The Portfolio Benefit of Real Estate

Lost amid the focus on the continued weakness of the housing market has been the tremendous performance of investment real estate. For example, the Vanguard REIT Index has generated a total return of 27% in 2010 (through 10/26) and nearly 41% over the past 12 months. In fact, among dozens of Morningstar investment categories, real estate easily represents the top-performer for the past year. In light of the potentially counterintuitive nature of these results, this is a prime opportunity to review the definition and merits of investment real estate.

Diversifying a Portfolio with Real Estate

Real estate as a wealth generator is hardly a new idea. People owned property long before the advent of stock exchanges and other capital markets. In more recent times, large corporations and institutions have held commercial real estate in their portfolios.

But individual investors have not traditionally had ready access to a professionally managed, diversified real estate portfolio. This has changed in the last few decades with the development and growth of real estate investment trusts, or REITs. Now individuals can add a real estate component to their portfolio to improve overall diversification.

What is a REIT?

A REIT is a company that owns, operates, and/or finances real estate property. Most of this discussion will address equity REITs, which manage different types of income-producing properties, such as hotels, office buildings, industrial facilities, apartments, and shopping centers. As commercial landlords, equity REITs typically generate dividend income from the rent paid by tenants. Many REITs in the US are traded on the public stock exchanges.

Publicly traded REITs offer investors several potential benefits:

• Real estate exposure. While publicly traded REITs account for only a small portion of the real estate investment universe and the equity market, academic evidence suggests that REITs have similar returns to the overall investment real estate market.¹

• Low correlations with financial assets. Over longer periods of time, historical correlations of REITs and stocks have been generally low. (When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)

• Diversification. A REIT holds a portfolio of properties, which may specialize by property type and industry, or be broadly diversified according to industry and region. Investors can further diversify their exposure among foreign developed markets.

• Higher yield, regular income, capital appreciation. Since REITs have to pay out a large fraction of earnings as dividends, they tend to offer higher-dividend income than equities. Total return of the shares is tied to income and change in market value.

• Distinct asset class. While REITs are considered equity vehicles and can have significant exposure to the equity market risk factors, they are generally considered to be a separate asset class, due to their low long-term correlations with stocks.

• Liquidity. Publicly traded REITs can be bought or sold whenever the stock market is open for business.

• Tax treatment. REITs operate as “pass-through” corporations in which most income goes directly to shareholders. They typically pay little or no taxes on corporate income.²

Investing in REITS

Though REITs carry stock market risk, as well as risks specific to individual properties, sectors, regional markets, and operating firms, adding a real estate component generally improves portfolio efficiency and diversification.³ However, strategy and implementation are crucial; some of the major factors to consider are:

• Asset coverage. Many stock funds and indexes include REITs in their equity holdings. This creates the potential for overlapping asset class exposure for investors who add a REIT component in their portfolio. Treating REITs as a separate and distinct strategy helps you achieve more precise risk exposure in the asset class weights.

• REIT category. Equity REITs may operate property in a specific area of expertise, such as retail, office and industrial, hotels, or health care facilities. Residential REITs own and operate apartment buildings and multi-family commercial dwellings, rather than single-family homes. Mortgage REITs, which lend money directly to real estate owners or invest in existing mortgages or mortgage-backed securities, are generally excluded from the equity REIT universe because they perform more like fixed income instruments. Hybrid REITs combine the strategies of equity and mortgage REITs.

• Diversification. As with financial assets, owning a broad mix of REITs can help reduce specific risk in a portfolio. A REIT mutual fund or exchange-traded fund that manages a portfolio of REITs typically offers more diversification than owning a single REIT. This diversification prevents concentrated exposure to a single REIT category, manager style, or geographic region. Also, the addition of international real estate can further enhance the potential diversification benefit.

Diversifying by owning both real property and businesses is an age-old concept. REITs offer an efficient means of integrating income-producing properties in the investment portfolio. The strength of REITs recent performance is reflective of the depths of its 2009 lows, the ability to maintain or increase occupancy levels, and the opportunity for large, cash-rich REITs to capitalize on the credit crisis struggles of smaller real estate investors. As demonstrated in 2010 and over the time, the diversification benefit and return potential of real estate can deliver significant portfolio benefit.

Endnotes
¹ Joseph Gyourko and Donald B. Keim, “Risk and Return in Real Estate: Evidence from a Real Estate Stock Index,” Financial Analysts Journal 49, no. 5 (September-October 1993): 39-46.

² A US REIT must invest at least 75% of its assets in real estate and derive at least 75% of its income from real estate property or interest on real estate financing. It must also distribute at least 90% of its income to shareholders to maintain tax-advantaged status. This pass-through provision allows REIT investors to have access to the same cash flows as investors in private real estate equity. REIT shareholders then are taxed on income they receive from a REIT.

³ Over the 20-year period from 1990 to 2009, the annual return correlation between US REITs and the US stock market was 0.498 (1.0 denotes exact positive correlation in returns).

REITs vs. US Stocks

Annual Returns: 2000-2009