From the September 2013 issue of Research Magazine • Subscribe!

August 26, 2013

Fitting Real Estate into a Portfolio: Picket Fences or REITS?

“My clients own their own homes. Many of them own vacation houses, too. Doesn’t that give them all the real estate they need in their portfolios?”

That’s a common question posed by financial advisors about the role of real estate in investment portfolios. After all, even among very wealthy Americans, net equity in their primary residence comes to a significant share—commonly around one-fifth—of total net worth, while the norm for other homeowners is upwards of three-quarters.

Interestingly, I’ve never fielded the same question from homeowners themselves. That revealing fact hints at the answer: While a house may represent an important component of net worth, that doesn’t mean it’s part of an investment portfolio.

Consider the financial situation of a client with total net worth of $1 million, composed of home equity ($250,000) and an investment portfolio ($750,000) allocated to domestic large-cap stocks, 60%, and domestic bonds, 40%. The client’s questions are: What role should real estate play in a portfolio? And, by changing the asset allocation, can wealth be increased without taking on additional risk?

Houses as Investments

Investors typically want strong returns with moderate risk, of course, and portfolio diversification. They also look for liquidity, scalability (or “right-sizing”) and rebalancing. Now consider what clients want from their homes: a location in the city where they want to live, a neighborhood convenient to their work and community resources, and a house of the right size.

The Federal Housing Finance Agency estimates that house prices have appreciated by 3% percent per year, on average, since early 1991. Most of the benefit from owning a house comes from living in it, meaning that you save on rent; the Bureau of Economic Analysis estimates the value of that “imputed rent” as the equivalent of a return averaging nearly 5.6% per year. Historically, owner-occupied housing has made sense for most people—but that’s almost entirely because of the value of living in the right home, not because of its price appreciation.

Think about your client’s investments: Since Q1’91, the financial portfolio would have generated returns averaging 8.62% per year with volatility of 9.55%. The total “portfolio,” including the house, would have returned slightly more, around 8.65% per year, with volatility of only around 7.28%. But the higher returns and lower volatility come mainly from the substantial (and very steady!) value of “imputed rent”— because the clients get to live in their house.

Real Estate as an Asset Class

Real estate is one of the four fundamental asset classes around which every portfolio should be built. Princeton professor Burton Malkiel, author of “A Random Walk Down Wall Street”—wrote that “basically, there are only four types of investment categories that you need to consider: cash, bonds, common stocks and real estate.” Mark J.P. Anson, formerly the chief investment officer of the California Public Employees Retirement System, agreed: “Real estate is not an alternative to stocks and bonds—it is a fundamental asset class that should be included within every diversified portfolio.”

David Swensen, the chief investment officer for Yale University and author of “Unconventional Success,” went further by recommending a “basic formula” with one-fifth of the portfolio invested in real estate (listed real estate investment trusts, or REITs) and the remainder in stocks, bonds and cash. Listed REITs—real estate owned through the stock market—provide investors the combination of strong returns, moderate volatility, and portfolio diversification along with liquidity, scalability, and ease of rebalancing that clients need in their investment portfolios.

Getting back to the client’s two questions, the answer to the first is twofold: First, the home shouldn’t be considered part of the investment portfolio; second, the real estate asset class—listed REITs—should be part of it.

Since Q1’91, the total return on listed equity REITs has averaged 13.31% per year—much better than large-cap stocks (9.98% according to the S&P 500), small-cap stocks (11.39% per year according to the Russell 2000), international stocks (6.70% per year according to the MSCI EAFE), or owner-occupied housing (including imputed rent, between 6.81% and 10.78% per year, depending on the city).

Plus, REITs provide valuable portfolio diversification. Even though they’re traded through the stock market, listed equity REITs have a low correlation with non-REIT stocks: just 0.58 with large-cap stocks, 0.67 with small-cap stocks, and 0.56 with international stocks. In contrast, non-REIT stocks move fairly closely together with correlations of 0.89 (large-cap with small-cap), 0.84 (large-cap with international), and 0.77 (small-cap with international).

