• Portfolio Strategies
  • The Role of REITs for Long-Term Investors

    by Brad Case

    The Role Of REITs For Long Term Investors Splash image

    The German statesman Konrad Adenauer was quoted as saying “We all live under the same sky, but we don’t all have the same horizon.”

    That’s certainly true of investors: We all live among the same set of assets, but how we combine them into an investment portfolio depends on our own circumstances—including our investment horizons.

    To simplify, we might say there are two types of investors. The first type—call them tactical—pays attention to short-term fluctuations, hoping to identify opportunities to buy undervalued assets or to sell overvalued ones. Tactical investors play an active role in identifying mispricings and trading in a way that tends to eliminate them. For tactical investors, correlations among asset classes are less important than current valuations—and volatility may actually be good, because it creates trading opportunities.

    The second type of investor—call them strategic—doesn’t have time to look for short-term mispricings; instead, they structure a well-diversified portfolio and take advantage of the interactions among their assets—that is, the power of diversification—to reduce the likelihood of a hit that would affect the entire portfolio. Strategic investors have a long investment horizon: Current valuations are less important than low long-term correlations and strong long-term risk-adjusted returns.

    It’s not surprising that the investment characteristics of particular assets change over time: For example, return volatility for publicly traded real estate investment trusts (REITs), along with most or all other assets, spiked during the credit crisis of October 2008–March 2009. (REIT volatility rapidly declined to normal levels after the crisis ended, however.) What is more surprising, though, is that investment characteristics may also change over different investment horizons. If that’s the case, then you can potentially make better portfolio decisions by understanding investment characteristics at your own most relevant horizon.

    Stock Correlations Move Closer Over Time

    As an example, Figure 1 shows correlations between the telecommunication services sector of the U.S. stock market and two measures of returns to the broad stock market, the Wilshire Total Market index and the S&P 500 index of large-cap stocks. [Correlation measures how closely two variables tend to move in relation to each other.] All of the correlations are computed over the same historical period, from January 1990 through November 2011—but they’re computed over differing investment horizons ranging from one-month returns to 60-month returns. [All sectors are represented by the S&P Global Industry Classification Standard (GICS) series of sector total return indexes.]

    As Figure 1 shows, the return correlations over longer investment horizons are much greater than the return correlations over shorter horizons—in fact, the correlation of the telecommunication services sector with the Wilshire Total Market increases from just 63% using a one-month horizon to 94% using a 60-month horizon. That kind of a change can make a huge difference in portfolio strategy: It suggests that telecom stocks provide little diversification benefit relative to the broad market for investors with relatively long investment horizons.

    Why might long-horizon correlations be higher than short-horizon correlations? One explanation may be that, while telecom stock prices may fluctuate in the short term in response to conditions specific to the telecom sector, longer-term returns depend more on the state of the overall economy—which is reflected by returns to the broad stock market, rather than just one sector.

    That explanation is supported by other sectors of the stock market, where a similar pattern holds: Return correlations between the sector and the broad market increase as the investment horizon lengthens, as shown in Figure 2. That makes sense if stock market returns over longer horizons are driven by factors common to all companies—such as growth in the gross domestic product (GDP) or changes in interest rates—while returns over shorter horizons may be affected by factors specific to a given sector of the economy. Notably, the materials sector, which encompasses many commodity producers, differs from other sectors of the stock market, with correlations declining as the investment horizon lengthens (not shown in Figure 2).

    REIT Correlations Widen Relative to Stocks

    There is another segment of the stock market, however, in which this pattern is reversed: publicly traded equity REITs. Equity REITs are the stocks of companies that own commercial real estate assets, such as office buildings and shopping centers. REITs are required to pay out almost all of their taxable income to their shareholders annually as dividends. The effect of the large dividend requirement is to channel the bulk of rent income to shareholders, providing them with the kind of real estate income stream they would receive if they owned and managed the properties directly.

    As Figure 3 shows, equity REIT returns actually have a lower correlation with broad stock market returns over longer investment horizons. In fact, for investment horizons greater than six months, the decline in REIT-stock correlations is both steady and dramatic. For example, the correlation between equity REITs and the Wilshire Total Market is 67% over six-month horizons, but only 14% over 60-month horizons. (Equity REIT returns are represented by the FTSE NAREIT All Equity REITs total return index.)

    Perhaps even more surprising, the same pattern holds even when REIT returns are compared with the financials sector of the stock market—ironically, the sector in which equity REITs are classified. For example, the REIT-financials correlation is measured at 79% over six-month investment horizons, but only 27% over 60-month investment horizons.

