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Investment Committee Briefing – Q2 2016: Understanding the Role of REITs in Your Portfolio

By Payel Farasat, Chief Investment Officer, Loring Ward


The story of the U.S. stock markets this year has been fairly straightforward. Stocks slid lower at the start of the year, fueled by concerns over the falling price of oil. By mid-February, however, the worries about oil abated as oil prices returned to a more normal range.

With no major concerns on the horizon, stocks began a slow and steady climb from their lows in mid-February to a peak in mid-June — a recovery of more than 15% off the 2016 low. Much of the enthusiasm behind this rally was driven by the belief that the Fed, having promised a series of tightenings starting in December 2015, might be changing its mind.

In fact, instead of rising, short-term interest rates during Q2 continued their sharp 2016 decline. In Q2 alone, the ten-year U.S. Treasury yield fell 28 basis points and actually hit a historic low. Shorter rates (e.g. the two-year U.S. Treasury) have followed a slightly more volatile pattern during 2016, rising earlier in the year on the Fed’s announcement that it would raise rates. As it became clear to all markets (stocks, bonds, shorter notes) that the Fed was not in fact going to raise rates, even shorter-term rates have fallen. Across Q2 2016, the two-year Treasury yield fell 15 basis points.

In Q2, one market event did catch the markets by surprise — the Brexit vote. On Thursday June 23, British citizens voted to inform their government to pull out of the European Union agreement, of which they had been a party since 1993. The shock waves came swiftly, as markets pondered the potential for reduced global growth and possibly worse — a contagion effect that might drive other EU members out of the union. Markets quickly fell 5% in just two trading sessions. Nevertheless, the markets then proceeded to shrug off the event and recover nearly all of those losses. By the end of the quarter, the S&P 500 index closed out the quarter just two points shy of where it had begun.

As for other stock markets, both the U.S. Small Cap market and U.S. Value stocks did relatively well in Q2 — Small Caps rose 3.8% during the quarter and Value stocks rose 4.6%. These moves were not mirrored in overseas markets — International Small Cap fell -1.3% and International Value stocks fell -2.2%. Emerging Market Value stocks were also off, although only by -35 basis points.

The star for the quarter was the REIT (Real Estate Investment Trust) marketplace. Its gain of 5.4% matches similar-sized gains in Q1, for a year-to-date gain of 10.8%. Over the last 12 months, the REITs market has generated returns of nearly 23%.

With these numbers in mind, let’s look at the role of Real Estate in investing generally, and then compare investing in physical real estate to REIT investing.


The Role of Real Estate in Investing

As anyone, who has ever bought or sold a piece of real estate or refinanced a mortgage or been a landlord can tell you, real estate is a more complicated investment than meets the eye.

Some have pondered whether real estate deserves to be considered an asset class in a portfolio or whether it should be tracked separately, away from your growth portfolio. This has long been an investing and planning quandary. Does physical real estate belong in the stock asset class, given its tangibility, or does it belong in the bond asset class, given the potential to generate income?

The valuation process of physical real estate as an investment is a tough nut to crack, and has led many to conclude that physical real estate does not belong in an investment portfolio. Here are some arguments for that conclusion:

  • Unlike stocks, or even liquid bonds, real estate properties are not liquid and are not traded on an exchange
  • Their valuation is often the result of an appraisal done at infrequent intervals, usually annually, or derived from actual transaction prices that only occur on average every 3 to 10 years

    – Indices of home prices and even commercial property prices are granular because they are made up of slow-moving, slow-changing prices, and therefore, are poor comparators to indices of more liquid assets like stocks and bonds

    – Over time, physical real estate indices show low correlations to other classes because of their underlying granular nature

  • And, there is a second valuation issue with real estate indices — an appraiser has no “skin in the game.” He or she is not buying a house with their own money, whereas every traded price and every bid/ask price for a stock or bond is someone actually committing to a transaction

REITs, on the other hand, are a completely different story. A REIT is a commingled investment vehicle, structured as a company that owns a variety of real estate or real estate-related entities (e.g. leases, mortgages, etc.) Simply put, a REIT is just like a business corporation that owns a series of fixed assets that are put to profitable use and can be owned by individual investors.

