The financial crisis of 2008 laid waste to any illusions that real estate investment trusts (REITs) operated in a safer world than traditional equities. The old saw that stable rental flows and hard assets provided a safe harbor from market turbulence went out the window as REITs fell even harder than stocks during the great recession. Equity REITs returns dropped by 32% in September 2008 alone. Then they dropped another 23% in October. Nothing like losing half your investment in two months to remind an investor that all corporations are at the mercy of markets.
Since their epic fall in the great recession, REITs have rebounded big time. A recent pause in rising REIT prices has many wondering whether now is the right time to take profits on equities and avoid the risk of holding bonds in a rising interest rate environment. So let's take a fresh look at REITs in the 21st century to see whether they make sense in a modern portfolio.
Lay of the Land
First, what are REITs? Conventional wisdom says a REIT is like investing in real estate without the headache. REITs separate management from capital in the rental real estate business, allowing a real estate investor to avoid hiring a plumber or evicting a tenant. Like a corporation, investors pool their money and hire an expert to invest it productively and to manage the properties and tenants. Managers buy shopping malls or offices (or real estate debt for mortgage REITs) and then pay out at least 90% of their income every year in dividends. They avoid corporate taxation by allowing their profits to pass through to REIT shareholders, but the majority of dividends are nonqualified and subject to higher ordinary income tax rates.
I’ve even heard some speculate that apartment dwellers should allocate a larger percentage of their portfolios to REITs because lesser portions of their own personal portfolios are allocated to home equity. Assuming REIT returns move with residential real estate values isn't accurate. In a study of correlations between various REIT indexes and other investments, University of Southern California professor Peng Fei and his co-authors estimate the correlation to be 0.06 between the Case Shiller housing price index and REITs. There is no correlation between REITs and residential housing prices.
Like an investment in corporate equity through stock, cash flows on real estate equity can be unpredictable and volatile over time. But cash flows are going to be higher during an expansion and lower during a recession. Just like stock prices. That's why the correlation between equity REITs and the S&P 500 was a much higher 0.45 between 1987 and 2008. Still low enough to provide a possible portfolio boost, but REITs are certainly not a hedge against a bear market for equities.
Despite their fall in 2008, REITs have outperformed the S&P for a long period of time now. If you had invested $1 in the FTSE NAREIT All REIT index in 1990, you’d have $10.59 by March 2014. An investment in the S&P 500 would have given you almost exactly half that amount ($5.30). Think stocks have rebounded well from their low point in March 2009? REITs have still trounced stocks since the great recession. The outperformance didn't come for free since investors have been subjected to a bumpier ride. REIT monthly standard deviations have been 23% higher than stocks since 1990.
One comparative disadvantage of REITs relative to equities is that its dividends are mostly subject to ordinary income tax rates (actually about 80% of REIT dividends are non-qualified since some of the dividend may come from capital gains sales). This also gives REITs an advantage over a corporation because it avoids corporate taxes—much like a mutual fund.
Research suggests that REITs can have a big impact on improving risk-adjusted portfolio performance. A recent study by Fidelity showed that adding a REIT exposure to a traditional stock bond portfolio consistently increased the Sharpe ratio. While a 60/40 stock/bond portfolio provided a Sharpe ratio of only 0.27 between 1993 and 2013, adding the FTSE NAREIT index boosted Sharpe up to 0.34 with a 10% REIT allocation and up to 0.46 for a 20% REIT allocation. That's a significant boost in portfolio efficiency unmatched by many other alternative asset classes.
Higher tax rates on dividends means that building an efficient portfolio with REITs should involve sticking REITs and other tax-disadvantaged investments in a sheltered account and shifting tax-advantaged investments into taxable accounts. In terms of style box weighting, REITs tend to fall toward the small cap and value exposure. This can explain both their recent excess performance, and also their potential risk if you believe that small cap and value reflect priced risk factors that need to be balanced.
