Do REITs Really Diversify Your Portfolio?

By Brendan Conway

The idea of tacking on some real-estate investment trusts is often sold as portfolio diversification. Samuel Lee of Morningstar argues in a notable article this morning it’s not all it’s cracked up to be.

Start by throwing out REITs’ historical returns as any kind of guide for the future. You have to account for the change in the asset class from an esoteric niche for risk-takers into something more mainstream.

Once you do this, you see that REITs trade much more in line with the rest of the stock market than they used to.

What’s more, Lee shows, investors effectively have to believe REITs can increase their per-share dividends faster than the rate of inflation. That, in any event, would be needed in order to come anywhere close to the asset class’ annualized 11.9% return since the early 1970s.

Lee argues it’s more realistic to expect relatively pedestrian returns like 2% or 3% after inflation. You should also bank on participating in any broad-market selloff, should one occur.

From Lee:

I calculated a rolling three-year market beta, controlling for REITs’ exposure to size, value, momentum, and interest-rate risks, to better isolate pure market exposure. The change is striking: REITs went from an average market beta of 0.5 to over 1 in the early 2000s and have stayed there since. Over this period, REITs went from small-cap, deep-value stocks to larger-cap, growthier stocks. …

Anyone who buys REITs on historical risk/return characteristics without considering the fundamental drivers of return and potential changes to market structure is being reckless. A deeper look strongly suggests that REITs’ diversification powers are down and so are their expected returns. While we can still expect REITs to respond positively to inflation–all else held equal–it would be a mistake to think they’ll exhibit the kind of anti-inflationary properties they exhibited back in the 1970s.

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There are 2 comments

DECEMBER 31, 2013 1:52 P.M.

Derek wrote:

Congress is also risking a permanent real estate crash by eliminating 1031 exchanges. As a real estate professional, I fear that eliminating the tax rules for 1031 like-kind exchanges could be a catastrophic threat to the real estate market or even bring it to a grinding halt as investors will have a strong disincentive to sell their property, causing property values to plummet.
The real estate market has been one of the few bright and productive sectors of the economy for at least the last 40 years, and one that continues to produce strong middle class jobs to brokers, Realtors, escrow officers, mortgage brokers, appraisers, title officers, and construction workers to name a few.
1031 exchanges have been a valuable tool in providing a strong incentive for real estate investors to reinvest the proceeds of their sales equal to or greater in value. Eliminating this incentive will cause investors not to sell, and will drive the value of property downwards, and the cost of rents, and anything sold by the tenant, up. Not only do many states rely on property tax for revenue (some completely), but Wall Street has been heavily invested in mortgage backed securities and REITS. A downward trend could send both the real estate and equity markets into another crash.
Eliminating 1031 tax deferred exchanges would not only cause instant job losses to the real estate industry, but could propel us back into another recession.

DECEMBER 31, 2013 1:53 P.M.

Derek P wrote:

Congress is also risking a permanent real estate crash by eliminating 1031 exchanges.
As a real estate professional, I fear that eliminating the tax rules for 1031 like-kind exchanges could be a catastrophic threat to the real estate market or even bring it to a grinding halt as investors will have a strong disincentive to sell their property, causing property values to plummet.
The real estate market has been one of the few bright and productive sectors of the economy for at least the last 40 years, and one that continues to produce strong middle class jobs to brokers, Realtors, escrow officers, mortgage brokers, appraisers, title officers, and construction workers to name a few.
1031 exchanges have been a valuable tool in providing a strong incentive for real estate investors to reinvest the proceeds of their sales equal to or greater in value. Eliminating this incentive will cause investors not to sell, and will drive the value of property downwards, and the cost of rents, and anything sold by the tenant, up. Not only do many states rely on property tax for revenue (some completely), but Wall Street has been heavily invested in mortgage backed securities and REITS. A downward trend could send both the real estate and equity markets into another crash.
Eliminating 1031 tax deferred exchanges would not only cause instant job losses to the real estate industry, but could propel us back into another recession.

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