Very often, people challenge me with the following question: When building portfolios, why don’t I include real estate investment trusts (REITs)?
By way of background, REITs are large, diversified real estate companies. Some own office buildings, while others own apartments, hotels, shopping centers or other kinds of properties. An example is Simon, 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: For REITs, dividends aren’t optional; they are mandatory. Net of expenses, REITs are required to pay out virtually all of their income to shareholders each year. As a result, REIT shareholders can expect a reliable, and relatively high, stream of income each year. 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:
1. Real estate is extremely straightforward. Tenants pay rent, and REIT shareholders receive a share of that rent, after expenses. In essence, REITs allow you to become a landlord without the hassle of managing properties yourself.
2. REIT stocks have lower correlations to the overall stock market than other kinds of stocks. This means they offer a greater diversification benefit. On a scale from 0 to 1, REIT stocks’ correlation to the S&P 500 is just 0.6. By way of comparison, most other companies’ stocks—such as those in technology, healthcare or energy—have correlations in the range of 0.8 or 0.9. Especially in an environment where the stock market feels high, additional diversification seems like it should make sense.
3. REITs seem to provide an attractive compromise between bonds and stocks. Like bonds, REITs’ rental income provides steady income. And 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 do I still not recommend buying REITs? There are four points to keep in mind:
1. I actually do like REITs—but I don’t like them any more than any other kind of stock. And when you buy an index like the S&P 500, it already includes REITs. I’ll grant that it is a small portion of the overall market—just 3%—but they are in there. So I see no reason to buy more.
2. REITs’ performance is undistinguished. Over the past fifteen years, REITs have done a bit worse than the overall stock market but with much greater volatility. In 2008-2009, when the overall market fell 50% from peak to trough, REITs fell 68%.
3. I appreciate the argument that REITs have lower correlations to the overall market than most other kinds of stocks. That does make them somewhat unique. But that is just a relative advantage. For true diversification, I turn to bonds, which have traditionally demonstrated 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 very 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 #2 took home $5 million. And so forth. When you own a rental property directly, it certainly takes more work, but I also believe the rewards are much greater because you’re not burdened by expenses like this.
For these reasons, 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 are not. In this discussion, I have been referring only to the publicly-traded variety. Private, or non-traded, REITs are a different matter. A favorite of brokers because of their high sales commissions, non-traded REITs have a terrible reputation, and I would stay far away from them.