing a liquidity crisis, creating opportunities for those with cash on hand.
In this paper, we will examine the merits of CRE debt and explore the opportunities presented in today’s market environment. Specifically, we will evaluate the following characteristics of CRE debt:
- Historical performance relative to other investment options
- Historical risk-adjusted returns relative to traditional investments
- Correlation relative to traditional investments
- Drawdown analysis relative to other credit options
Endnotes
- See: Davidow, Tony. “Building better portfolios with alternative investments: Rethinking retirement.” Franklin Templeton Institute. May 2023.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Investments in many alternative investment strategies are complex and speculative, entail significant risk and should not be considered a complete investment program. Depending on the product invested in, an investment in alternative strategies may provide for only limited liquidity and is suitable only for persons who can afford to lose the entire amount of their investment. An investment strategy focused primarily on privately held companies presents certain challenges and involves incremental risks as opposed to investments in public companies, such as dealing with the lack of available information about these companies as well as their general lack of liquidity. Diversification does not guarantee a profit or protect against a loss.
Risks of investing in real estate investments include but are not limited to fluctuations in lease occupancy rates and operating expenses, variations in rental schedules, which in turn may be adversely affected by local, state, national or international economic conditions. Such conditions may be impacted by the supply and demand for real estate properties, zoning laws, rent control laws, real property taxes, the availability and costs of financing, and environmental laws. Furthermore, investments in real estate are also impacted by market disruptions caused by regional concerns, political upheaval, sovereign debt crises, and uninsured losses (generally from catastrophic events such as earthquakes, floods and wars). Investments in real estate related securities, such as asset-backed or mortgage-backed securities are subject to prepayment and extension risks.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Equity securities are subject to price fluctuation and possible loss of principal.
An investment in private securities (such as private equity or private credit) or vehicles which invest in them, should be viewed as illiquid and may require a long-term commitment with no certainty of return. The value of and return on such investments will vary due to, among other things, changes in market rates of interest, general economic conditions, economic conditions in particular industries, the condition of financial markets and the financial condition of the issuers of the investments. There also can be no assurance that companies will list their securities on a securities exchange, as such, the lack of an established, liquid secondary market for some investments may have an adverse effect on the market value of those investments and on an investor’s ability to dispose of them at a favorable time or price. Past performance does not guarantee future results.