Why Should You Maintain A Balanced Diet Of REITs?

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 |  Includes: VER
by: Brad Thomas

Summary

Great salsa is all about diversification. Only by adding diverse ingredients together can we achieve the desired outcome.

REITs have been around long enough (5 decades) and generated solid enough returns that I don't view REITs as an alternative class.

Since the emergence of the modern REIT structure, dividends have been a large factor in the outperformance of REITs relative to the broad equity market.

Last week, I wrote on article on American Realty Capital Properties (ARCP), and I explained that "risk tolerance is simply the extent to which you as an investor are comfortable with the risk of losing money on an investment. If you're unwilling to take the chance that an investment that might drop in price, you have little or no risk tolerance".

On Thursday (May 8th), ARCP will report first-quarter earnings, and depending on the results, some investors will feel either better, worse, or indifferent regarding their own tolerance for investing in shares of the world's largest Triple Net REIT. For me, I'm looking to determine whether or not ARCP has begun to integrate its management team and whether or not the company has demonstrated stable earnings trends. The integration of five large portfolios in one year's time is considerably complex, and I have taken a more cautious approach until I see the dust settle.

Currently, I have around 5% of my REIT portfolio invested in ARCP. I enjoy the high dividends; however, I'm not willing to risk more capital until I witness successful integration and a few quarters of stable and growing monthly dividends payments. As of today, I consider ARCP a "winner", and I'm not dumping my shares unless I see something unexpected.

How Much Diversification is Acceptable?

The answer to that question depends on your tolerance for risk. By diversifying, I acknowledge that my REIT portfolio will have some winners and losers. Although I spend a considerable amount of time researching REITs, it's virtually impossible to sidestep a loser. Consequently, my diversification strategy is structured such that one or two losers will not impact my nest egg.

In addition to diversifying in REITs (I recommend 7-15), it's also important to maintain a balanced investment multi-dimensional portfolio allocation strategy. Craig Israelsen, Ph.D., founder of the 7Twelve strategy explains (by phone):

Great salsa is all about diversification. Only by adding diverse ingredients together can we achieve the desired outcome. However, there are some ingredients in salsa that most of us would never want to eat individually, like hot peppers or Tabasco sauce. But, without the "hot" ingredients the salsa would be flat.

Similarly, investment portfolios should include a wide variety of diverse ingredients or "assets". Mutual funds that invest in US stocks are a core ingredient for a portfolio, analogous to tomatoes in salsa. But, US stocks are only one asset class. More asset classes are needed. We need non-US stock. But, even after adding non-US stock, our portfolio still only has "stock" ingredients. We need diversifying ingredients such as bonds, real estate and commodities.

Each investment asset adds an important dimension to the portfolio because each asset behaves differently. This diversity is vitally important in salsa … and in portfolios.

Israelsen describes his trademark 7Twelve™ portfolio strategy and, unlike traditional two-asset 60/40 balanced funds, the 7Twelve™ balanced strategy utilizes multiple asset classes - including REITs - to enhance performance and reduce risk. He explains:

The whole idea of "alternative" is kind of a curiosity to me. What's considered an alternative presupposes that there is an agreed upon baseline asset class. One could argue just to be provocative that real estate is that core asset class and that based on returns everything else is alternative -- REITs have generated the highest returns over the last 40 years.

Presumably, the assumption is that U.S. large cap equities are the bedrock asset class. That's not a ridiculous assumption, but it is an assumption. Somehow, other types of asset classes are presently labeled alternative. Traditionally, REITs have been put in that group.

REITs have been around long enough (5 decades) and generated solid enough returns that I don't view REITs as an alternative class. I view them as a core asset class.

The 7 of 7Twelve represents the suggested number of asset classes to include in your portfolio. The Twelve represents the 12 separate exchange traded (or mutual fund) products to fully represent the 7 asset classes in your 7Twelve portfolio. Israelsen's portfolio has approximately a 65/35 allocation: approximately 65% of the portfolio is invested in equity and diversifying assets, and about 35% invested in bonds and cash.

