The REIT Stuff?

Adam M. Grossman

WHEN BUILDING portfolios, why don’t I include real estate investment trusts? REITs are large, diversified real estate companies. Some own office buildings, while others own apartments, hotels, shopping centers or other kinds of property. An example is Simon Property Group, which owns more than 200 shopping malls across the country.

A REIT is, on the surface, just like any other company, but with one unique feature: Dividends aren’t optional. REITs are required to pay out virtually all of their income, net of expenses, to shareholders each year. As a result, shareholders can expect a reliable—and relatively large—stream of annual income. Simon, for example, is currently paying a dividend of nearly 6%. This compares to an average of less than 2% for other stocks in the S&P 500. This is one reason REITs have great appeal.

In addition to their reliable dividends, REIT fans cite these benefits:

  • Real estate is an extremely straightforward business. Tenants pay rent. After expenses are deducted, REIT shareholders receive a share of that rent. In essence, REITs allow you to become a landlord without the hassle of managing properties yourself.
  • REIT stocks have a lower correlation with the overall stock market than other kinds of stocks. This means they offer greater diversification. On a scale from 0 to 1, REIT stocks’ correlation to the S&P 500 is just 0.6. Most other companies’ stocks—such as those in technology, health care and energy—have correlations in the range of 0.8 or 0.9. In an environment where the stock market feels high, additional diversification seems like a good idea.
  • REITs appear to provide an attractive compromise between bonds and stocks. Like bonds, REITs provide steady income. Like stocks, REITs offer the potential for growth, as their properties appreciate and rents increase. This seems like an ideal combination.

With all these perceived benefits, why don’t I recommend REITs? Keep in mind four points:

1. I actually do like REITs—but I don’t like them any more than any other kind of stock. When you buy an index like the S&P 500, it already includes REITs. I’ll grant that it’s a small portion of the overall market—just 3%—but they are in there. I see no reason to buy more.

2. REITs’ performance has been undistinguished. Over the past 15 years, they’ve done a bit worse than the overall stock market, but with much greater volatility. In 2008-09, when the overall market fell 50% from peak to trough, REITs fell 68%.

3. I appreciate that REITs have lower correlations to the overall market than most other stocks. That makes them somewhat unique. But that is just a relative advantage. For true diversification, I turn to bonds, which have traditionally demonstrated a negative correlation with stocks. In other words, bonds have gained when stocks have fallen, and vice versa. That is true diversification.

4. Owning a REIT is different from owning your own rental property. Yes, REITs have a scale advantage, but they also have a cost disadvantage. At Simon, for example, Mr. Simon took home $11 million last year. His second in command took home $5 million. When you own a rental property directly, it takes more work, but I also believe the rewards are much greater because you’re not burdened by such expenses.

The bottom line: I see no reason for investors to go out of their way to load up on REITs. Are REITs bad? Hardly. But they’re not special, either. The 3% allocation in the S&P 500 is, in my view, sufficient.

A final point: There are two types of REITs—those that are publicly traded and those that aren’t. In this discussion, I have been referring only to the publicly traded variety. Private, or nontraded, REITs are a different matter. A favorite of brokers because of the high sales commissions they can earn, nontraded REITs have a terrible reputation—and I would stay far away from them.

Adam M. Grossman’s previous articles include Candy LandOwning Oddities and Imagining the Worst. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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