The Case Against REITs as a Separate Asset Class Holding

Morningstar has another educational article about investing in REITs as a separate asset class (free registration may be required). The entire article is worth a read, as it does a good job of summarizing the basic arguments for either carving out a special place in your portfolio for REITs, or simply leaving it at the ~4% market weighting that exists in most broad US index funds. For those already familiar with that, the historical charts add additional depth.

Historical correlations. This M* chart tracks the rolling 36-month correlation between the Vanguard Real Estate Index Fund (VGSIX) and Vanguard Total stock Market Index Fund (VTSMX), Vanguard Total International Stock Index Fund (VGTSX), and Vanguard Total Bond Market Index Fund (VBMFX). Note that the popular Vanguard Real Estate ETF (VNQ) has the same underlying holdings as VGSIX.

Sometimes the correlation between REITs and the overall stock market is very high, close to 1, but at other times it is closer to 0.5.

Historical return vs. volatility. Here’s a good stat: From 1972 to 2018, REITs have had a slightly higher average total annual return than the US Total Stock Market (11.4% vs. 10.3%), but also a higher average standard deviation (16.9% vs. 15.5%).

My take. I agree that REITs are not an “alternative” asset class on the level of fine art, music royalties, or Bitcoin. I think common sense would predict that publicly-traded corporations that own commercial property would be at least moderately correlated with the overall stock market. Historically, REITs provided a slightly higher return than stocks but also slightly higher price volatility. Using a broad REIT fund instead of a stock fund (or vice versa) is only going move the needle a relatively small amount.

However, I do see real estate as “different”. It has the limited availability of a commodity like gold or silver, yet it is productive like a factory. Land can produce rent, timber, or food (farmland). I could own single family rentals or farmland, but personal experiences have taught me that the higher potential returns also come with higher potential headaches. I’m willing to give up some of the return and simply hold REITs which don’t have be dealing with chasing late rent, fixing damages, civil lawsuits, and governmental bureaucracy.

Thus, I do hold a dedicated REIT portfolio allocation via the Vanguard REIT ETF and mutual funds. If I’m lucky they will add a bit of diversification and/or extra return, but even if they just offer more of the same, that’s good enough. (I noticed that the M* article author also discloses that he holds VNQ.) If you are interested in something closer to direct real estate ownership, see my Fundrise vs. Vanguard ETF experiment where I track my small side investment.