There’s a maxim that says when there is blood on the streets, buy property.
However, troubled times are not the only occasion to consider real estate. In fact, the housing market has really shone in recent years, and the stocks of real estate investment trusts (REITs) can enhance returns—while providing diversification benefits. Yet many investors are underexposed to this growing asset class.
Portfolio optimization benefits of REITs
REITs own investment-grade, income-producing real estate—including office buildings, apartments, shopping centers, and storage facilities. REITs are required to distribute at least 90% of their taxable income in the form of dividends, and dividend income has constituted nearly two-thirds of REITs’ total returns. This may be significant for several reasons. For instance, rental rates tend to rise during periods of increasing inflation, therefore REIT dividends tend to be protected from the detrimental effect of rising prices, unlike many bonds.
While most investors know about the risks and rewards of including stocks and bonds in their portfolio, in many cases the benefits of REITs may not be understood. The primary benefits of REITs include their low correlation and strong historical track record of performance relative to other assets. In particular, REITs can be beneficial for investors with multiple asset classes and a long-term investing window.
During the past 20 years, REITs have had a relatively low correlation with the broader stock market (0.56) and very little correlation with investment-grade bonds (0.13), both of which are typically viewed as core holdings in a diversified portfolio.1 (Note that a perfect negative correlation is –1, 0 is the absence of correlation, and 1 represents a perfect positive correlation.) Correlation is an important factor in diversifying a portfolio because assets that are less than perfectly correlated may be able to partially mitigate the impact of market volatility over time.
Investors underexposed to REITs
Publicly traded U.S. REITs have become a widely accepted investment vehicle, evidenced by their inclusion in several prominent stock market indexes. However, actively managed diversified stock funds are largely underweight REITs (see the chart below).
In each of Morningstar’s nine style box categories, the average equity fund has been underweight REITs relative to the respective benchmark index since 2003 (see the chart above). Looking across all market capitalizations (small, mid, and large), value-oriented equity funds have the largest underexposure to REITs—and are consistently greater than growth-oriented equity funds.
Additionally, fund managers across all three market capitalizations have tended to allocate less capital to REITs over time. For example, in the mid-cap universe, the average relative REIT exposure of value equity funds has declined from a –4.8% underweighting in August 2003 to a –7.6% underweight in June 2013. In the small-cap universe, the average relative REIT exposure of value funds has fallen from –5.4% to –8.4% over the same period (see the chart below).
Interestingly enough, investors who use passively managed stock strategies that track major indexes may have adequate exposure to REITs, which can provide an optimal level of diversification, in our opinion.
Institutional investors have embraced REITs
While many individual investors and actively managed funds have been underexposed to REITs, pension plan sponsors, endowments, foundations, and other institutional investors that are considered the “smart money” have long embraced commercial real estate as a core asset class.
The characteristics most attractive to this group are diversification (across multiple geographic regions, countries, and sectors), income (rent), and a hedge against inflation (property is a real asset). Also, REITs have the added benefit of being more liquid, transparent, and having lower capital requirements compared with owning actual property.
Additionally, there are a large number of opportunities in REITs (see the chart below). Today, there are nearly 170 U.S. public REITs with a total equity market capitalization in excess of $650 billion. Investors who would like to gain exposure to REITs have many choices.
As of October 22, 2013, the largest publicly traded REITs by market capitalization are Simon Property Group Inc. (SPG), American Tower Corp (AMT), and Public Storage (PSA).
REIT myths dispelled
Many believe that home ownership may provide ample exposure to real estate. However, publicly traded REITs generally own commercial real estate, which has different investment characteristics than residential housing. Unlike single-family residential property, direct ownership of commercial property is unrealistic for most individuals due to high capital requirements. REIT stocks can be an ideal way for individual investors to get exposure to the commercial real estate asset class.
Also, the performance of REITs historically has demonstrated surprisingly minimal and inconsistent sensitivity to changes in interest rates (see the chart right). This is contrary to a widely held belief that because real estate is a capital-intensive business, potentially higher interest rates—resulting in higher borrowing costs—would be detrimental for commercial property owners.
Even though interest rates have risen in recent months, there is an expectation held by many that rates may continue to rise if the Fed eventually begins to reduce some of its easy money policies. Historical evidence suggests that this may have little impact on REITs.
Gradually rising interest rates generally portend improving economic activity, which can help support REIT cash flows due to strengthening demand for commercial real estate and an increased ability for landlords to raise rental rates. It should be noted that our analysis suggests there are other factors at play that may better explain REIT stock returns at any given time, such as the macroeconomic backdrop, fundamentals, valuation, and technical conditions.
As with any other investment, there are risks associated with REITs that must be taken into account. In addition to the market risks inherent with any investing vehicle, REITs are sensitive to a downturn in the real estate market—particularly commercial property. Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry. REITs may also be sensitive to interest rate risk as lending rates can impact costs, and thus, the performance of the REIT.
Nevertheless, REITs may be an effective way to diversify your portfolio. Yet many investors remain underexposed to this asset category. Our analysis shows that having an appropriate allocation to REITs in a multi-asset class portfolio can help improve a portfolio’s risk-adjusted returns over time.
In real estate, it may be all about the location. In terms of your portfolio, location matters as well: your asset location. REITs, as an asset class, can be a potent source of returns as well as an excellent portfolio diversifier.