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REITs Belong in Your Investment Portfolio

Thursday, April 1, 2010   

Real Estate Investment Trusts (REITs) were created by Congress in 1960 so that the general public would have access to income-producing real estate investments.  Today, REITs account for more than $250 Billion of US equity investments, or 1-2% of the public market, having doubled their market capitalization over the past decade.  These securities are appealing because of their unique structure, historical risk-adjusted returns, and significant diversification benefit.  Long-term investors should seriously consider adding REITs to their asset allocation plans. 

A Distinct Asset Class

A typical REIT owns and manages a portfolio of commercial real estate properties like offices, malls, hotels and apartments.  By law, REITs are required to pass on at least 90% of income to investors, so equity-like gains are distributed when properties are sold for a profit, and bond-like income is generated from periodic rent collection.  This combination of equity and bond-like characteristics is what makes REITs unique.  Although they trade on exchanges like stocks, their historical returns aren’t explained predominantly by size and value factors, as is typical with most equity investments.

High Returns, Low Correlations

From 1972-2009, REITs brought compound returns of 11.45% with a standard deviation of 12.45%, higher returns and lower volatility than the overall US Stock Market during that same period.  REIT returns also exhibited low statistical correlations with the returns of other major asset classes like US Stocks (.62), International Stocks (.43), and Bonds (.22).  Modern Portfolio Theory tells us that we can increase our portfolio’s risk-adjusted return by adding volatile, non-correlated assets.  Although past performance may not be indicative of future results, REITs have historically offered a very attractive diversification benefit in a portfolio context.

“Invest in More Real Estate? You Should See My Mortgage!”

Some homeowners are reluctant to invest in REITs because they see their home as a sizable real estate investment.  For the typical American homeowner, however, the family home is not an income-producing investment.  It’s a consumption item, used for shelter and personal enjoyment.  Unless you own dozens of rent-producing properties around the country, home ownership is quite different than a REIT investment (except, perhaps, for the inflation hedge that both can provide).  By providing geographic and property-type diversification, REITs (and particularly REIT funds) drastically reduce idiosyncratic risk and provide a reliable, investable proxy for the $5 Trillion commercial real estate market.

Conclusion

I believe that REITs are one of the fundamental building blocks of a long-term equity portfolio.  For that reason, all of the portfolio recommendations on our site include REITs in the potential investment pool.  Before investing, however, there are a couple of things that you should be aware of.  First, the high dividend yield offered by REITs, while attractive to income investors, makes these securities quite inefficient from a tax perspective.  If possible, purchase them in a tax-sheltered account.  Secondly, you could already own some REITs without even knowing it.  A typical fund that mirrors the total US Stock Market is comprised of about 2% REITs, while a small-cap value index fund could contain 10% or more REITs.  Taking your existing holdings into account, a reasonable long-term REIT allocation would be 5-15% of your equity portfolio.  Finally, while there are over 100 publicly available REITs to choose from, you don’t need to be an expert in order to invest.  Control costs and simplify your portfolio by investing in a REIT index fund or ETF like those offered by Vanguard (VGSIX/VNQ).

Reminder:  Need an opinion on a risk-appropriate asset allocation?  Get a free portfolio recommendation today!

Posted by George | Asset Allocation | Comments (0)
 

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