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With interest rates so low on almost everything, investors have been desperately searching for yield. That's why they're still scooping up bond funds, despite all the warnings. It's why they're still piling into dividend-paying stocks, high-yield bonds, master limited partnerships, business development companies -- anything that yields more than 2%.

And it's why they have still been buying real estate investment trusts (REITs), despite the huge run REITs have had since the bear market lows of 2009. During that time, REIT returns easily topped major equity indices like the Dow Jones Industrial Average. They have outperformed the S&P 500 for 11 of the last 16 quarters. Their yields are way down from their peaks. And, increasingly, they have moved in tandem with stocks rather than being a counterweight to equities in investors' portfolios.

REITs are companies that own a portfolio of commercial properties, such as office buildings, shopping centers, and apartment complexes. They get tax breaks if they pay out 90% of their income each year to shareholders. That's where the higher yields come from. But in a piece published earlier this year, Joe Davis, head of Vanguard's Investment Strategy Group, warned investors not to use REIT yields as a substitute for the interest on bonds.

"REITs tend to correlate with the broader equity market, not with bonds," he wrote in his article "REITs: A Word Of Caution." "If you substitute REITs for bonds in order to generate greater income, the final result is a more aggressive and more stock-heavy strategic asset allocation." Translation: buying REITs may give you more stock exposure than you want.

"[Stocks and bonds] are two different asset classes and they have different risk characteristics," Davis told me in an interview. "My point is that [REITs] are a component of the equity market." In fact, he told me that "during volatile markets, REITs can [move] more because of their smaller size." Case in point: the financial crisis, when the FTSE/NAREIT Equity REIT index plunged 70% from October 2007 to March 2009, while U.S. stocks plummeted 57%.

Of course, REITs outperformed stocks easily in the years before the crisis and in the four years since, when the FTSE NAREIT index has soared by over 300%, more than doubling the S&P 500's gains of 141%. During that time, REITs' yields have fallen from over 11% in February 2009 to below 4% now. That's still a lot better than the yields on 10-year Treasuries and corporate bonds -- but, remember, they're not bonds.

Even Brad Case, senior vice president of the National Association of Real Estate Investment Trusts -- a Washington, D.C.-based trade association representing REITs -- agrees with Davis on that. "REITs are part of the stock market," he told me in an interview. And he acknowledged that REITs move with stocks much more than they have in the past. He estimates correlation with stocks is now .7 to .75. That means REITs will reflect stocks' moves 70% to 75% of the time.

Correlation was about .5 to .6 before the crisis, and over longer periods (more than five years) Case says it goes down to .15 to .2. That's diversification. But not now. Case argues that REITs are superior performers over the long run. The FTSE NAREIT index almost quadrupled from its December 1999 bottom to its February 2007 pre-crash peak.

If you bought at the 1999 lows (when everyone loved dot-coms and hated REITs) and held through that sickening 70% bungee jump in 2008-09, you'd still have racked up a cumulative 446% gain, for a compound annual growth of 13.4%. Over that same period , the S&P gained a mere 16.4%, total, in nearly 13 and a half years (not including dividends). Talk about a lost decade!

But Case of NAREIT thinks REITs will continue outperforming stocks, for two reasons. First, he says real estate cycles are much longer than stock market cycles -- they last on average 18 years, so you can fit four stock cyclical bull markets into one real estate bull market. The last one began in 1989 and ended in 2007, he said. If that's true, we're only four years into the new cycle.

Second, he says REITs' earnings are just beginning to pick up as commercial real estate has recovered more slowly than corporate America. "Current earnings have been extraordinarily low," he explained, "because rent growth and occupancy rates are close to their worst levels. ... At this point in the market, REIT earnings are near their low point, and stock earnings are at their high point." That's why he thinks there's more upside for REITs than for stocks.

Still, The Wall Street Journal reported that the value of property owned by REITs is back to peak levels. And after such massive gains, I'd be inclined to take at least some profits and reduce REIT holdings from, say, 5%-10% of your portfolio to maybe 2%-5%. That way you'll profit from any extended real estate boom while limiting your risk of a big REIT correction. Which, given their huge advance, is likely to be worse than any pullback we see in stocks.

Source: It's Not The Right Time For REITs