Correlation Building Between REITs and Other Stocks

Question: I've been advised to add REITs to my retirement portfolio to provide some diversification. Can you explain what they are and how they do this?

Answer: REITs, or real estate investment trusts, are a type of stock made up of portfolios of commercial properties. These properties generate income from rent and capital appreciation in the form of rising property values. REITs typically invest in office buildings, shopping centers, hotels, and other properties. Some focus on specific types of real estate, such as health-care REITs that own hospitals, skilled-nursing facilities, and so forth. There also are mutual funds and exchange-traded funds made up of REITs as well as those that track REIT indexes.

REITs' main purpose is to generate revenue from leases. And because they are required to pay nearly all of that revenue to shareholders, they can offer high yields, making them good choices for investors looking for a steady source of income, though they are far more effective in tax-advantaged accounts such as IRAs or 401(k)s where their nonqualified dividends are shielded from Uncle Sam. They also provide a hedge against inflation, which tends to increase real estate prices and rents.

For many years, REITs were seen as a good way to diversify a portfolio and provide some degree of protection against volatility in the equities market. During the 2000 market downturn, for example, when the S&P 500 lost 9%, real estate stocks gained 34% on average. However, that was an extreme market environment, and events since then have altered REITs' role as a diversification tool.

Addition to the S&P 500
One significant change was the addition of REITs to the S&P 500 in late 2001. (Today real estate makes up about 2% of the index.) This change has had a significant impact on the correlation between REITs and the S&P 500, one of the most widely used measures of overall stock market performance. With REITs added to the index, the S&P 500 has become more sensitive to their performance. In addition, as index funds have increased in popularity--total net assets in S&P 500 index funds increased from $249.5 billion in 2001 to $375.9 billion in 2010, an increase of about 50%--more money has flown into REITs, as well, helping to increase this correlation.

To illustrate how this level of correlation has risen, consider that during the past 15 years, the R-squared (a measure of correlation) for real estate funds and the S&P 500 has averaged 35.6, meaning that only 35.6% of the real estate fund category's movements can be attributed to the performance of the S&P 500. During the past five years, however, that number leaps to 67.5% (with a three-year average slightly lower at 61.3%). Furthermore, the average gap in the annual performance of real estate funds and the S&P 500 has narrowed, from 16.5 points per year during 2002-06 to 9 points per year during 2007-11.

Lesson From the 2008 Crash
The increased correlation between REITs and stocks was borne out in painful fashion during the 2008 market crash, when real estate funds lost 39.6%, compared with a 37% drop in the S&P 500. Real estate would also lead a strong rebound from the market bottom in March 2009, beating the S&P by about 14 points on average in the subsequent three years. 

It also should be noted that REITs are not the low-volatility asset class some think. Real estate has had a standard deviation (a measure of volatility) greater than that of the S&P 500 index during the trailing three-, five-, 10-, and 15-year time periods.

Asset Class Still Has Value in a Portfolio
Do these statistics mean REITs shouldn't play a role in your portfolio? Not at all. Although they might not provide the degree of diversification from stocks they once did, REITs do offer the benefit of exposure to an asset class that can deliver consistent income and possibly above-market returns.

Also, be aware that many stock funds contain REITs, so you might already have some exposure to them without even knowing it. In fact, the average small-cap blend fund currently holds 4.4% of assets in real estate, and some popular funds have much more exposure than that. For example,  Wells Fargo Advantage Small Cap Value has nearly 11% of its portfolio in real estate.

If you're unsure how much real estate is in your portfolio, you can use Morningstar's Instant X-Ray tool or the X-Ray function in Portfolio Manager to find out. You can compare your weighting with that of a total-market index fund such as
 Vanguard Total Stock Market Index (VTSMX) to see whether your exposure is on the high or low side.

It's also worth noting that, like stocks, REITs generally have a low level of correlation with bonds. Be aware, too, that Morningstar currently rates the real estate sector as overvalued.

REITs' role as a diversifier from stocks might be diminished, but they are still a great way to invest in real estate without having to take out a mortgage. Just keep REITs' volatility and correlation to stocks in mind when considering your asset allocation.

R-squared and volatility data as of Feb. 29.

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