November 24th, 2014 | by The Gerstein Fisher Team
Why We Believe Your Portfolio Needs Global REITs
Real estate investment trusts- aka REITs- are in the news. Year-to-date through November 20, global REITs, as represented by the S&P Global REIT index, returned 19.2%, which made them the best performer among the 14 global asset classes we track. On November 19, Paramount Group, an American REIT with commercial properties in New York City, San Francisco and Washington, D.C., raised $2.3 billion in an initial public offering, which made it the largest US REIT IPO on record.
I have no opinion on whether Paramount is an attractive investment (for insight into the post-listing performance of IPOs, see our recent research paper, Should you Buy IPOS? I also don’t know if this year’s surge in REIT prices has legs. But I do feel that most investors are under-allocated to REITs, especially international REITs, in their portfolios. In this column, I will lay out the case for a significant allocation to global REITs in a well-diversified global portfolio.
The Democratization of Commercial Real Estate
Let’s first define this interesting asset class. REITs are investable securities of real estate companies that own (and often operate) baskets of income-producing properties that may include office buildings, shopping malls, hotels and warehouses. Since these securities trade on stock exchanges just like equities, the REIT structure permits small investors to invest in commercial property managed by professional real estate operators around the world.
REITs currently trade in about 40 countries (that number is steadily increasing as more nations pass REIT legislation), which enables us to provide diversified exposure for our clients to a wide range of real estate from Manhattan to London to Hong Kong. Of the total world equity market capitalization of $55 trillion, REITs account for $1.4 trillion (nearly evenly split between US and international REITs), or about 2.5% of global market cap (Source: Bloomberg).
Similar Historical Returns, Different Composition
So why am I so keen on adding global REIT exposure to a portfolio? Global REITs offer strong asset class diversification benefits due to their relatively low correlations with not only the rest of an investor’s portfolio, but also with any residential real estate (such as a home) that he or she may own.
Let’s first examine REITs’ expected returns. Over extended time periods, REITs and equities tend to generate similar returns. For example, from November 1, 2004 to October 31, 2014, the S&P US REIT Index returned 8.8% annualized compared to 8.2% for the S&P 500 Index. During the same 10-year time frame, global REITs compounded by 7.8% annualized versus 7.1% for the MSCI All Country World Index of equities.
But note the differences in how REITs and equities generate those similar returns. The bulk of equities’ return comes from capital appreciation (about a quarter to a third of the S&P 500’s total return is due to dividends), while 50%-60% of REITs’ return is generated by dividends (REITs are required to distribute 90% of their income to investors). Thus, the yield on REITs has historically been significantly higher than for common stocks (which is why tax-deferred accounts are generally a better home for REITs than taxable ones). REITs also offer some inflation protection: unlike fixed income securities with set coupons, REITs’ rental rates and underlying property values—and thus income– tend to rise during periods of inflation.
Especially in light of today’s remarkably low interest-rate environment (yields on 10-year US Treasuries are 2.32% as I write), a natural question would be: “Don’t REITs suffer when interest rates rise?” We have conducted research on interest-rate cycles back to 1978 and found no clear pattern of REIT underperformance during periods of rising rates. For instance, during the last five periods when 10-year Treasuries rose more than one percentage point, REITs rose during each period and actually outperformed equities in two of the five periods. REITs are capital-intensive, but periods of rising rates often coincide with strong demand for commercial property and increasing rental income.
REITs’ Place in a Portfolio
The diversification benefits of adding global REITs to a portfolio we believe are substantial. From January 1, 1990 to October 31, 2014, the correlation of global REITs with US equities was 0.61; the correlation with US fixed income (as represented by the Barclays US Aggregate Bond Index) was only 0.22. Remember that combining asset classes with low correlations can help to reduce a portfolio’s volatility; thus, when added to a stock/bond portfolio, global REITs can potentially improve the portfolio’s risk-adjusted return.
For instance, we compared two portfolios with and without global real estate from January 1990 to October 2014. The 60/40 balanced portfolio (60% US equities, 40% US bonds), rebalanced quarterly, returned 8.72% annualized with a standard deviation (a measure of volatility) of 9.07%. When we added a 10% allocation to global REITs, dropping equities to 52% and bonds to 38%, the portfolio (again, rebalanced quarterly) return increased to 8.83% annualized and volatility dipped to 8.99%. As shown in the exhibit below, in about 80% of rolling 10-year periods the portfolio with real estate achieved a higher return; volatility was lower in about 65% of the same periods.
This leaves the questions of what kind of REITs to buy and how much of a portfolio allocation is appropriate. As I’ve indicated above, I have a strong preference for globally diversified REIT exposure. American investors’ home bias in REITs is even more severe than in equities. A typical US investor may have a 2% to 3% allocation to US REITs but virtually zero to international real estate. By investing in a basket of REITs around the world, including in emerging markets, an investor is exposed to a diversified basket of property markets, economies, inflation- and interest-rate environments, and yield curves. Depending on the investor’s situation, I feel that a 4% to 10% portfolio allocation to global REITs is generally appropriate.
Global REITs have historically provided good diversification and an improved risk-adjusted return for a portfolio. Most US investors are under-weighted to these securitized commercial properties, particularly international REITs. For more detail on Gerstein Fisher’s strategy and thinking on this important alternative asset class, I invite readers to read Gerstein Fisher’s Multi-Factor® Approach to Global Real Estate Investing or watch our latest video on REITs.