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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.

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