When deciding on your portfolio’s asset allocation, another option beyond broad stock funds in domestic or international markets is to invest in is real estate. Besides directly owning a home or office complex, an easy way to get exposure is to own Real Estate Investment Trusts, or REITs.
What is an REIT?
From the National Association of REITs website:
A REIT is a company that owns, and in most cases, operates income-producing real estate such as apartments, shopping centers, offices, hotels and warehouses. Some REITs also engage in financing real estate. The shares of many REITs are freely traded, usually on a major stock exchange.
To qualify as a REIT, a company must distribute at least 90 percent of its taxable income to its shareholders annually. A company that qualifies as a REIT is permitted to deduct dividends paid to its shareholders from its corporate taxable income. As a result, most REITs remit at least 100 percent of their taxable income to their shareholders and therefore owe no corporate tax.
Since the REIT income essentially “passes through” directly to the shareholders, you are getting relatively direct exposure to commercial real estate. You’re not investing in a builder, or some other funky derivative. There are both domestic and international REITs, but lots of the following is based on US REITs.
Characteristics of REITs
Long-term historical data for REITs are not directly available, as there was not necessarily a consistent index to track them, or actual broad mutual funds investing in them. I’ve read various estimates from varying companies and academic studies via different books for returns (annualized).
- From All About Asset Allocation for 1930-2004: US REITs returned 9.3% vs. 9.7% for the Total US Stock Market.
- From Intelligent Asset Allocator for 1970-1998: US REITs returned 13% vs. 13.5% for the S&P 500.
- From Unconventional Success for 1978-2003: US REITs returned 12% vs. 13.5% for the S&P 500.
To generalize, the performance of REITs is a little less than that of broad stock indexes, but higher than the return from bonds.
However, the main reason why many investment professionals and institutions all invest in REITs is that they have a historically low correlation with the overall stock markets, and also the bond market. This diversification benefit allows you to incorporate Modern Portfolio Theory and try to construct a portfolio with a better return/risk ratio than you had previously.
Below is a graph comparing historical risk/return relationships between various portfolios with a market weight of REITs (the amount already contained in total market index) and one with an additional 10% allocation to REITs. It is taken from a helpful Vanguard research paper on REITs.
As you can see, adding a bit of REITs boosted returns for each portfolio data point, while actually reducing volatility. Again, this is historical information, you’ll have to decide if you think such behavior will persist.
REITs also historically have a high correlation with inflation, so many believe them to be a good inflation hedge. There are a couple of explanations for this. For one, most of the income for REITs is from rent payments, which usually move in line with inflation. (They raise the rent!) Also buildings are made from raw materials like wood and steel, so a building’s replacement costs also move with inflation.
So How Much REITs Should I Own?
As hinted above, a publicly-traded REIT is simply a stock. So if you own a broad index fund, you already own some REITs according to their market weight. Per this Diehards post by CyberBob, REITs make up ~2.5% of a US Total Stock market fund and over 12% of Vanguard’s Small Cap Value index fund. So you might not even want to add any more.
I would recommend taking a look at my Comparison of 8 Model Asset Allocations, which includes several Real Estate allocation suggestions from various sources. You’ll see most are around 10-15% of equities, although they do vary from just the market weight of about 2-3% to as high as 29%.
Note that REITs are very tax-inefficient. Most of the returns are via unqualified dividends, which don’t get the lower dividend rate and are instead taxed at your ordinary marginal rate. As such, they should get kept within tax-deferred accounts like IRAs whenever possible.
My Decision
I’ve already shared that I am going to have 10% of my overall equity allocation in US REITs. That ends up being 8.6% of my entire portfolio (I’m 86% stocks/14% bonds), but if you add up the exposure already built in my Total US or Small Value funds, I’m closer to 10% in total. From my readings, I feel that this a reasonable allocation to add some diversification to my portfolio. Specifically, I hold the Vanguard REIT Index Fund (VGSIX) within my IRAs.
I believe that commercial real estate will continue to have decent returns in the long run, even though it is prone to wild fluctuations in the short run. I’m happy to dollar-cost-average through it all. In addition, I think the relatively low correlation with stocks and high correlation with inflation will persist due to the inherent unique characteristics of the sector. I will probably add international REITs in the future, as costs go down and there are better investments options which index this area.
But that’s just me, and this is just a quick summary of what I’ve come across. Hopefully the references and resources listed here can help others make their own informed decisions.
