There’s a maxim that says when there is blood on the streets, buy property.
However, troubled times are not the only occasion to consider real estate. In fact, the housing market has really shone in recent years, and the stocks of real estate investment trusts (REITs) can enhance returns—while providing diversification benefits. Yet many investors are underexposed to this growing asset class.
REITs own investment-grade, income-producing real estate—including office buildings, apartments, shopping centers, and storage facilities. REITs are required to distribute at least 90% of their taxable income in the form of dividends, and dividend income has constituted nearly two-thirds of REITs’ total returns. This may be significant for several reasons. For instance, rental rates tend to rise during periods of increasing inflation, therefore REIT dividends tend to be protected from the detrimental effect of rising prices, unlike many bonds.
While most investors know about the risks and rewards of including stocks and bonds in their portfolio, in many cases the benefits of REITs may not be understood. The primary benefits of REITs include their low correlation and strong historical track record of performance relative to other assets. In particular, REITs can be beneficial for investors with multiple asset classes and a long-term investing window.
During the past 20 years, REITs have had a relatively low correlation with the broader stock market (0.56) and very little correlation with investment-grade bonds (0.13), both of which are typically viewed as core holdings in a diversified portfolio. Correlation is an important factor in diversifying a portfolio because assets that are less than perfectly correlated may be able to partially mitigate the impact of market volatility over time.
As with any other investment, there are risks associated with REITs that must be taken into account. In addition to the market risks inherent with any investing vehicle, REITs are sensitive to a downturn in the real estate market—particularly commercial property. Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry. REITs may also be sensitive to interest rate risk as lending rates can impact costs, and thus, the performance of the REIT.
Nevertheless, REITs may be an effective way to diversify your portfolio. Yet many investors remain underexposed to this asset category. Our analysis shows that having an appropriate allocation to REITs in a multi-asset class portfolio can help improve a portfolio’s risk-adjusted returns over time.
In real estate, it may be all about the location. In terms of your portfolio, location matters as well: your asset location. REITs, as an asset class, can be a potent source of returns as well as an excellent portfolio diversifier.
Source: Steven Buller, CFA; Sam Wald, CFA; and Andy Rubin, CFA, Fidelity Investments
Vanguard REIT Index ETF (VNQ) and iShares Mortgage Real Estate ETF (REM) are components of the the D2 Capital Management Multi-Asset Income Portfolio. Current yields in those two funds are 3.90% and 15.56% respectively (as of 25 October 2013).
The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.
The Jacksonville Business Journal has ranked D2 Capital Management in the top 25 of Certified Financial Planners in Jacksonville. The Firm is also a member of the Financial Planning Association of Northeast Florida, the Jacksonville Chamber of Commerce, the Southside Businessmen's Club, and the Beaches Business Association.
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