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Real Estate’s Place

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Real estate is an important asset class. Unfortunately, it’s not an easy one for most investors to gain access to. The real estate market meets none of the usual tests for market efficiency: Each parcel is unique, transaction costs are very large, sales occur only occasionally, and market knowledge is often local and restricted, making this an insider’s market. Most transactions are private, so detailed knowledge of rent rolls, replacement costs, deferred maintenance, and other critical data is not widely known. Liquidity can be nonexistent, and the smallest possible purchase unit can be above the means of many investors.

Real estate has always acted differently than the stock market. It goes through its own market cycle, which is characterized by boom and bust periods. During the 1980s, tight rental markets, insane tax incentives, lax or corrupt supervision of banks and savings and loans, and inflationary fears all encouraged a national fit of gross overbuilding. Real estate partnerships traded properties at ever escalating prices. Inevitably, vacancy rates rose, and many developers were unable to meet their mortgages. Entire skylines were foreclosed upon. The US government had changed the rules on investors, stripping almost all tax benefits from investing in real estate and chopping hundreds of billions of dollars off market values. The funding agencies themselves went bankrupt, bank and S&L presidents marched off to jail, and liquidity for transactions all but dried up. The government, through the Resolution Trust Company, became the country’s major landlord. Real estate went into a long depression.

Major institutions and pension plans found themselves holding nonperforming assets with values that were small fractions of their acquisition costs. Worse yet, management of these properties required major resources, and the prospect of further investment in the properties dampened any remaining enthusiasm. Unloading real estate became a major focus of boards across the country. With traditional buyers almost extinct, the institutions turned their attention to either creating or selling to real estate investment trusts (REITs) as a mechanism to “securitize” their portfolios. REITs blossomed like toadstools after a heavy rain. Wall Street focused considerable attention on raising funds for a new opportunity. Suddenly, REITs were propelled from obscurity to being a major force in the market. But the driving factor was the desire of institutions to dump real estate rather than the desire of retail investors to own it.

Hence, Wall Street’s marketing machine had a few small problems to overcome. Investors remembered their severe losses in real estate partnerships; the industry was still in a depression; short-term results were uninspiring; and REITs were a poorly understood hybrid investment. Investors confused equity REITs that actually owned properties with the disastrous mortgage REITs of the 1970s that had been a financing mechanism for new construction. Many of these early mortgage REITs transformed themselves into equity REITs as they foreclosed on failed projects one by one. It-s fair to say that those shareholders didn-t enjoy or soon forget the process.

An expanding economy soaked up much of the overcapacity in real estate, but perceptions lagged the recovering industry fundamentals. The spin doctors responded with a major PR campaign aimed at both advisors and retail investors: This time it’s different. Today’s REITs are totally changed. Forget all that past history–the new equity REIT is larger, better financed, holds better properties, and is more aggressively managed. And now, they said, REITs are major players in the industry. As proof, the spin doctors presented data going back all of three years. A couple years of relatively good performance and one period of good performance during a short down market were widely overhyped.

Actually, the long-term data is encouraging. The NAREIT(National Association of Real Estate Investment Trusts) Equity index for the period 1975 to 1997 shows that both rate of return and risk were higher than those of the S&P 500. True, it-s possible that the REIT index overstates performance due to survivorship bias. And in the early years, there were few equity REITs, so their market presence was small. Even given those concerns, however, risk and reward seem acceptable.

Real estate has always been attractive to investors because–as I noted earlier–it doesn-t act much like stocks. There are several reasons for this lack of correlation. Many lease agreements are entered into for years at a time, so rentals continue without regard to short-term economic swings. As a result, real estate values appear to ‘lag’ the market cycle. Because sales are infrequent, many institutional investors rely on appraisals. These appraisals appear to ‘smooth’ the market value of the properties, understating volatility.

In theory, today’s REITs should offer investors many of real estate-s advantages without its aggravations. REITs are entirely liquid, provide for diversification, are marked to market daily, are tradable in convenient quantities, and make a convenient passive investment.

