The “20% rule” states that an investor should have a minimum of 20% of their portfolio invested in alternatives like commercial real estate. This rule was made famous by the Yale endowment, which has outperformed traditional endowments made up of only stocks and bonds for the last 25+ years. In fact, an investor who invested using the 20% rule in 1995 would have earned about twice as much as an investor who used a more traditional allocation.
An investor obtains financing and buys or builds a commercial real estate property like an apartment complex, office building, retail center, or industrial warehouse.
The investor leases space in the property to tenants (individuals or businesses), who pay rent. After expenses are paid, the remaining rental income is profit for the investor.
The property’s value may increase over time. If the investor sells the property, they may earn additional profits from the sale as a result of this appreciation.
Unlike most stocks, commercial real estate generates consistent cash flow (income) from rent. For investors in need of regular income from their portfolio, commercial real estate can provide an attractive alternative to bonds, which also generate regular cash flow, but generally at much lower rates.
Real estate is a hard asset – it provides intrinsic value through its use as a home, office, factory, etc. Real estate is also scarce. There is only so much land in a given area. As cities grow, demand for real estate increases, while supply is limited by geography. This is why real estate assets have historically appreciated in value over time.
The information presented above represents the average annual dividend yield for the Vanguard 500 Index Fund (VFINX), the iShares Core Aggregate Bond ETF (AGG), and the iShares Mortgage Real Estate Capped ETF (REM), from 2008 to 2016. Source: Yahoo Finance Historical Prices.
The information above represents the growth in percentage of the Median Sales Price for New Houses Sold in the United States and the Consumer Price Index: All Items for the United States from 1965 to 2016. Source: Federal Reserve Bank of St. Louis Economic Data.