By Marilyn Kane and Sean Shanahan: Since when is real estate an alternative asset? Real estate is integral to any well diversified portfolio

Real estate-land, buildings with their improvements, air and mineral rights-has long been established as a holder of wealth and value, even through turbulent times of warfare, revolution, and industrialization. However, beginning with the advent of the stock markets, capital allocation to real property began to wane. The introduction of Markowitz Portfolio Theory, or MPT, led most investment advisors to allocate substantial assets to public equities in a hope to diversify across multiple sectors. This approach, however, had a substantial flaw. If all or nearly all assets are in public equities, the investor has diversified across multiple asset classes, but only one asset type-stocks. Prior to our recent financial crisis, many investors believed that investing across a wide swath of equities and ETFs (Exchange Traded Funds) would provide them the diversification needed to weather market downturns. Yet during the market turmoil, the correlation of these various equities went nearly to one, essentially slashing the concept of diversification through asset sectors. The main issue was not that all these sectors were preforming equally poorly, but rather that the exposure to these sectors was nearly entirely in one asset type-equities. One way to address this correlation risk is with a strategy that puts asset "class" first and asset "type" second rather than an equities-first strategy. By understanding the underlying metrics of an asset class, investors can then determine the best asset type to invest within that class. Investors who want to add real estate exposure to their portfolio have several different asset types in which they can invest. The greatest exposure to the real estate market comes with direct ownership of real property, that is, determining availability and buying a piece of property. This type of asset generally requires substantial management and is fairly illiquid. However, if it is a cash-flowing property, it tends to be valued on its own merits rather than the broader real estate market. This type of asset generally requires a large down payment, currently around 35% of the purchase price, and may thus out price some investors. An investor who does not have the required capital to purchase a property on their own may choose to allocate to a joint-venture or fund investment. These entities can invest in either a single property or a large diversified portfolio of properties. Each offering will have its own objectives, terms, and fees, as well as varying levels of liquidity. The performance of these funds tends to be tied closer to the managers' abilities and objectives rather than to the broader market. For investors wanting the most liquid exposure to real estate, public REITs offer this alternative. REITs, or Real Estate Investment Trusts, are companies organized to buy real property or mortgages and are required to distribute at least 90% of their income to investors in the form of dividends. Although REITs derive their income from real estate, they can become far more correlated to the general equity market than real estate during times of volatility in equities, the opposite purpose of asset diversification. REITs can be purchased on an individual basis or through a REIT ETF. The previous investment examples focused on the equity side of owning real estate, however, investors can also participate on the debt side through a variety of investments. Real estate investors wishing to buy real estate debt can participate in mortgage-backed security pools, essentially a pool of mortgages, either commercial or residential, which pays a consistent return. MBS garnered a bad reputation after the recent financial crash; however, risk can be substantially reduced through investing in high-credit MBS pools. Alternatively, investors can purchase bonds issued by public or private REITs, which are secured by underlying real estate owned by the REIT. These bonds generally pay lower rates than the equity alternative, but they can also provide an important debt component to a portfolio. Identifying real estate outside of REITs as an "alternative asset" is a common misunderstanding of true asset allocation. In order for a portfolio to be truly diversified, it must begin from an asset-class approach before beginning to assess in which asset types to invest. Real estate has long been a store of value as a real asset, and long-term holdings have been shown to weather almost all markets. Well diversified portfolios ought to begin viewing real estate as integral to its strategy rather than an "alternative" asset. Marilyn Kane is the president and Sean Shanahan is the chief financial officer at Iridium Capital, New York, N.Y.