Successful institutional investors think beyond asset class-specific decisions and think in terms of the overall portfolio. They see the forest for the trees.
Institutional investors don’t invest in one silo or asset class. Instead, they invest a balanced portfolio, consisting of bonds, stocks and some other stuff, like real estate.
Some institutional investors borrow to invest in particular asset classes. They don’t generally go to the bank and borrow money in order to make investments. Instead, they effectively borrow at the asset class level.
Assuming the asset class of real estate, one could frame borrowing to invest in real estate as a question of whether it makes sense to take out a mortgage at 3-4% to buy a building that is expected to yield a return of 5-7%. Framed that way, borrowing to buy real estate seems to be a no brainer. But, is it?
There are two problems with this thinking, one of which you’ve probably read about and another you may have not:
- The building’s return might not be 5-7%. If the building’s return is, say, 1-2% for a prolonged period the investor would suffer losses on the borrowed-and-invested piece of the investment. This is the commonly discussed problem with leverage.
- An equally important problem is that the investor may be missing an opportunity to lend to himself rather than borrow from capital markets. This is rarely, if ever, discussed when balanced investors assume leverage in parts of their portfolios. This is the forest that successful investors see.
Buying bonds is the same thing as lending money. Someone else may have lent the company the money originally, but by buying the bond you become the person to whom the bond issuer owes a repayment. In effect, you can think of yourself as lending the bond issuer money.
If you are both borrowing to invest in your real estate portfolio and investing (or lending) in your bond portfolio you may have an opportunity to cross your trades:
- Decrease your allocation to your bond portfolio,
- Increase your allocation to your real estate portfolio, and
- The result is that you decrease your leverage in your real estate portfolio.
Now you are lending to yourself rather than borrowing from, and lending to, the open market. There are savings to be enjoyed by avoiding the open market, which has a gap in interest rates: you pay more to borrow (higher interest rate) than you receive for lending (lower interest rate). This gap compensates bankers and other players that stand between borrowers and lenders.
Crossing lending and borrowing – and foregoing some reliance on the open market – doesn’t quite provide investors with a free lunch, but it is close.