Here's a snapshot of the 7-Asset portfolio during the 1970s:

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Here's a snapshot of the 7-Asset portfolio during the 1980s:

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Here's a snapshot of the 7-Asset portfolio during the 1990s:

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Here's a snapshot of the 7-Asset portfolio during the 2000s:

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Here's a snapshot of the 7-Asset portfolio during the 2010s:

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Interesting to see that REITs were the best-performing asset class in the 2000s. Obviously, the success during the Pre-Recession period offset the losses suffered during one of the most trying times in US history.

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Cash shows up as the "worst" asset class in the 1980s and the 2010s:

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Here's a snapshot of the 7-Asset model compared with Inflation during all periods referenced:

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Here is an interesting comparison of the 7-Asset model compared with the 60/40 model (from 1970-2013):

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Finally, by increasing the 7-Asset model to include 5 other products (12 actual holdings), Israelsen demonstrates the power of broader portfolio diversification:

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So What is Your Risk Tolerance for REITs?

The game of roulette is made up of 38 specific bets, and one way to increase your "margin of safety" is to place multiple bets - that's called diversification. In American roulette, most wheels include 0 and 00 along with the numbers 1 through 36, for a total of 38 slots. The casino offers a maximum payout of 35 to 1, so if you were to bet $1 on every number, you would win $35, but you would also lose $1 on all 37 slots, making the net loss $2. That difference (of $2) represents the house spread of 5.26% on your $38 total bet.

Now before you call me a gambler, I'm not. I just think that the game of roulette is a great way to explain the power of diversification - the simplest and cheapest way to widen your margin of safety.

As Benjamin Graham taught, a fundamental principle of investing is that, over time, diversification is the key to stability of performance and preservation of capital. You might have outstanding results if you put a huge portion of your assets in one stock, but nobody can foretell the future. Occasionally, even Warren Buffett has zigged when he should have zagged, and real estate has, in the past, been a somewhat cyclical investment.

As a group, REITs are known for their dividends. Historically, REITs have offered higher dividend yields than other equities with similar risk profiles, resulting from their cash flow-oriented businesses and the requirement that they distribute nearly all of their taxable income to shareholders. For example, U.S. REITs must distribute at least 90% of their annual taxable net income to maintain their REIT status.

Since the emergence of the modern REIT structure, dividends have been a large factor in the outperformance of REITs relative to the broad equity market. The snapshot below shows that on average, dividends have comprised more than half of the returns for U.S. and global REITs, significantly more than those of the broad equity markets.

REITs have a history of consistently raising dividends due to the inflationary nature of rents and property values. From the early 1990s through 2007, U.S. REITs raised dividends at an average annual rate of 5.9%, compared with a 2.6% long-term inflation rate (as shown in the chart below). With the onset of the Great Recession, many REITs cut dividend payouts to the minimum required level to preserve capital, and also began issuing a portion of dividends in common stock. As conditions have improved, cash dividends have made a strong comeback.

According to Cohen & Steers, U.S. REITs should "continue to raise their dividends at an above-trend rate over the next several years, growing 6.6% per year on average through 2016, based on estimates. This projection is based on the improving cash flows in nearly all property sectors". Cash flow growth can come organically from rising rents and occupancies, or externally from development or through the acquisition of properties or companies.

In closing, don't put all of your chips on black or red. The key to winning is to manage your risk, and by employing sound diversification, you can reduce risk without sacrificing returns.

Although I write about REITs just about every day of the week, I'm not putting all of my chips one number (or color). I believe that by investing around 20% of my capital in REITs, I can maintain a moderately aggressive investment strategy.

Yesterday, fellow Seeking Alpha writer, Chuck Carnevale wrote an article explaining the "primary principles of diversification and how they relate to generating returns and to mitigating risk". If you haven't read the article, you should. Here's how the author summarized his diversification strategy:

I suggest extensive research, coupled with a high commitment to sound valuation. If you want to be better than average, you must be willing to do what's necessary in order to accomplish it. Personally, for the reasons presented in this article and others, I favor concentration over broad diversification. However, I acknowledge that this only makes sense for those investors endeavoring to do better than average and willing to put in the necessary effort.

For more information on my SALSA portfolio, check out my newsletter site HERE.

Disclaimer: 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.

Disclosure: I am long O, DLR, VTR, HTA, STAG, UMH, CSG, GPT, ARCP, ROIC, MPW, HCN, OHI, LXP, KIM, WPC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.