    What might explain this pattern, in which long-horizon correlations are actually lower than short-horizon correlations? One explanation may lie in mutual funds and exchange-traded funds (ETFs), which enable investors to trade broad categories of stocks rather than individual companies.

    For example, investors who are bullish or bearish on bank stocks may trade their predictions by buying or selling a financial sector mutual fund or ETF—which would have the unintended consequence of driving up or down the stocks of non-bank companies encompassed within that sector, including REITs. Over longer investment horizons, though, REIT returns are driven by conditions in the real estate economy, rather than in the banking industry—or, indeed, in the broad economy as reflected by the broad stock market. Over longer horizons, then, any short-term mispricings of REIT stocks that are caused by non-REIT market factors (such as trading of bank stocks through a financial sector mutual fund or ETF) may be corrected in a way that brings down longer-horizon correlations.

    If correlations can differ sharply over different investment horizons, then what about volatility? Figure 4 shows the annualized volatility of monthly returns measured over the same historical period—January 1990 through November 2011—but over different investment horizons extending from one to 12 months. As the figure shows, volatility declines sharply as the investment horizon lengthens. For example, the annualized volatility of equity REITs is 19.7% when measured using one-month investment horizons, but just 6.6% when measured using 12-month investment horizons.

    (While correlations can be computed using overlapping periods of different lengths, volatilities must be computed using non-overlapping periods. As a result, the historical period January 1990 through November 2011 encompasses just 21 non-overlapping 12-month investment periods.)

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    Figure 4. Volatilities Over One-Month to 12-Month Horizons*

    Implications for Portfolio Management

    How can an investor make use of these results? As noted, for tactical investors, correlations are less important than current valuations, and volatility may actually be good. In fact, it may be trades by tactical investors that explain the results, by driving mispriced securities back toward their fundamental values.

    For strategic investors, however, these results are potentially very important in constructing optimal asset portfolios. If long-horizon correlations among sectors of the stock market are higher than short-horizon correlations, then strategic investors with long investment horizons won’t find good opportunities for portfolio diversification by holding assets in different sectors. In other words, investment characteristics based on short investment horizons (such as monthly data) overstate the diversification opportunities within the non-REIT parts of the stock market.

    On the other hand, if long-horizon correlations between REITs and stocks are lower than short-horizon correlations, then strategic investors with long investment horizons can take advantage of greater diversification opportunities with larger holdings of REITs within their stock portfolios. Moreover, if volatility declines with the investment horizon, then risk-adjusted returns measured over long investment horizons are better than risk-adjusted returns over short horizons. In this case, investment characteristics based on short investment horizons (such as monthly data) understate the benefits of diversification through a mixed portfolio of REITs and non-REIT stocks, as well as the risk-adjusted returns of both asset classes.

    Investors should consider which style best defines them: the tactical approach, in which investors look for short-term mispricings, or the strategic approach, in which investors take advantage of the power of diversification and long-term risk-adjusted returns. Long-horizon investing may well have greater benefits than we ever realized.

    What Is a REIT?

    A REIT is a company that mainly owns, and in most cases operates, income-producing real estate such as apartments, shopping centers, offices, hotels and warehouses. Some REITs also engage in financing real estate.

    To qualify as a REIT, a company must have most of its assets and income tied to real estate investment and must distribute at least 90% of its taxable income to its shareholders annually. A company that qualifies as a REIT is permitted to deduct dividends paid to its shareholders from its corporate taxable income. As a result, most REITs remit at least 100% of their taxable income to their shareholders and therefore owe no corporate tax. Taxes are paid by shareholders on the dividends received and any capital gains. Most states honor this federal treatment and also do not require REITs to pay state income tax. Like other businesses, but unlike partnerships, a REIT cannot pass any tax losses through to its investors.

    For REITs, dividend distributions for tax purposes are allocated to ordinary income, capital gains and return of capital, each of which may be taxed at a different rate. All public companies, including REITs, are required early in the year to provide their shareholders with information clarifying how the prior year’s dividends should be allocated for tax purposes. This information is distributed by each company to its list of shareholders on IRS Form 1099-DIV. A historical record of the allocation of REIT distributions between ordinary income, return of capital and capital gains can be found in the Industry Data section of www.reit.com.

    A return of capital distribution is defined as that part of the dividend that exceeds the REIT’s taxable income. A return of capital distribution is not taxed as ordinary income. Rather, the investor’s cost basis in the stock is reduced by the amount of the distribution. When shares are sold, the excess of the net sales price over the reduced tax basis is treated as a capital gain for tax purposes.

    Brad Case Ph.D., CAIA, is senior vice president of research and industry information for NAREIT, the National Association of Real Estate Investment Trusts (www.reit.com).


