Chilton: Time to Put REITs in the Portfolio

by: Brad Case

Bruce G. Garrison, CFA and Matt Werner, CFA of Chilton Capital Management (formerly of Salient Capital Advisors) this month published their latest "REIT Overview," and it has a very good discussion of the benefits of a long-term strategic allocation to publicly traded REITs, as well as their bullish view of the next few years. Unfortunately the report isn't available to the public (though they're hoping to make it available on the Chilton web site next month), but they've given me permission to quote it. Their overall position is that, while "we believed that REITs were overpriced at the beginning of (May), ... our view becomes much more positive longer term."

First to the role of REITs in the overall asset allocation:

The principles that make REITs attractive are:

  1. Low correlation with bonds and equities lowers portfolio risk and increases total return;

  2. Returns are linked to economic [inflation] growth and value added by management;

  3. Increased predictability of returns due to dividend stream; and

  4. Diversification by geography, sector, property, and tenant.

The first point, in particular, gained emphasis for me because I had just been looking at a discussion of diversification from the classic and excellent book "Asset Allocation: Balancing Financial Risk," by Roger C. Gibson, founder and CIO of Gibson Capital:

Before modern portfolio theory, investment manageemnt was a two-dimensional process focusing primarily on the volatility and return characteristics of individual securities. Modern portfolio theory shifted the focus of attention away from individual securities and toward a consideration of the portfolio as a whole. Optimal diversification goes beyond the idea of simply using a number of baskets in which to carry one's eggs; major emphasis must also be placed on finding baskets that are distinctly different from one another.

Getting back to their REIT Overview, Garrison and Werner show that having a meaningful REIT allocation has generally increased portfolio return while simultaneously reducing portfolio volatility: "In fact, adding a 10% allocation to REITs for any 10 consecutive years since the start of the modern REIT era in late 1990 through September 2008 experienced less risk and more return" (their emphasis), and "even with the added volatility since the Lehman collapse and the 70% price drop from February 2007 to March 2009, the 10-year Sharpe ratio for a portfolio comprised of 10% REITs, 55% equities, and 35% bonds was 0.29, while a traditional 60/40 portfolio had a Sharpe ratio of 0.21. We would argue that REITs have held up well to a real world stress test!"

Perhaps more important for current investment decisions is Garrison and Werner's view of the current market situation for REITs:

We thought conditions were good for REITs in the early 1990s, but overall circumstances are even better today, all things considered.
Now, with the economy on a slow recovery, the current conditions have ironically produced one of the best environments in the 50 years since REIT legislation was passed by Congress.

In particular, Garrison and Werner predict strong growth in earnings and therefore REIT dividends, as well as a favorable response to both higher inflation and higher interest rates:

Our analysis suggests that dividends should rise 40%-50% over the next five years.
With payout ratios as a percent of adjusted FFO at record lows, REITs have a lot of room to increase the dividend to get back to historical averages. In fact, some REITs are going to be forced to increase the dividend because of the rule to pay out at least 90% of taxable income
Dividend growth rates over the last decade have outpaced inflation, and we expect this trend to continue for the next decade.
Although an unexpected rise in (interest) rates would be negative for REITs over the short term, the inflation hedge that real estate provides protects the fundamentals and attracts investors after the initial shock.

In summary, Garrison and Werner's view is that "equity REITs are well positioned to be major beneficiaries of the current recovery cycle underway in commercial real estate," and as a result they "now are fully invested."

Strong stuff, but I think their analysis is well supported, and their track record suggests it should be taken seriously.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.

Disclosure: I am long Vanguard REIT Index Fund and ING Global Real Estate Fund.