From the May 2014 issue of Investment Advisor • Subscribe!

Two New Alternative Asset Classes Here to Stay?

Defining new asset classes is hard, but determining how long they’ll last is even more difficult

Is it too early to declare the U.S. residential real estate market as the new alternative asset class? Is it too early to declare the U.S. residential real estate market as the new alternative asset class?

It's no secret that investors are hailing the U.S. residential real estate market as the new alternative asset class. By asset class, they mean a group of securities or things whose value rises and falls together, and that theoretically rise and fall independently of other asset classes. But definitions are fuzzy. When you talk about asset classes, you might include international equities or emerging markets, along with U.S. stocks, bonds and cash. Others might include infrastructure or impact investing. “SWAG,” or silver, wine, art and gold, has gotten some buzz as an asset class. My definition includes commodities and real estate (traditionally, that has meant the commercial kind), and I am also looking at illiquid credit to broaden my portfolio. The point is, there's continuous debate about what constitutes an asset class and which asset classes will thrive.

Let's take a look at two of these possible newcomers to the alternative asset class family: illiquid credit and residential real estate. Both can trace their evolution from niche investments to potential asset classes back to the 2008 financial crisis. When millions of homes were foreclosed on, single-family homes became affordable to opportunistic investors like hedge funds and private equity. Meanwhile, the opportunity to invest in illiquid credit was widened by tough post-2008 regulations requiring banks to hold more capital and higher quality assets.

As banks relinquished their historic role making what are, in effect, private loans to businesses, pension funds and asset management firms have stepped in to fill the gap. For investors looking for higher returns than those of government bonds, illiquid credit is an option, but one with risk trade-offs. In exchange for higher yields, they must be willing to not only accept lower rated paper, but also give up liquidity. Unlike bonds issued by Fortune 500 companies, these loans are not traded in the public market.

Is this new asset class here to stay? It's possible, but illiquid credit has been a profitable business for banks in the past, and as their balance sheets recover, they may reclaim their role.

The future of residential housing as an asset class is also open to question. Some of the biggest names in alternative investing have gotten into the game. One strategy is to buy cheap foreclosed houses and rent them until prices increase. Another strategy is to hold the property permanently, a play on the idea that millennials, the generation born between the early 1980s and the early 2000s, will rent instead of own their homes. The Blackstone Group has taken the idea the furthest, with its groundbreaking move last year to sell bonds backed by rents on 3,207 of the 43,000 homes that it has bought in the last few years, according to Bloomberg. The idea, of course, is that rental-home bonds will generate more income than low-yielding government bonds, while giving investors another option to diversify away from the record-high levels of the U.S. stock market.

Again, it is early days. Investing in multiple asset classes is supposed to reduce risk through diversification, but it remains to be seen how rental-home bonds correlate with other asset groups. If stocks swoon, or if the supply of housing increases, how will rental income be affected? There's no track record, so no one can be certain. In this closely watched test, Bloomberg reported in February that rents collected by Blackstone fell 7.6% over the last quarter of 2013. On the other hand, lease renewals were higher than expected. While Blackstone also announced in mid-March that it was slowing its purchases of houses, exiting the asset class entirely apparently isn't on the horizon. “We’re not selling the homes. We’re building a long-term business,” Jonathan Gray, Blackstone's global head of real estate, told Bloomberg.

Meanwhile, though, some of the players have already exited. One alternative asset investment firm with expertise in distressed assets decided to call it quits after buying 300 homes, but declined to say why.

In the case of Berkshire Hathaway HomeServices, it's interesting that Warren Buffett is buying the transactions (the brokerage service) and not the product (the houses). Buffett may have found a better way to profit from this new trend. However, in the ongoing quest for broad new asset classes, not even he can set the boundaries. Only time and market forces will decide that.

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