    Dave from WA posted over 4 years ago:

    Please make the Figures clear so we can actually see the comparisons. Thanks.

    Charles from IL posted over 4 years ago:

    Dave - If you click on the images twice, they will enlarge to a full screen view. This will allow you see the figures in better detail. -Charles Rotblut

    George from VA posted over 4 years ago:

    The charts were hardly legible ever after I had clicked twick on them.

    Charles from IL posted over 4 years ago:

    George, did you increase them to full screen view so they appear separate from the article? -Charles Rotblut

    Leslie from MD posted over 4 years ago:

    I did both enlarging efforts and they were still blurry and I could not read them.

    Roger from WA posted over 4 years ago:

    I just read in Money magazine that
    9 times at much money flowed into REITS in 2010 vs. 2009. Also, the price of REIT equity stocks have soared 192% since March 2009. If this is true, why would anyone want to invest in REITS right now?

    Curtis from IA posted over 4 years ago:

    they were clear on my laptop

    Jon from NY posted over 4 years ago:

    Very interesting article; next, it would be useful to have someone build upon it by suggesting appropriate portfolio allocation percentages for REITs throughout the investor's life cycle; for example, should they replace stocks, bonds or a percentage of each, and, if stocks, what capitalization, what region...

    Mary from MD posted over 4 years ago:

    Figures very blurred whether enlarged or full screen.

    Also, I'm new and could use some help. Where do I even get the names of some REITS to evaluate, and would I use the stocks screens to evaluate?

    Charles from IL posted over 4 years ago:

    Mary, if the figures are not appearing correctly on your screen, try printing the .pdf and see if that helps. The physical magazine should be arriving in mailboxes soon as well. As far as identifying REITs, NARIET has a list on its website: http://www.reit.com/IndividualInvestors/REITsinSPIndexes.aspx -Charles Rotblut, AAII

    Brian from GA posted over 4 years ago:

    If you right click on the figures and then "open in new window" or "open in new tab" they are very legible. Double clicking does not appear to do the trick anymore.

    John p from GA posted over 4 years ago:

    All you have to do RIGHT click on the image and choose "Open in a New Tab." The image will then be large, clear and in separate window.

    C from RI posted over 4 years ago:

    Correlations are an academic exercise that data miners and people looking to influence others use to ... influence others. What would have this 'correlation view' done to help investors avoid REITS in 1975 when they got creamed .... or in 1990 .... or in 2008 ?
    I'm sure NAREIT would love AAII member to pile into REITS that would feed through to more commisions for realtors but it this really in the best interests of AAII investors ? Doubtful. Caveat emptor. Real estate can be a great investment but it is also very illiquid and VERY CYCLICAL. This article says nothing about those cyclical risks at present.

    Brad Case says : "Current valuations are less important than low long-term correlations and strong long-term risk-adjusted returns."
    This is baloney; current valuations DRIVE risk-adjusted returns so Brad is selling snake oil with this statement.

    Ron from FL posted over 4 years ago:

    I often have about 5% on Reits and have never been burned. As my 4.5% corporate bonds mature I use Reits and utilities as pseudo bonds.

    James from WI posted over 4 years ago:

    In their "Model Portfolio for Retirees - Balanced Portfolio", Morningstar recommends 2.5% in Real Estate (REITS)

    John from CA posted over 4 years ago:

    Are REIT's qualified investments for an IRA? Or are they, like Master Limited Partnerships considered to be off limits due to unrelated business income?

    Charles from IL posted over 4 years ago:

    John, my understanding is that REITs are qualified to be held in an IRA. They typically do not generate UBTI. -Charles Rotblut, AAII

    Doug from CA posted over 4 years ago:

    I have held REITs in an IRA for years, keeping between 10-15% of my total equity allocation. The results have been quite satisfying.

    Leonard from NV posted over 4 years ago:

    I am an ex-stockbroker of 30+yrs. My objective is to accumulate a good portion of my portfolio in REIT's that are extremely oversold and keep a close stop loss as they rise in value over the next 2 yrs or so. We are in an excellent interest rate environment and the fed will keep rates low for the next 2 yrs. Every stock or REIT has a cycle and if you buy into the extreme dips, you should generally be in good shape. Collect the divs and add more to the portfolio as each opportunity arises. Same is true for MLP's.

    Winthrop from IL posted over 4 years ago:

    Leonard from Nevada
    You wrote "My objective is to accumulate a good portion of my portfolio in REIT's that are extremely oversold and keep a close stop loss as they rise in value over the next 2 yrs or so."

    My question is:- Why do you what to keep a close stop loss....if you expect they would rise in value over the next 2 yrs or so?

