Keep an Eye on REITs' Correlation With Equities

A reader asks;

I am curious about your take on REIT ETFs at this stage. It seems to me that as a group they have been overly beat down because of the subprime mess and perhaps the coming of the long-awaited slowdown in the economy. To avoid single stock risk, I have been thinking of putting a toe into this category of stocks. Any thoughts? Any best of breed insights?

A lot of people love REITs. You can find recommendations out there suggesting as much as 15% or 20% in REITs. If you do a search for lazy portfolios, you will see various suggested weightings there as well.

REITs are an asset class, and like most asset classes there are periods when they do very well. I think there is an element of REITs being too adored, people owning too much and the declines being very big when these happen.

The one REIT I own across the board has been hot very hard, but not noticeably harder than other REITs. I have 2-3% allocation, depending on the client, which I consider an underweight.

One of the benefits of REITs is the low correlation to equities. iShares has two domestic REIT ETFs with long track record; the Dow Jones US Real Estate (IYR) and the Cohen and Steers Realty Majors (ICF). According to PortfolioScience.com IYR has 0.758 correlation to the S&P 500 and ICF has 0.701 correlation. That isn't that low. There is a closed end fund that invests in Asian real estate (RAP) that has a 0.486 correlation, which is a little more like it. The one REIT I own has a 0.658 correlation. Remember an ETF is likely to have a higher correlation than an individual name.

I am considering taking a tax loss on the one REIT I have, and swapping it for something foreign, but not RAP. The logic behind possibly going foreign is the desire for a lower correlation.

The question seems to have a short term element to it. I don't doubt that the decline in REITs is more than what is justified, but to the extent that they are guilty by association, more decline would not be shocking. As I have said before, I am not in a hurry to add financial exposure until the yield curve normalizes, and it seems that the abnormal curve may have played a role in the REIT decline too.

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Well there certainly appears to be a tight correlation there.

On something like this, I think I would need to have a fundamental justification for increasing exposure. Changing it, as I plan to do, is a different matter. It is an asset class, and I believe some exposure is warranted in the interest of maintaining a diversified portfolio.

Comments

[NoFate]

I would be more concerned about the correlation with the Case-Shiller housing index. IYR also doubled in 4 years between 2003 and 2007 ...prior to that it was pretty flat.

And I realize IYR has a high % of commercial property, but I think investors bid it up mainly because it was a real estate play and more liquid than buying actual property. In fact, IYR got a big lift right after Paulson's mortgage plan was announced ...which won't directly affect commercial property at all!

Finally, I agree foreign REITs might be the way to go though ...as long as you avoid other bubble countries! The Economist had a great article on which countries have inflated housing prices a few issues back.