The Case for REITs

Real estate has a unique position between fixed income and equity in a portfolio. While it generates income like a bond, its principal generally adjusts over time with inflation. Oddly, it is one of the few investments where both the income stream and principal are generally expected to appreciate over time with inflation.

The easiest way to invest in real estate is via a Real Estate Investment Trust or REIT for short. REITs were created when President Eisenhower signed into law the REIT Act title contained in the Cigar Excise Tax Extension of 1960. REITs were created by Congress in order to give all investors the opportunity to invest in large-scale, diversified portfolios of income-producing real estate1.Today the publicly listed REIT universe is a $1trillion market.

Because the capital structure of REITs is leveraged (they typically hold a debt on the properties they own), the correlation to interest rates is much lower than stocks despite REIT ownership being an equity security. While declining interest rates are often indicative of a slowing growth and inflation environment (growth and inflation naturally are good for owning real estate as property values and subsequently income streams rise), it also simultaneously lowers the bar for returns, and lowers the cost of capital for these sometimes highly levered structures.

This can be seen in Table 1. Within this table the lower the number, the lower the annualized correlation two markets have. For example, we note that the Dow Jones US Select REIT index has a high correlation (.72740) to the S&P Global ex US REIT Index, but a low correlation (-.26080) to the Barclays US Government Bond Index Intermediate.

Given the different sensitivity to both interest rate levels and the overall stock market, REITs can act as a compelling diversifier to a balanced portfolio. Always counterbalanced to returns, cyclical and credit events are the dominant risks. In fact, a dominant explainer of REIT returns year over year is the Corporate Bond Baa spread.

As shown in the table below, REIT returns show the highest correlation to US High Yield Bonds (other than to Global REITs) with nearly 60% of returns explained by movements in high yield bonds.

A traditional 60/40 portfolio has returned approximately 641% since 1990, while a 55% stocks/35% bonds/10% REIT portfolio has returned 713%. This additional return has not come without cost. The volatility of REITs has been slightly higher than in equities, but mostly due to the heightened volatility during the Great Recession (2008/2009) when real estate was at the epicenter of the crash. Still, the average annualized volatility since 1989 of the portfolio with REITs (11.01%) was only 0.3 points above the portfolio without (10.82%).

As Figure 2 illustrates, REITs are slightly more volatile than the broader equity market, but they have also offered higher return. Because of their capital structure, they have historically acted as a diversifier to both interest rates and the general stock market. Unlike commodities, which our past newsletter explored, the addition of REITs to a balanced portfolio adds meaningful diversification and return enhancement. In closing, REITs should have a small, but meaningful allocation in your balanced portfolio.