One of the reasons REITs boost portfolio performance is related to a major misconception about REITs. Not only do they not correlate at all with residential real estate, they also don't correlate that strongly with bonds or interest rates either. Over the last 20 years, the correlation between REITs and investment-grade bonds has been only 0.13. Since 1990, the correlation between bonds and REITs is about the same as the correlation between stocks and bonds. This low correlation with bonds and modest correlation with stocks gives REITs a big portfolio advantage—especially since returns have been so strong in recent decades.
Headwinds in recent REIT returns have been attributed to an expected rise in interest rates. REITs have been around for decades, however, and rising interest rates haven't been nearly as harmful to REIT returns as a negative business climate. For example, REIT returns have remained positive during the five periods of rising interest rates since 2002. They even outperformed the S&P during three of these rising rate periods. Between 1979 and 2012, REITS outperformed stocks during the 135 months of rising 10-year Treasury yields and the 95 months of rising Federal funds rates, according to a study by investment management firm Cohen and Steers. They also found that REITs performed better during inflationary periods than during periods of lower inflation.
REITs aren't that sensitive to rising rates because managers have the power to raise rents. This power to raise rents is related to the length of lease. If you have a long-term contract with tenants, you can't change the terms if interest rates or inflation rise. Todd Lukasik, a senior analyst in the real estate sector at Morningstar, explains that some companies “engage in very long-term leases that might be 12 to 15 years on average where the tenant might have renewal options that could turn into a 30 year lease. Those, on my list, tend to be the most sensitive to changes in interest rates.” Other companies who manage apartments or self-storage facilities may be more insulated from rising rates.
The popularity of REITs has exploded since the 1990s. As their prices have increased, the spread between equity market and REIT dividend yields narrowed from 6% in the early 2000s to just over 2% today. With popularity comes greater demand and higher prices. And with higher prices come more modest return expectations. REIT income continues to attract investors, but the potential for future dividend growth is limited by the ability of managers to generate profits from the property market.
Lukasik agrees that demand, and in particular the search for income from investments, has affected REIT valuations. Investors’ search for yield has “had a big impact on the share prices of the publicly traded REITs.” Despite rising prices, Lukasik points out the potential for growth in sectors such as health care that may be currently underappreciated. Health care REITs have “really taken it on the chin since last May.” But REITs own only about 15% of the health care real estate market and Lukasik expects “demand in general to grow long term due to the growing and aging U.S. population.”
Another recent REIT trend is the popularity of non-traded REITs, which are not regulated by the SEC* and thus are less subject to oversight and regulation. This lack of transparency has led to some predictable abuses, which resulted in a recent investor alert by FINRA. These investments are often sold as a high income earning product available only to the select few lucky enough to have access. In reality, they often have much higher fees and there is limited evidence of actual net performance advantage (and they can be very difficult to get rid of).
Lukasik notes that “the fundraising in that area has been huge. Those types of firms have emerged rather quickly as competitors to the publicly traded REITs, and in some cases have been acquired by publicly traded REITs as the exit strategy for investors.” Are they a good idea for investors? According to Lukasik, “if you invest $100 in the product and maybe $85 to $90 is actually being used to buy properties, investors need to be concerned about what they’re actually buying.”
Future prospects for publicly traded REITs will depend on the strength of the economy and the demand for rental property. Lukasik is optimistic. First, there isn't much evidence of an oversupply of real estate if the economy continues to grow at a steady pace. “That's been a great environment for landlords,” which has “led to an environment where you get rising occupancies, rising rental rates and overall organic growth in REIT portfolios,” notes Lukasik. “We expect that slow and steady growth to continue, and that's a great environment in REITs.”
Is there a place for REIT investment in a 21st-century portfolio? REITs have provided strong returns historically and are a good complement to stocks and bonds. They enhance diversification and are particularly attractive in tax-sheltered accounts. Worries about interest rates and overvaluation are real, but no more so for REITs than for the current stock and bond markets. As alternative asset classes go, publicly traded REITs provide attractive liquidity, transparency, relatively low management expenses and a winning track record.
* - Editor's note 6/6/14: The author has clarified that REITS may be less subject to market oversight but still must meet SEC requirements.