Achieving Portfolio Diversification Through REITs

by: Parsimony Investment Research

Since the markets bottomed in 2009, real estate investments have performed very well. The FTSE NAREIT Equity Index reported a total return of 27.99% and 27.96%, respectively, for 2009 and 2010.

Historically, real estate investment returns have shown a low correlation with equity and bond returns, offering significant portfolio diversification benefits for the investor.

One of the easiest ways for individual investors to gain exposure to the real estate markets is through publicly-traded real estate investment trusts ("REITs").

What is a REIT?
(Source: NAREIT)

REITs are companies that own and most often actively manage income-producing commercial real estate. Some REITs make or invest in loans and other obligations that are secured by real estate collateral. The shares of most large REITs are publicly traded.

The special investment characteristics of income-producing real estate provide REIT investors with competitive long-term rates of return that complement the returns from other stocks and from bonds.

REITs are required to distribute at least 90 percent of their taxable income to shareholders annually in the form of dividends. Significantly higher on average than other equities, the industry's dividend yields historically have produced a steady stream of income through a variety of market conditions. The dividend yield for the FTSE NAREIT All REIT Index at year-end 2010 was 4.2% compared to 1.95% for the S&P 500 and 3.3% for the 10-year U.S. Treasury Note.

In addition to the investment performance and portfolio diversification benefits available from investing in REITs, REITs offer several advantages not found in companies across other industries. These benefits are part of the reason that REITs have become increasingly popular with investors over the past two decades:
  • Predictable Revenue Stream - REITs’ reliable income is derived from rents paid to the owners of commercial properties whose tenants often sign leases for long periods of time, or from interest payments from the financing of those properties.
  • Earnings Transparency - Most REITs operate along a straightforward and easily understandable business model: By increasing property occupancy rates and rents over time, higher levels of income may be produced. When reporting financial results, REITs, like other public companies, must report earnings per share based on net income as defined by generally accepted accounting principles (GAAP).
With a very diverse profile, the REIT industry offers investors many alternatives across a broad range of specific real estate property sectors, including:
  • Apartment communities
  • Office properties
  • Shopping centers
  • Regional malls
  • Storage centers
  • Industrial parks and warehouses
  • Lodging facilities, including hotels and resorts
  • Health care facilities
  • Natural resources.

Property Fundamentals vs. Interest Rates

A REIT investor needs to pay close attention to economic fundamentals and interest rates. A strengthening economy is good for REITs, because it leads to better occupancy rates, more financially secure tenants, and higher property values. However, as the economy improves, interest rates also rise (which increases the borrowing costs for REITs as they buy new properties).

We believe that REITs will continue to perform well over the next 2-3 years as we expect a moderate economic recovery and relatively flat or slowly rising interest rates.

Residential occupancy has started to stabilize and rents are starting to increase across all real estate sectors. There is a good chance that even if interest rates rise, the increased borrowing costs will be more than offset by increased operating profits.

Individual REITs vs. ETFs

Listed below are several excellent REIT ETFs that offer investors nice dividend yields and great diversification within the REIT space. In general, global REIT ETFs offer higher dividend yields as foreign real estate investments tend to generate higher income streams due to the higher risk inherent in these investments.

  • WisdomTree International Real Estate (NYSEARCA:DRW) - 8.87% yield
  • SPDR DJ International Real Estate (NYSEARCA:RWX) - 8.55% yield
  • SPDR DJ Global Real Estate (NYSEARCA:RWO) - 6.63% yield
  • iShares FTSE EPRA/NAREIT Dev RE ex-US (NASDAQ:IFGL) - 5.92% yield
  • iShares FTSE EPRA/NAREIT Dev EU Index (NASDAQ:IFEU) - 5.33% yield
  • iShares S&P Dev ex-US Property Index (NYSEARCA:WPS) - 5.18% yield
  • iShares FTSE EPRA/NAREIT Dev Asia Index (NASDAQ:IFAS) - 5.18% yield
  • iShares DJ US Real Estate (NYSEARCA:IYR) - 3.20% yield
  • iShares FTSE NAREIT Real Estate 50 (NYSEARCA:FTY) - 3.19% yield
  • Vangaurd REIT Index ETF (NYSEARCA:VNQ) - 3.12% yield

In addition to REIT ETFs, investors can invest in individual REITs as well and take a much more targeted approach.

We have wrote several articles over the past week discussing our views on mortgage REITs:

Note: Over the next several weeks, we will be writing more articles highlighting other REIT sectors with specific investment ideas within these sectors.

Disclosure: I am long RWO, RWX.

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