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In my experience the best exposure to real estate has come through TIAA-CREFs real estate variable annuity. As you note above, it doesn’t quite match market return but unlike other real estate options I’ve seen, it returns year after year with surprisingly low volatility. For example, last year was generally acknowledged as a bad real estate year and the annuity had more than 13% return.
http://www.tiaa-cref.org/performance/retirement/profiles/1009.html
I have thought about REIT’s also, perhaps when I get debt free I can be more serious about it.
but before i forget, tag you’re it,
You have been tagged on my blog.
Lost my a** on Vanguard REIT over the last two years. I won’t be putting any money in any US-based REIT until I’m confident that the housing market has bottomed out.
Even seeing the acronym REIT pi**es me off right now.
I’ve had Vanguard REIT for a few years and I’m pleased with it. You know that they aren’t going to be making any more real estate.
How can 10% REITs boost average return of a stock portfolio when historically REITs have lower return than stock? What am I missing?
For someone who already owns a house, 5% REIT may already be enough…
When I used Vanguard’s financial planning service about a year ago, their advice was to eliminate my holding in their REIT Index fund. (It was about 10% of my equities.) They reasoned that REITs are essentially a sector play, and their standard advice it to avoid investing in sectors. I raised the diversification issues, but they said their research supported their approach. I decided to retain half my REIT holdings. I will be interested to read the Vanguard research paper you referenced.
How can you expect to improve a stock portfolio’s return by including REITs when REITs have historically underperformed stock?
I do invest in REIT’s, but only in my IRA.
IMHO, to utilize the benefit of long-term asset allocation-style investing, I’d say REIT’s should only be used in a 10 to 50 year window.
And moreso w/ today’s volatile RE market…….I’d say for short-term money, stick w/ the traditional models. MM/Bonds/mattress….. 😉
Wait a minute. Owning a house doesn’t have the same effect as owning REIT stock does. REIT funds, especially broad index funds like Vangaurd’s VGSIX are less prone to be hit by local effects. Your house will appreciate or depreciate in line with your local housing market, while an REIT fund will be significantly more robust in exposure.
Personally I think REITS are shady investments right now in light of the current real estate debacle. Unless you are willing to keep averaging down for the next 2-3 years, I’d suggest avoid them or keeping allocation to a minimum.
Slow down REIT’s are a horrible idea right now, did’nt you read the NYTimes this week?
““REITs, after all, were the darling of Wall Street for several years, providing average annualized returns of 23.6 percent from November 1999 through January 2007, outperforming the overall stock market. But last year, property REITs — companies that own portfolios of commercial real estate like hotels and office buildings, and make up the bulk of the market — posted negative returns of 15.7 percent, on average, according to the National Association of Real Estate Investment Trusts.”
http://www.nytimes.com/2008/01/06/realestate/commercial/06sqft.html?ref=commercial
I would agree that for the short-term REITs look bad. The NY Times is great at telling me things… after the fact. 🙂 But I for one have no idea when they will turn around. So I’ll just keep my allocation and buy them both on the way down and on the way up. That’s what dollar cost averaging is all about for me.
Good comments – The REIT return/risk graph from the Vanguard paper was probably based on a slightly different data set than the studies that I quoted earlier. If you took the Wilshire Equity REIT Index from 1978-2004 to represent REITs, then REITs actually outperformed the Total Stock Market during that period.
The paper itself simply quotes “Source: Author’s calculations using data from NAREIT and Thomson Datastream.” so I can’t be sure.
But from other books, by adding REITs you might end up with a slightly higher or slightly lower return, but the main benefit of adding REITs is significantly reduced volatility (increased Sharpe ratio). The reason to add REITs is not for an expected higher return.
“BB Says: How can you expect to improve a stock portfolio’s return by including REITs when REITs have historically underperformed stock?”
Ooh! I know! I know! (This is a riddle, right?) Buy the Ultra Short Real Estate ETF from ProShares (SRS). It’s up about 96% in the last year! SWEET!
Although it’s probably a little late to buy into it now and expect more gains like that.
“When times are greedy be fearful, when times are fearful be greedy.”
This is the time to buy REITS for long term investors such as myself. So what if it keeps going down for a few years? I’m getting cheaper and cheaper buys building up my holdings waiting for the next surge.
I still can’t believe how many people chase markets and only buy on peaks.
The problem with DCA is that if you buy something like the Vanguard REIT fund, you have to start at the $3,000 minimum, you can’t completely avoid market timing. I added VGSIX in February 2006, and it’s been down 35% ever since since. I’m not panicking since (1) it’s less than 10% of my total retirement portfolio, (2) I plan to rebalance in the summer, and (3) I’m at least 30 years from retirement. While it’s definitely a bit of shock to watch an investment tank like that, but that’s a feeling everybody should get used to.
