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WHEN BUILDING portfolios, why don’t I include real estate investment trusts? REITs are large, diversified real estate companies. Some own office buildings, while others own apartments, hotels, shopping centers or other kinds of property. An example is Simon Property Group, which owns more than 200 shopping malls across the country.
A REIT is, on the surface, just like any other company, but with one unique feature: Dividends aren’t optional. REITs are required to pay out virtually all of their income, net of expenses, to shareholders each year. As a result, shareholders can expect a reliable—and relatively large—stream of annual income. Simon, for example, is currently paying a dividend of nearly 6%. This compares to an average of less than 2% for other stocks in the S&P 500. This is one reason REITs have great appeal.
In addition to their reliable dividends, REIT fans cite these benefits:
With all these perceived benefits, why don’t I recommend REITs? Keep in mind four points:
1. I actually do like REITs—but I don’t like them any more than any other kind of stock. When you buy an index like the S&P 500, it already includes REITs. I’ll grant that it’s a small portion of the overall market—just 3%—but they are in there. I see no reason to buy more.
2. REITs’ performance has been undistinguished. Over the past 15 years, they’ve done a bit worse than the overall stock market, but with much greater volatility. In 2008-09, when the overall market fell 50% from peak to trough, REITs fell 68%.
3. I appreciate that REITs have lower correlations to the overall market than most other stocks. That makes them somewhat unique. But that is just a relative advantage. For true diversification, I turn to bonds, which have traditionally demonstrated a negative correlation with stocks. In other words, bonds have gained when stocks have fallen, and vice versa. That is true diversification.
4. Owning a REIT is different from owning your own rental property. Yes, REITs have a scale advantage, but they also have a cost disadvantage. At Simon, for example, Mr. Simon took home $11 million last year. His second in command took home $5 million. When you own a rental property directly, it takes more work, but I also believe the rewards are much greater because you’re not burdened by such expenses.
The bottom line: I see no reason for investors to go out of their way to load up on REITs. Are REITs bad? Hardly. But they’re not special, either. The 3% allocation in the S&P 500 is, in my view, sufficient.
A final point: There are two types of REITs—those that are publicly traded and those that aren’t. In this discussion, I have been referring only to the publicly traded variety. Private, or nontraded, REITs are a different matter. A favorite of brokers because of the high sales commissions they can earn, nontraded REITs have a terrible reputation—and I would stay far away from them.
Adam M. Grossman’s previous articles include Candy Land, Owning Oddities and Imagining the Worst. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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Here’s a focused slant on this topic of REITs as portfolio diversifier, which doesn’t get much discussion here at HD (that I have found).
If you’re truly a buy-and-hold investor, and thus deeply agnostic about REIT market prices in your lifetime, another way to think about REITs in a portfolio is as a diversifier for your bond income, with an added inflation hedge.
I compared the dividend yield of Vanguard Group’s VNQ (or VGSLX) fund with yield from 10-year TIPS and 10Y Treasury notes. Since 2002, Vanguard’s REIT fund has had a higher average and median yield than both, by almost one percentage point on average (+84 basis points vs TIPS, +90 basis points vs 10Y nominal). And its annual yield correlation with these two types of Treasurys is roughly zero (0.12 for VNQ vs 10Y TIPS, -0.08 for 10Y nominal), which is appealing.
Before you leap into using REITs in place of some bond allocation for portfolio income, consider two things.
1) Past performance is no guarantee of future performance, especially when looking at data for such a brief time span. REIT yield has dipped significantly even in this short period, once in 2007 (subprime meltdown) and again in 2021 (spiking inflation).
2) REIT prices are obviously WAY more volatile than Treasury prices, hence the major caveat about their fit as an income diversifier. If you plan to sell 4% of holdings each year for income, a REIT index fund would be an unsuitable replacement for bonds in your portfolio.
3) And the obvious one: Unlike bonds, which are contractual obligations to repay debt with interest, putting bondholders ahead of most other creditors in bankruptcy, a REIT fund’s dividends have no such commitment and creditor seniority.
As Adam noted when writing this piece in 2019, major stock indexes like the S&P 500 include some REIT exposure. At this moment, the REIT allocation in that index is down to 2%, as the market cap of tech stocks has risen.
Another observation, for those who worry about embedded risks, e.g. pandemic impact on commercial office space income or valuations: Vanguard’s REIT fund is very diversified over the entire real estate sector, with holdings in: data centers, health care, hotels, industrial properties, multi-family residences, offices, retail, self-storage, single-family residences, telecom towers, and timber.
A REIT as income diversifier is not a novel idea. I’m just starting to dig up papers on this. If you know of any reading on the subject, I’d be grateful for a pointer. Thanks!
I construct my own portfolio and I often use REITs instead of bonds. Thus, my portfolio is 100% stocks, but it includes some REITs when they are reasonably valued.
For example, in march 2000 I was 100% in REITs, but sold out in 2004. Like most investments it all depends on the price.
I found the REIT benefit to be questionable as well. In building my own portfolio, I found a small benefit from REITs, but that was not true in some alternative approaches – which could well mean that any back-tested advantage is a statistical fluke (as so many are).
When you have an asset that goes from being an undiscovered niche to a mainstream investment, its historical record is always suspect. Now that “everyone” owns REITs, they’ll increasingly tend to trade like other stocks, plus the return advantage to pioneering investors is long gone.
I have the Vanguard REIT Index Fund as a regular part of my portfolio. This is good food for thought, but I’ll probably hang on to it because of the somewhat lower correlation with the S&P.