Other Correlations

REIT returns have almost nothing in common with owner-occupied housing returns: The correlation between them is just 0.13, and of course, listed REITs expose investors to the commercial real estate market cycle without high transaction costs and without giving up liquidity or the abilities to right-size and rebalance investments.

The value of an office REIT is driven by office space rentals; the value of a retail REIT by consumer spending; the value of a hotel REIT by business and vacation travel; the value of an industrial REIT by shipping and warehousing activity. In comparison, the value of a home reflects demand from other folks who want to live in your neighborhood.

In short, real estate—listed REITs—should play an important part in your client’s portfolio, just as Burton Malkiel, Mark Anson and David Swensen have recommended for essentially every other investor’s portfolio.

Optimizing to Improve Returns

What about changing the client’s asset allocation to achieve higher portfolio returns without increased volatility? First, even without adding real estate, it would have been possible to increase the average returns of the client’s portfolio over the historical period. You could help the client reduce the large-cap stock allocation from 60% to 24.4%, shifting most of it into small-cap stocks (30%, say, if that is the limit of the client’s comfort level) for higher returns, and putting the remainder (45.6%, up from 40%) into domestic bonds for greater stability.

Such a financial portfolio would have preserved average volatility at 9.55% while increasing average returns from the 8.62% per year of the current allocation to 8.85%—after just 10 years, a difference in financial wealth of more than $37,000 based on the current financial portfolio of $750,000.

But that pales in comparison with what the client could have accomplished by incorporating the real estate asset class—listed equity REITs—into the portfolio. With a 30% allocation in equity REITs—thanks to their diversifying power and strong returns—over the historical period the client could have realized portfolio returns averaging 9.64% per year with no increase in portfolio volatility.

That’s a wealth difference after just 10 years of more than $130,000 over the financial portfolio including small-cap stocks, and more than $168,000 over the current financial portfolio. The client would have achieved that result by shifting most of the large-cap stock holdings to listed equity REITs (30%) for higher returns and diversification and to small-cap stocks (21.5%) for higher returns, plus some added domestic bonds (48.3%) for greater stability, while leaving just 0.2% in large-cap stocks.

REITs: The Better Real Estate Investment

What would a client’s wealth portfolio look like by treating the home as an asset? First, the client could increase his or her home equity as a share of net worth—say, to the same 30% constraint used for small-cap stocks and REITs. But the financial portion of an overall portfolio optimized to maximize return without taking on additional risk would look remarkably similar to the optimized financial portfolio.

If REITs were ignored, the client could still increase the average overall portfolio return from 8.65% per year (including the value of living in the house) to 8.92%, without changing the wealth volatility of 7.28%, by reducing holdings of large-cap stocks from 45% (60% of the financial portion) to 8.6%, establishing a 30% allocation to small-cap stocks for higher returns, and increasing bond holdings to 31.4% (45% of the financial portion) for greater stability.

Again, though, the client could have realized much greater portfolio performance, with no added portfolio volatility, by incorporating the real estate asset class—listed equity REITs—into the financial portion of the portfolio. Maintaining the home at the same 30% share of overall net worth, the client could have reduced the large-cap stock holdings from 45% to 2.2%, established an allocation of 30% in listed equity REITs for higher returns and portfolio diversification, added 5.3 in small-cap stocks for higher returns, and increased bond holdings to 32.4% for greater stability.

Over the historical period, such a portfolio would have maintained the same 7.28% volatility while providing portfolio returns averaging 9.54% per year—a difference in wealth after just 10 years of more than $136,000 over the portfolio including small-cap stocks, and more than $194,000 over the current portfolio.

For clients who ask how their home fits into their investment portfolio, you can distill the lesson this way: A home is like a bond—and the more equity they have in a home, the less they should be holding in bonds. But essentially every client should devote part of their equity allocation to the real estate asset class—listed equity REITs—for its combination of stock-like strong returns with moderate volatility, along with portfolio diversification, liquidity, right-sizing ability and ease of rebalancing. Listed REITs can keep your clients living in the best home while helping to grow their wealth, too.

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