But what happens when we take real estate and turn it into a stock? Does the REIT act like real estate or not? Early REIT management whined that stock investors didn-t understand their companies, that the market couldn-t properly evaluate them, and that their prices didn-t accurately reflect the value of their underlying properties. In fact, the opposite may be true. A paper by Joseph Gyourko and Donald Keim at Wharton showed that REIT prices more quickly reflected real estate fundamentals than do appraisals and current sale prices. REIT prices accurately predicted actual property sale prices one year later.

In any event, REIT prices have had very low correlation to the S&P 500 (.49), and at first blush seem to be a potent diversifier. But REIT prices have fairly high correlation to small-cap value stocks (.78) that we already hold in our model portfolio, which reduces their value as a diversifier.

1975-1996 S&P 500
Interm 5yr
20yr L/T
Value Index
S&P 500 Index 1.00 .41 .47 .57 .49
Interm 5yr Treasury .41 1.00 .94 .26 .16
20yr Long Term Treasury .47 .94 1.00 .27 .16
CRSP Sm Value Index .57 .26 .27 1.00 .78
NAREIT Index .49 .16 .16 .78 1.00


As we have previously noted, investors do not enjoy risk, so they will expect higher returns from risky asset classes. The good news is that there is strong economic reason to believe that they will receive above-average returns over time. No one would invest in emerging markets if that were not the case.

It shouldn’t come as a surprise that countries with high economic growth rates also have high stock market performance. As a rule of thumb, over reasonably long periods of time, for every percent of increase in a country-s Gross Domestic Product, its stock market will increase about three to four percent. In a developed country a 3.5% growth rate may be the highest sustainable. But many emerging markets are forecast to have growth rates of 6 to 10%. Given this strong historical relationship, it doesn’t take a math whiz to see the potential for superior stock market returns in an economy growing at that rate.

There’s a good argument to be made that today-s emerging markets present investors with historic opportunities. With the total collapse of communism, developing countries worldwide have embraced capitalism and economic reform with a vengeance. Suddenly, Lesser-Developed Countries (LDCs) are doing everything right:

The NAREIT Index has not tended to move in sync with large-cap stocks, as measured by the S&P 500 Index, but it has had a higher correlation with small-cap movements, as represented by the CRSP Small Value Index.

Because REITs, as do utilities, tend to pay very high dividends, many investors use them as a bond substitute. This would lead us to predict that REITs should be interest-rate sensitive. However, you might be surprised to see such low correlation to both long (.16) and intermediate-term (.16) bonds.

When I added REITs to our existing asset allocation (Portfolio v. 5.0), there was only a very tiny benefit. To make room in the portfolio, I subtracted one percent from each existing equity asset class. The resulting mix showed lower return and risk, but landed just a few basis points above the “efficient frontier” that we drew for Applying Our Lessons. Given concerns about the NAREIT index mentioned earlier, the plotting may not be statistically significant.

Adding the real estate asset class to our portfolio does not do much to expand our efficient frontier. It has the effect of slightly reducing our overall risk level, but it also reduces our returns. Conclusion: Take it or leave it.

In the end, using REITs pretty much comes down to personal preference. There isn-t an overwhelming case to be made either way. Some investors may prefer to add an additional asset class, while others may opt for portfolio simplicity and lower transaction costs.

REIT mutual funds, like REITs, come in a wide variety of flavors. There are REITs that specialize in hospitals and health care, apartment buildings, theaters, office space, shopping malls, or warehouses. Some mutual funds expand the definition to include construction companies and property managers as well as firms that simply own and manage their own real estate. These different definitions and specialty focus can have important impacts on short-term performance.

As asset-class investors, however, we don’t have to worry about the focus of any individual REIT mutual fund. If we choose to, we can effectively and economically participate in the REIT and real-estate markets through index funds that invest in REITs. Rather than try to “beat” the real-estate market, or play the sector game, we should opt for wide diversification and low cost to obtain the lowest risk profile and least tracking error with the asset class.