A Response to the Wealthfront CEO
Recently, Andy Rachleff, the CEO of Wealthfront, penned an article about investing in real estate called “Playing the Real Estate Game”. Although it was a thoughtful analysis and addressed many of the nuances of real estate investing, it missed some critical aspects that highlight more broadly the general challenges of investing in public markets today.
As Andy wrote, new legislation has in fact created more opportunity for retail investors to invest in previously unattainable private markets. Meanwhile, the Internet is making it possible to more efficiently access parts of the real estate market that traditional private equity players have historically ignored. In other words, advances in regulations combined with technology are unlocking a whole new, less efficient market for investors. This democratization of the market is the essence of why we exist as a business and the very opportunity that we are so excited about.
The fundamental business proposition of robo-advisors such as Wealthfront revolves around the idea that the public markets are (nearly) perfectly efficient. This means that as an investor, since you cannot possibly beat the market, then you should instead focus on matching the market’s performance at the lowest cost possible. Of course, for the average investor, indexing has shown to be a much more reliable way to invest over the long-term and as a result indexing the market has become a commodity and the race to the bottom on pricing has now reached the point that firms like Charles Schwab will provide the service for free!
And, this is where Andy’s analysis starts to break down, because private markets are not nearly as efficient as public markets.
In fact, private markets can be dreadfully inefficient for a variety of reasons ranging from opacity to fragmentation to friction. And you don’t have to be an economist to recognize it. If you’ve ever bought or sold a house, tried to rent out a condo, or managed a small investment property, you probably wouldn’t describe the process as being highly efficient. Instead, you may have found that it can be a random and murky process with wildly varying results depending on the unique set of circumstances at the time…at least that has been my experience working in real estate over the past two decades.
Buying an office building for example is just a very different proposition than buying a share of a publicly-traded ETF. Relatively speaking the public markets are extremely transparent with a highly regulated flow of information. Meanwhile, we’ve seen properties where the only remnants of leases are hand-written photocopies that are decades old.
A stock may trade millions of times a day, with each trade effectively “pricing” the company in real time (in fact Investor Business Daily considers a stock to be thinly traded if fewer than 400,000 shares trade per day). A heavily bid sale of a building may attract a half-dozen offers or less. Often buildings are purchased “off-market,” never even getting more than one bid, and it might be the first time in a generation that the building has actually traded hands.
Less competitive, inefficient markets mean an investor can generally buy comparable assets at lower prices than efficient markets. With Shiller price-to-earning (PE) ratios at all-time historic highs only seen in 1929 and 2001, more than ever investors need to find ways to invest at a reasonable cost basis.
All this is to say that applying the same sort of indexing philosophy used in the stock market just doesn’t hold up when you’re talking about the private real estate market.
A New Investment Model
I believe that there is a enormous opportunity for the majority of passive investors to diversify a portion of their portfolio into real estate as an alternative to the stock market. This idea is something that many large institutions have done for years. For example, the Yale Endowment, which has handily beat the market for decades by investing in private alternatives, has held an average of 17% of their portfolio in private real estate over the past five years. Private real estate can provide more stability, higher current income, and greater tax efficiency than public equities, not to mention potentially higher overall returns due in part to market inefficiency.
Lastly, Andy concludes that investing in a Vanguard REIT ETF is the superior way to gain real estate exposure because of its seemingly low cost. However, a REIT ETF is simply a bundle of underlying real estate investment trusts (REITs), which themselves charge standard asset management fees for the work of actually owning and operating the real estate. The result is that the “low” ETF wrap and robo-advisor fees are both in fact on-top of—rather than instead of—existing fee structures.
Because public markets have been the only option for most investors, few tend to recognize the premium that is charged for the liquidity provided. If you are a short-term investor or trader, this liquidity is a very good thing. Owning illiquid real estate would make no sense for you. On the other hand, if you are a long-term investor, why pay a premium for liquidity you aren’t going to use?
It is structural flaw of the public markets that long-term, buy-and-hold investors are forced to pay a liquidity premium for the ability to sell their shares daily. Our research suggests that this public liquidity premium could cost as much as 20-30% upfront and may be the most significant reason why private alternatives have historically outperformed public equities, at least for institutional investors like the $200 billion California Public Employees’ Retirement System (CalPERs).
The ability to create a more diversified portfolio that includes illiquid assets from inefficient private markets is an opportunity that is only now available to millions of investors thanks to the combination of regulatory advances and the Internet.
One day, technology may eliminate the inefficiencies of the private markets. There is certainly no question real estate markets are more efficient now than they were decades ago. Until that time, we will work to harvest those inefficiencies for the benefit of our customers and promote a new portfolio model for the average investor. Only time will tell if the model outperforms.