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Yesterday I wrote an article, Build a Fortress Portfolio like an Intelligent REIT Investor, and in that article I explained the value of diversification and the argument that real estate should be a core asset class; based on returns, REITs have generated the highest returns over the last 40 years.

As Craig Israelsen, a personal and family finance Professor at Brigham Young University, explained (in article above),

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 and generated solid enough returns that I don't view REITs as an alternative class. I view them as a core asset class.

Professor Israelsen, who also researches mutual funds and the design of investment portfolios, argues that

over a contiguous 42-year period from 1970 to 2011, REITs had a return of rough 11.5 percent. Large cap U.S. equities were somewhere around the 10 percent range. The argument for REITs as an investment is that it typically has a lower correlation to the benchmark asset class. What gets lost in that correlation argument is that REITs on their own generate very impressive returns.

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Put Some Salsa in Your Portfolio

Professor Israelsen makes a great point and his suggestion that real estate should be more of a "core" asset component is certainly justified by historical evidence as well as the current economic performance trends. Accordingly, Israelsen advocates equally weighted portfolio allocations determined by a pre-designed core of assets utilized for each investor on an individualized basis. Professor Israelsen explains his diversification theory:

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.

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Build a Tower of Dividend Power

Because REITs must pay out almost all of their taxable income to shareholders, investors have historically looked to REITs for reliable and significant dividends (typically four times higher than those of other stocks on average). 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.

At July 31 the dividend yield of the FTSE NAREIT All REITs Index was 4.16 percent, and the dividend yield of the FTSE NAREIT All Equity REITs Index was 3.23 percent. The dividend yield of the FTSE NAREIT Mortgage REITs Index was 12.50 percent, with Home Financing REITs yielding 13.06 percent. The S&P 500's dividend yield was 2.26 percent

REITs paid out approximately $22 billion in dividends in 2011 and this is indicative of the tremendous value that investors place on dividend performance. Accordingly, dividends represent over half of total returns over time and this represents a very substantial income component of return - making REITs a very desirable sector for investors.

The Power of Compounding

As Albert Einstein said,

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn't … pays it.

REITs, in turn, could be considered one of the ninth wonders of the world. The compounding effect for the dividend investor has the ability to turn a small amount of money into a substantial sum and the longer the compounding effect, the more profits you earn over time. Because REITs pay out considerably higher dividends, the compounding principle allows an investor to grow his or her portfolio and achieve magnified results and exceptional performance.

Since paying dividends is the secret sauce for the power of compounding, it is important to build a REIT portfolio that is durable and sustainable. The consistency in dividend performance is certainly a true measure of risk control; however, being able to maintain and grow dividends is the mark of an intelligent REIT performer. As explained by Ben Graham (in The Intelligent Investor):

One of the most persuasive tests of high-quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company's quality rating.

As Graham wrote, "the defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition". Graham believed that finding companies with repeatable dividend performance could be used to "advantage and distinguish the differences in an investment operation and a speculative one".

The great recession was also a great divide as many REITs were forced to cut or suspend dividends. However, a handful of REITs were not forced to cut dividends and several continued increasing dividends - even during this very difficult period. Federal Realty (NYSE:FRT), National Retail Properties (NYSE:NNN), Tanger Factory Outlets (NYSE:SKT), Realty Income (NYSE:O), Urstadt Biddle Properties (NYSE:UBA), Essex Property Trust (NYSE:ESS), and Universal Health Realty (NYSE:UHT) were all able to sustain and grow their dividends.

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Unless you are Warren Buffett or Bill Gates, it is hard to get broad access to real estate ownership by purchasing individual shopping centers or office buildings. By owning REITs, an investor is able to gain access to a very diverse group of asset sectors and geographies. Also, REITs are exceptional risk managers and there is no substitute for investing in a company that has a remarkable track record (based on decades of consistency) for controlling risk.

Tom Lewis, Vice Chairman and CEO of Realty Income provided me with a quote that sums up the power of compounding - a primary ingredient to an Intelligent REIT portfolio:

The compounding of dividends over a prolonged period of time is at the heart of Realty Income's strategy for delivering value to shareholders. Since our listing on the New York Stock Exchange in 1994, through June 30, 2012, the price of our shares has risen from $8 per share to $41.77 per share. This share price increase represents an annual return of 9.8% and, over that time, would have turned a $1,000 investment in Realty income into $5,221. However, when our increasing monthly dividend is included, the compounded annual return to shareholders has been 18.1% and the $1,000 has become $18,901. This clearly demonstrates the importance of compounding dividends over time.

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Source: SNL Financial, NAREIT, and 7Twelve Portfolio

Source: Spice Up Your Salsa By Adding Some Intelligent REITs To Your Portfolio