Characteristics of Real Estate Investment Trusts and the Benefits of Including REITs in a Portfolio
"Ninety percent of all millionaires became so through owning real estate" - Andrew Carnegie
When discussing the basics of investing, stocks and bonds are the most commonly referred to asset classes. Embedded within stock market indices are publicly traded real estate companies known as Real Estate Investment Trusts (REITs). REITs are companies that own or finance real estate across a wide variety of property types, from apartment buildings to warehouses to free standing retail such as your local Walmart. REITs currently make up about 3.6% of the U.S. stock market (using the Russell 3000 Index). There is good reason to believe that this allocation is suboptimal and that a REIT-specific allocation within your portfolio can improve both returns and diversification.
Characteristics of REITs:
REITs own, operate, and finance income producing real estate across 13 property types including office, industrial, residential, retail, and lodging. In order for a company to qualify as a REIT, they must invest at least 75% of their total assets in real estate; derive at least 75% of gross income from real estate rents, interest on mortgages that finance the real estate, or sales of real estate; pay at least 90% of taxable income to shareholders via dividends; be a taxable corporation; be managed by a board of directors or trustees; have at least 100 shareholders; and not have 5 or fewer individuals own 50% or more of its shares (what's a REIT). REITs typically do not have to pay corporate income taxes because their earnings are passed along to shareholders as dividend payments.
Including REITs in a Portfolio:
Due to the mandatory distribution of income, REITs provide a steady stream of above average dividends to their shareholders. Secondly, owning real estate provides the opportunity for capital appreciation as the value of that real estate rises. As a result, REITs are often thought of as having characteristics of both bonds (steady income streams) and stocks (capital appreciation).
REITs have also exhibited returns that are only moderately correlated to stocks and bonds. Over the last 10 years, the widely used FTSE NAREIT All Equity REITs index has only a 0.69 correlation with U.S. stocks (as defined here by the Russell 3000 Index) and a 0.36 correlation with bonds (as defined by the Bloomberg Barclays U.S. Aggregate Bond Index). As a reminder, if the returns of two investments move closely together, the correlation of those returns will be close to 1 and if they move inversely to each other, the correlation of those returns will be close to -1. In addition, since the end of 1994 (the modern REIT era began in 1993/1994 as 88 REITs went public over the two year period) through the end of July, the NAREIT All Equity REIT Index has returned 10.97% vs. a return of 11.02% for the Russell 3000 Index. By providing a strong return profile that has been competitive to the U.S. stock market at only a moderate correlation to the U.S. stock and bond markets, there is a strong historical argument to be made that a standalone allocation to REITs can improve the diversification and, potentially, the return profile of a portfolio of stocks and bonds.
Furthermore, there is reason to believe that REITs can provide protection against inflation as rents and real estate values tend to rise when prices do. Additionally, some leases are even tied to inflation. Overall, the growth in dividend payments by REITs has tended to far outpace the rate of inflation. The ability to raise prices and translate that into dividend growth combined with the fact that real assets such as real estate tend to increase in price during inflationary periods may support REIT values in inflationary times.
Investing in publicly traded REITs via individual stocks or mutual funds/ETFs provides an easy way for the everyday investor to invest in the commercial real estate market in a diversified manner. As an asset class with both bond-like and stock-like characteristics, a moderate level of correlation with stocks and bonds, and the potential for inflation-hedging characteristics, REITs can be an important component of an individual's investment portfolio.