To echo Cheapster Bob above: DON’T rate-chase. Buying high and selling low pretty much guarantees a substandard return.
Instead, figure out how much you’re comfortable allocating to REITs, set that as a target, and then deal with volatility either ether through DCA or regular re-balancing.
I’ve been wondering if I should allocate some to REITs myself. FundAdvice.com had some stuff to say about REITs as a component in their “Ultimate Buy and Hold Portfolio”. The REITs reduced the volatility and increased their return, but if they had not been allocated for, it would only have affected the backtested total annualized return by only 0.03%.
But they also caution that it has been a perhaps unusually profitable time for them in recent history.
To sector play REITs, wait a few months then seek REITs that are either exclusively or are primarily residential apartment investors that manage residential apartment complexes. Rents are increasing, and with the potential pool of property owners shrinking (don’t expect it to be easy for people with defaults and foreclosures and bankruptcies on their records to secure home loans over the next few years), as long as inflation doesn’t push costs up faster than rents, renter REITs should become an attractive buying opportunity, especially as their share prices drop along with all the other REITs. – IMHO
BB says: “How can you expect to improve a stock portfolio’s return by including REITs when REITs have historically underperformed stock?”
Rebalancing between the two classes will do that, to the extent that they fail to correlate perfectly; when one outperforms, the proceeds can be used to procure cheap shares on the other.
What are the tax implications for REIT? Dot they get the 15% or are they taxed as income. I seem to remember there is a difference on taxation with them.
Because they are not a victim of “double taxation” like most corporate dividends, the vast majority of dividends from REITs are not subject to the lower 15% max dividend rate – they are taxed at your income rate. There may be a few special exceptions.
I think that REITS can be a good investment, because half of your income there comes in the form of dividends. As long as the REITS you own are sound companies and won’t go under, you won’t be as dependend on capital appreciation as you are with common stocks or the major indexes.
I have read recently about investing in timber, which seems like a pretty interesting asset class, which is not correlated to stocks. Yale’s endowment fund is rumored to have 10% of its assets in timber. There’s a timber etf CUT, but i believe that it is different that the timber asset class itself.
I bought into REIT’s in 2003 when I first opened my Roth IRA. Why did I buy them? Past performance of roughly 30%. I continually bought into the ING REIT until May 2007 when I smartened up and moved my IRA to Vanguard. At that point REIT’s composed about 30% of my portfolio, which I also averaged somewhere between 20-30% return during that time. Then I bought into the Vanguard S&P 500 index and Total International fund. I definitely got out at the right time 🙂 4 years of above average growth and selling at the right time, I only wish I knew what I was doing when I did it so I could reproduce it.
I will be investing in REIT’s again when I get enough money to hold a proper amount of REIT funds in my account.
This post if very timely for me because I was just looking into diversifying my portfolio by investing in a REIT stock. It’s good to know that REIT dividends are taxed at the income rate. Thanks!
When looking into investing in REITs I noticed that most of the major holdings in say ICF are also part of the SP500 or SP400, so isn’t investing in REITs essentially doubling down on real estate since you already have exposure through your core funds?
Great series of posts Jonathon which I am using to construct my own asset allocated portfolio. Quick question
I have a taxable acount (which I am planning to move to Vanguard so I can just do Index funds) and a 401K at work. Because of income limits I am not eligible for a IRA.
I could open a non deductible IRA just to hold the REITs; but how do you rebalance annually when the IRA just contains REITs?
@John – Good question, it can be tough. If the REIT amount shrinks and you need to buy more to rebalance, then buy more in another account. If the REIT amount grows and you should technically sell, just don’t and funnel new funds towards other asset classes. At least in that scenario the REITs are doing well 🙂
We were going to transfer some of our IRA money to Sterling Trust so we have the ability to purchase real estate through our retirement fund. I am confused as to how it all works. I received a 40 page explanation of legal financial jargon that I failed to comprehend. Is there a simple explanation for this type of investment regarding the risks?
REIT’s are a great way to passively invest in Real Estate. They also allow you to start investing in much smaller amounts .
REITs have been great, 3 1/2 years after this original post…
Cheers,
PedroNY
Its almost 2017 and REITs (publicly traded) have still not recovered to 2007 highs.
Have you properly accounted for all the dividend distributions you would have gotten in the meantime?