    Benjamin from VT posted over 4 years ago:

    Where can i find current net asset values for reits?

    Jean from IL posted over 4 years ago:

    REIT data can be found at www.forbes.com/reits -Jean, AAII

    Lee from NC posted over 4 years ago:

    Mary asked for some names of REITs but no one seemed to respond. Here are some of the lower priced ones that I hold and their current dividend rate.
    TWO [Two Harbors]div. rate 15.79%
    MFA [MFA Financial] 12.66%
    DX [Dynex Capital] 12.17%
    CIM [Chimera Invest.] 16.00%
    See also RSO, MSW, ANH, NYMT, ARR, AGNC

    Peter from FLA posted over 3 years ago:

    I remember the Rothschild maxim, to keep 1/3 of assets in real estate, 1/3 in equities and 1/3 in fine arts. I've applied the first part (1/3 in real estate) to my IRA and annuity accounts using RIET mutual funds, and the results have been excellent. very good article that quantifies the rationale for diversification with RIETs.

    John Fagan from CT posted over 3 years ago:

    I use the Vanguard REIT Index keeping it at 5% of my equity portfolio. I re-balance annually in January and have been finding that I am often selling some of my REIT shares and investing in parts of my equity portfolio that have not done as well. I have found that using this index is a lot easier than selecting individual REIT securities.

    Peter Rukavena from NY posted over 3 years ago:

    It is true that the correlation of the overall market with REITS does widen over long periods of time , there is one exception:

    Unfortunately during periods of significant decline in the overall markets , REITS start to become highly correlated.

    Just look at the levels of correlation with almost every investment during the 2008 meltdown.

    Overall , maybe with the exception of some bond investments it pushed 90% plus correlation.

    That being said I like REITS as a core asset holding, I currently have a significant position in a number of REITS.

    Eric Slater from CA posted over 3 years ago:

    I have had about a 15% allocation to REITS in my equity portion of my IRA for years, and also rebalance annually. I am very satisified with including them, but wonder why the reported P/E ratios for domestic REIT funds are so high compared to foreign REIT funds. I suspect this is due to the accounting of profits, and the fact that 90% must be returned to the stockholders to avoid corporate taxes, but would like to have an explanation from someone in the REIT industry that clarifies this.

    Richard Sar from CO posted over 3 years ago:

    My wife inherited a fraction of a REIT a few years ago and my son-in-law is executor for one his dad owned. Getting rid of them as part of an estate is difficult. Think as a mutual fund it would be easier to get rid of.

    C Nelson from CA posted over 3 years ago:

    REITs can be good and liquid. Nine years ago a friend (former mortgage banker and developer) suggested I look at a locally based triple-net-lease REIT because he liked their business model (not all REITs are the same!). The group traded on the NYSE "under the radar" at the time. Since it's local I attended their annual meetings - an astute CEO with a sense of humor, clear strategy and outstandingly transparent financial reports. The stock price doubled over the nine years all while paying an increasing monthly dividend (bought more when it dipped in 2008). Beginning this year they completed acquisition of another REIT and increased the dividend significantly. But recently the CEO retired and institutions now own a much larger percentage; such changes raise my nervousness level, so watching closely while holding (in my IRAs). The stock, Realty Income, trades under the symbol "O".

    William Curtis from MS posted over 3 years ago:

    REITS are cyclical, I have owned Vanguard's VGSLX since early 2009 and it did very well. I dropped them about mid-year due to the threat of Fed taper. As bond rates go up, REIT dividends become less appealing on a risk-adjusted basis. They have been under-performing the S&P since about mid 25013. I will buy again when they start to rise.

    Sanford Levey from MA posted over 3 years ago:

    I don't currently own any reits but would like to purchase some. I would appreciate any guidance re: the Timing to buy in. Thanks.

    Thomas Barry from VA posted about 1 year ago:

    I allocate 10% of my portfolio to REITs. The results have been excellent over the long term. They provide diversification, income and a greater return than bonds.

    Angelo Caruso from NY posted about 1 year ago:

    Just re-read this excellent article. This seems to suggest that it might be prudent to rebalance that portion of a portfolio allocated to stocks (e.g. among small, mid and large-cap stock allocations) more frequently, say quarterly, while rebalancing between REITs and total stock allocations less frequently, say yearly or even less often. Have there been an studies on that strategy?

    Sanford Levey from MA posted about 1 year ago:

    To make the graphs larger and more readable, click on the heading over the graph then "to see full image" will appear. Click on it and you will see full image
    Which is much larger and easily readable.

    Mike Callahan from CA posted about 1 year ago:

    How about Mutual Fund REITs? I have done quite well with them.

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