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ETF Specialist

Diversification Benefits of REITs

REITs look richly valued right now, but they have potential as a long-term diversifier and source of income.

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While real estate represents a significant portion of most homeowners' wealth, it rarely comes up in discussions about asset allocation. Instead, investors typically allocate their portfolios between stocks and bonds and determine their exposure to real estate primarily as a function of their housing needs. But a strategic allocation to real estate in a portfolio could make sense for investors seeking to improve diversification and generate income. Real estate investments share some characteristics with both bonds and stocks. A large portion of the returns on real estate come from rent payments, which are usually fixed in the short term, like a bond. Similar to stocks, real estate investments can appreciate in value and generate income growth, if market rents increase. Yet historically, the real estate market has exhibited low correlations with stocks and bonds, suggesting it can offer good diversification benefits.

A primary residence allows homeowners to save on rent and participate in any appreciation in local real estate values. But it is illiquid and undiversified and does not offer any income. Affluent individuals could purchase investment properties and rent them out to generate income, but without a very large asset base, it is difficult to get diversified exposure to the real estate market through direct ownership. Equity real estate investment trusts, or REITs, help solve this problem. These are publicly traded companies that own and manage income-generating real estate properties. While most REITs hold many properties, many focus on a narrow segment of the real estate market, such as shopping malls or health-care facilities. In order to further improve diversification, investors can hold a portfolio of REITs through a low-cost fund, like  Vanguard REIT ETF (VNQ). As an added benefit, REITs offer much better liquidity than a direct investment in real estate because investors can trade small stakes in these trusts without triggering any transactions in the primary real estate market.

Despite their advantages, equity REITs appear to be more highly correlated with the stock market than physical investments in real estate. From 1978 through September 2014, the FTSE NAREIT All Equity REITs Index was 0.58 correlated with the S&P 500. That figure increased to 0.78 over the past decade, attributable in no small part to the subprime crisis. In contrast, the NCREIF Property Index, which measures the appraised value of commercial real estate properties each quarter, was only 0.09 correlated with the S&P 500 since 1978.

Part of that seeming low correlation is an illusion. Infrequent appraisals smooth out fluctuations in actual market values, which may artificially deflate the index's correlation with the stock market. They also cause the NCREIF Property Index to lag actual changes in real estate values. Even so, REITs do behave more like stocks than physical real estate investments. S&P started to include REITs in its equity indexes in October 2001, and they are now represented in most broad stock indexes. However, REITs only represent about 3.6% of the CRSP US Total Market Index.

REITs are required to distribute at least 90% of their income to investors, which allows them to avoid paying corporate taxes and gives them higher yields than most stocks. The bad news is that most of their distributions are taxed as ordinary income. Because REITs distribute such a large share of their income, they may be more likely to cut their distributions than other firms if business sours. However, high payout rates don't tell the whole story. Net income includes depreciation charges that often exceed the economic depreciation of REITs' assets. As a result, REITs' cash flows often exceed their accounting income, so some may still have a bit of a cushion to support their distributions even if income falls.

Unlike many other income-oriented assets, REITs are not defensive assets with a low risk profile. They represent a leveraged claim on real estate assets, which amplifies the effect of fluctuating real estate values on their prices. This idea should be familiar to homeowners. For example, suppose a homeowner puts a $50,000 down payment on a $200,000 house and borrows the rest. If the value of the house increases 10% to $220,000, the return on the homeowner's equity is 40% (ignoring interest and additional equity paid in) because the amount the owner needs to repay is fixed. This same "leveraging effect" works in reverse if prices fall. Because REITs generally own properties that are largely financed with debt, they can experience large swings in value from small changes in property values.

This may explain why the FTSE NAREIT All Equity REITs Index was about 4 times more volatile than the NCREIF Property Index from 1978 through September 2014. However, part of this difference is due to the appraisal smoothing effect that understates the true volatility of the property values in the NCREIF index. During that time, the FTSE NAREIT All Equity REITs Index was also slightly more volatile than the S&P 500.

Investors have been rewarded for accepting this risk. From 1972 through September 2014, the FTSE NAREIT All Equity REITs Index generated a 12% annualized return, while the S&P 500 posted 10.5%. Not surprisingly, almost two thirds of the REIT index's return came from distributions, which are largely derived from rental income. Investors should have modest expectations for capital gains. Over the very long term, commercial real estate values should not grow faster than their potential occupants' sales, while residential real estate prices should not exceed household income growth. Faster growth requires real estate buyers to finance an ever greater portion of their purchases with debt. While debt-fueled growth can last for multiple decades, it is ultimately unsustainable. Debt financing allows REITs to parlay modest capital gains into attractive returns. But rental income will likely continue to generate a significant portion of their total returns.

Despite their tie to property values and rents, REITs have generally not been a good hedge against inflation in the short term. The FTSE NAREIT All Equity REITs Index's rolling three-year returns were only 0.13 correlated with changes in the Consumer Price Index since December 1972. Investors concerned about inflation may be better off in Treasury Inflation-Protected Securities, which offer a more direct hedge against inflation.

Given the importance of debt to the real estate market, it seems logical that REITs should be sensitive to changes in long-term interest rates. Rising interest rates can increase REITs' debt financing costs if they rely on floating-rate debt or need to issue new debt. Higher rates can make real estate more expensive to prospective buyers, which may reduce the prices they are willing to pay. Real estate valuations can also fall because higher rates reduce the present value of the cash flows a property will likely generate in the future. These effects work in reverse if rates fall. But interest rates don't change in isolation. They tend to increase as the economy strengthens, which often coincides with rising rents and real estate prices.

In order to assess the net effect of changing interest rates on REITs' performance, I ran a regression analysis. I used the equity market risk premium and monthly changes in the 10-year treasury rate from 1972 through September 2014 to explain the returns of the FTSE NAREIT All Equity REITs Index over T-bills. It turned out that there was no significant relationship between changes in the 10-year Treasury rate and the performance of the REIT index over the full period. However, that has changed over the past decade. During that span, the FTSE NAREIT All Equity REITs Index declined in value by 3.8% for each percentage-point increase in the 10-year Treasury rate (and vice versa), controlling for its exposure to the stock market. This suggests that interest-rate risk is important to monitor. If interest rates tick up significantly, without a corresponding improvement in the economy, it could hurt REITs' performance.

Investors should also be cautious about the relatively high valuations U.S. REITs now command. The 15 holdings in VNQ that Morningstar's equity analysts cover have an average price/fair value multiple of 1.12 (1.14 on an asset-weighted basis) as of this writing. At the end of September, the fund's holdings were trading at 33.8 times forward earnings, nearly twice the corresponding figure for the CRSP US Total Market Index (17.4). But as a result of their asset-laden balance sheets, they look slightly cheaper relative to book value.

High valuations and interest-rate risk are good reasons not to immediately overweight REITs. However, they can offer good diversification benefits over the long run. Rising interest rates could cause valuations to recede and offer investors an opportunity to reap these benefits more cheaply. If nothing else, REITs are worth watching.

 

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Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.