REITs: Diversifying, Real Returns for the Long Run?
The typical investor is virtually assured of experiencing some kind of disaster during his lifetime. Most are ill-prepared to weather major inflation, which hurts both stocks and bonds by raising discount rates. When inflation is high, investors reasonably worry about future macroeconomic stability, inducing them to demand higher real interest rates for lending over the long term. High real interest rates decrease the present value of all future cash flows. Nominal bonds are doubly hit because their fixed payments are devalued.
Good inflation hedges with decent yields are rare. Equity real estate investment trusts, or REITs, look like the rare exception. While their absolute yields are ugly, their yields relative to Treasuries look OK. Below is a chart of U.S. equity REIT yields minus the 10-year Treasury rate (a better comparison is to use real yields, but Treasury Inflation-Protected Securities only came into being in 1997). Not bad. Low interest rates, like alcohol, go a long way to lower one's standards. Should we buy REITs to hedge against inflation? While inflation hasn't been a problem since we entered the global balance-sheet recession, a properly balanced, robust portfolio demands that we load up on insurance when it's cheap. This chart suggests inflation protection can be had for a reasonable price by purchasing publicly traded real estate.