A few weeks ago I wrote an article, Is The Glass Half Full of Half Empty, in which I pointed out that "an asset allocation (strategy) with REITs has the potential to enhance total return, while not adding meaningfully to risk." I went on to explain that REITs can help to "enhance the return of a stock and bond portfolio" while reducing overall risk and that the value proposition for REITs is that they offer higher dividend yields than other equities with similar risk profiles.
One of the more interesting conversations that I have more frequently is not as much about REIT dividends but more so on total return. As such, most experienced and novice investors know that REITs pay out higher dividends; however, many don't know that they are also defined for their strong total returns.
The purpose of this article is to demonstrate that REITs have consistently produced strong returns relative to other equities and ﬁxed-income securities. Now, before I provide you with my research, remember that REITs on average return around 60% in dividends and 40% in capital appreciation; so clearly REITs benefit from a business model that is focused on generating steady and growing cash flows.
The other thing to know is that REITs can provide insurance against broader stock market movements, including those in the utilities, oil & gas, and consumer staples sectors. Historically (and outside of 2009-2010), REITs have continued to perform and pay out income to investors, even when there are macroeconomic shocks to the market that impact these other sectors.
How Much Real Estate Should I Hold In My Portfolio?
Before I show you a few charts, I want to provide you with my standard disclaimer and that is that this article is intended to provide information to interested parties. I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification. Readers (that is you) are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.
Now, as you will see, I've attached a few charts below showing the results for portfolios with 0%, 5%, 10%, 15%, and 20% in REITs over the past 20 years. I've used all REITs (FTSE NAREIT Composite U.S. REIT Index) rather than just equity REITs. As you can see, the average returns increase from 7.90% per year to 8.33% per year, and the final portfolio value for an initial total portfolio value of $100,000 increases from $439K to $480K.
Volatility initially goes down from 9.70% per year to 9.53% per year (at 15% REITs) but then increases again to 9.58% per year (at 20% REITs) - but it's still less than the volatility of a no-REITs portfolio, and besides returns are increasing faster than volatility, so risk-adjusted returns (and the return-to-risk ratio) are higher.
As illustrated below, the first basket has 0% (zero) REIT allocation, and starting with $100,000 and held over a 20-year period, the portfolio value was $439,475 and the average return was 7.9%.
The second basket has a 5% REIT allocation and the $100,000 initial investment grew to $450,578 while the portfolio average return was 8.01%.
The third basket has a 10% REIT allocation and the $100,000 initial investment grew to $462,019 while the portfolio average return was 8.14%.
The fourth basket has a 15% REIT allocation and the $100,000 initial investment grew to $472,616 while the portfolio average return was 8.25%.
The fifth basket has a 20% REIT allocation and the $100,000 initial investment grew to $480,002 while the portfolio average return was 8.33%.
One final chart; this one summarizes all five of the baskets (0% to 20%) of the asset allocations in the order of 0% REITs to 20% REITs. A picture is worth a thousand words:
As noted in my disclaimer above, I'm not recommending that one should allocate 20% in REITs; however, here is a portfolio that includes 20% as I utilized in my research:
What Effect Will REITs Have on Rising Interest Rates?
So clearly, as illustrated above, REITs have outperformed stocks and bonds in both the U.S. and global markets during the modern REIT era. Even over the past decade (a difficult period marked by two recessions, two asset bubbles, a financial crisis, and three periods of rising inflation), it's plain to see that REITs enhance the return of a stock and bond portfolio, while reducing overall risk (as measured by standard deviation). But what about rising interest rates?
In looking at the effect of rising interest rates, it's important to distinguish between "late-cycle" interest rate increases that come because the Fed is trying to prevent the economy from overheating and "early-cycle" increases that come because-as in the current market-the economic recovery has finally started to take hold. For example, during one very comparable period, January-June 1996, yields on 10-year Treasury bonds increased by 22.3% but equity REIT returns were strong at an annualized rate of 12.66%. Another comparable period was June 2005-May 2006, when yields increased by 27.8% but REITs returned 14.45%.
Take a look at this snapshot below that compares average total returns over various historical time periods (source: NAREIT):
Food For Thought
Around two months ago I launched my newsletter, The Intelligent REIT Investor, as a guide to assist individual investors with research and due diligence related to U.S. equity REITs. In the newsletter (and in online articles), I don't cover every REIT; however, I attempt to help investors by filtering out the best (and the worst) opportunities.
One thing to consider is that REITs have been around for over five decades so we have considerable data that can help us compare and measure market cycles, interest rate cycles, property sectors, returns, and many other metrics. In short, REITs should be a core part of an investment allocation strategy as they have a proven track record of long-term performance, due in large part to their dividends. They generally operate with a longer-term investment horizon, typically use low-to-moderate leverage in their business model and have acted as a stabilizing force within the real estate sector during times of economic uncertainty.
As most of my readers know, I write frequently on the REIT sector and I have published several hundred articles on Seeking Alpha and other investment-based web sites. It's hard to pick five of my favorite REITs for one article, so I thought I would include five REITs that had the highest page views on Seeking Alpha. Here you go:
The links to the articles for these REITs are as follows: HCP, Inc. (HCP), Monmouth Real Estate Investments (MNR), Realty Income (O), Lexington Realty Trust (LXP), and National Retail Properties (NNN).
So how big is your slice of the REIT pie?
By filtering a diverse landscape of REITs, I recommend a moderately diverse portfolio of REITs (10% or more) and with the use of a rigorous "margin of safety" application coupled with sound diversification, you will achieve the most favorable results. Regardless of how big you cut your "slice of REIT pie," you must consider the most important and essential element to any portfolio allocation strategy: Sir John Templeton, a recognized supporter of diversification, said it best:
The only investors who shouldn't diversify are those who are right 100% of the time.
Note: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.
Source: NAREIT and SNL Financial