By: Frank Armstrong
*As seen on South Florida Business Journal
It’s really nice in times of volatile markets like now to have an asset class that may zig when traditional stocks and bonds zag. An asset with low correlation to others in your holdings can both reduce risk at the portfolio level and increase returns.
Real estate is an important asset class, and the source of enormous wealth. Unfortunately, it’s not an easy one for most investors to gain access to.
Individual real estate properties meet 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.
By now we should have learned that speculating in houses carries a load of undiversifiable and unrewarded risk. When the housing market crashed it took far too many individual investors with it. Additionally, it’s a huge time sink to manage individual properties. Even if you don’t lose your shirt it may not be worth the effort and aggravation to be a landlord.
Real Estate Investment Trusts (REITS) solve those problems. REITs are special investment vehicles that hold real estate and avoid the double taxation problem of corporations as long as they distribute their earnings to investors.
REITs offer equity like returns with low correlation to other stocks which make them a potent diversifier for your portfolio with the potential to lower risk in the portfolio while increasing returns. 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, most notably commercial real estate in the 1980s, and residential in the recent housing bubble.
Using a portfolio of REITs investors can economically and efficiently obtain exposure to real estate in publicly traded, liquid, transparent, daily valued, regulated, audited securities.
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 or exchange traded 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. As an example, the Vanguard REIT ETF (VNQ) closely tracks the MSCI REIT index at an expense ratio of only 0.10 percent or 10 basis points.
To further diversify your portfolio, you might consider similar funds that invest in foreign real estate. While not all foreign countries have the exact REIT structure that U.S. law provides, they have many securities that participate in their local real estate markets. While any foreign security is subject to currency risk, it also provides a valuable hedge against a falling dollar. For each percent that the U.S. currency falls, a foreign security gains a percent.
Both foreign and domestic real estate are great asset classes with little correlation to the stock markets. That means that they can over time reduce portfolio risk and increase returns in a properly structured portfolio. However, it’s only one asset class out of many desirable choices. You want to own enough to give you a non trivial diversification of your assets, but not so much that you still have a well diversified portfolio. At the top end I would suggest that 20% of your risk assets be divided between domestic and foreign REITS through index funds or ETFs.