Portfolio Mix: Where Do REITs Fit In?

Includes: MCD, RWR, WMT
by: Roger Nusbaum

Roger Nusbaum submits: A reader asked for my two cents on Burton Malkiel's assertion that investors should have at least 10% in real estate securities. The reader wanted to know if 10% is necessary, where his home fits into the mix, and if exposure to things like Wal-Mart Stores Inc. (NYSE:WMT) and McDonald's Corp. (NYSE:MCD) should count.

There are a couple of different things at work here. First is the idea of investing in REITs to capture a real estate effect, specifically commercial real estate. Another big draw is the low correlation to stocks and accompanying high dividend yields.

Most of what I could offer here will be subjective, I don't think there is a hard right or wrong:

I maintain much less than 10% in REITs. Most clients are 3% or so, and some clients who are less tolerant of volatility have 6% or so. I can't say 10% is wrong but just not where I want to position.

Personally I don't think of my home as an investment in the context of how it balances out my portfolio. When we first bought our house it was a second home, and so maybe it made sense to think of it in terms of our portfolio then, but we have been living here full time for several years now with no plans of selling anytime soon, so its value has no significance to my portfolio. Plenty of folks would view this differently, and that is very valid, but whether my house is worth $100,000 or $600,000 plays no role in how I manage my own portfolio. I would feel differently, I suppose, if I were going to sell soon.

As far as whether McDonalds and Wal-Mart capture the effect, I'd say no. These companies and companies like them may benefit from real estate to be sure, but I don't think they capture the effect. Using streetTRACKS REIT Fund (NYSEARCA:RWR) as a proxy, WMT has a 0.33 correlation while MCD correlates at only 0.29.

To me this is similar to the question of whether a multinational that sells to China captures the China effect; it doesn't.

To get even fuzzier, there is another aspect to REITs, which is what they offer to a diversified portfolio. Typically they offer lower volatility, higher yield and more predictability than equities. This is desirable within a portfolio. But REITs are not the only type of thing that brings these attributes to the table. While I don't have 10% in REITs, it might be correct to say I have 10% in holdings that behave similarly to REITs most of the time. If REITs ever get pasted, it is reasonable to think that some of these other areas that behave similarly might hold up just fine, but of course there is no way to know for sure unless a crisis ensues.