Like your home, properties held in the REIT must also be appraised and/or infrequently sold to identify their value.

However, one characteristic of REITs that makes for a useful barometer on whether real estate (via REITs) is a sound consideration as an asset class in a portfolio is that many REITS (so called “traded” REITs) have been registered as stock securities and trade on the stock exchanges.

  • Despite containing properties subject to qualitative appraisals and infrequent sales, once a REIT company becomes an exchange traded security, it becomes subject to the real and true market forces of numerous investors willing to buy and sell the REIT – just as though they were stocks of companies
  • As with stocks, the attention of thousands of investors and professionals, willing to put up their own money, imparts upon traded REITs a level of volatility and correlation to other asset classes that can be trusted to have arisen from actual market forces of people with “skin in the game,” not appraisers


Characteristics of Traded REITs

So, what are the characteristics of traded REITs as a security and a sub-asset class in a portfolio?

When we looked at the relationship (correlation) of REITs to other asset classes in Loring Ward’s Model Portfolios, we found that REITs are a specialty asset class that has its own unique place in a diversified portfolio.

  • Generally, the correlations of REITs with the other major stock asset classes, both domestic and international, are significantly lower (around 50-60%) than the correlation of the stock asset classes amongst each other (around 80-90%). This suggests that REITs are not just one more stock asset class that is highly correlated with all the others — they are a unique asset class
  • Even though REITs tend to be an income-producing asset class like bonds, they clearly act more like stocks than bonds. This is consistent with the belief that real estate is somewhat of a hybrid between bonds and stocks — having moderate, but not strong correlations to either
  • REITs also differ from other specialty stock classes, such as Small Cap and Emerging Markets, as REITs have lower correlation to other stocks than these two specialty classes, but higher correlations with bonds. This suggests that, theoretically, REITs should have unique diversification ability in Model Portfolios that perhaps even specialty classes like Emerging Markets and Small Cap might not

In addition to having a unique relationship to the traditional stocks and bonds in a portfolio, REITs also have a unique relationship with certain macro-economic variables. With respect to inflation, for example, REIT returns appear to prefer calm, predictable periods of low inflation over either periods of deflation or periods of high inflation.

  • Over our sample period (12/1987 to 4/2016), we didn’t have a wide range of inflationary environments. We saw 12-month consumer price changes of between -2% to +6.4%
  • Within those parameters, when we looked at the median 12-month REIT returns in various inflation-range buckets, we found that when inflation deviates from the norm i.e. when it is negative or really high, REITs appear to perform poorly historically
  • When inflation is in historically normal ranges (between 0% and 4%) REITS appear to perform quite well

Source: Morningstar Direct and the Federal Reserve Bank of St. Louis, May 2016

With regards to the domestic macro-economy, REIT returns tend to increase in a strong economy and decrease in a weak one.

  • Looking at 12-month rolling rates of monthly total return for the Dow Jones US Select REIT Index over the period from December 1987 to April 2016, we find that REITs do very well in expansions and very poorly in contractions
  • Using the National Bureau of Economic Research metric from 12/1987 to 04/2016, we see that:

    – The median 12-month return of the REIT index was +13.4% during the 307 months that the U.S. was in an expansion

    – The median 12-month return of the REIT index was -17.0% during the 34 months that the U.S. was ‘officially’ in a recession

  • Generally, REIT returns are strong (except in economic downturns), but those higher returns come with higher risk. The volatility levels of REITs are much closer to those of stock asset classes (although not always quite as high), but certainly much higher than the volatility of bonds


REITs in the Portfolio

To examine how REITs act in a portfolio, we looked at the performance history of our current asset allocation weights over the last 15 years using benchmark index returns (rebalanced monthly). We then compared that allocation to another allocation in which REITs were excluded. What we found from this comparison:

  • In every risk profile of our current asset allocations, the presence of REITs as an asset class increased the level of return by about 35 basis points per year
  • In every risk profile, the presence of REITs as an asset class did increase the level of volatility, less so for the higher stock risk profiles
  • Overall, the presence of REITs as an asset class saw the Sharpe Ratio (a measure of risk-adjusted returns) either stay the same or increase marginally, which validates that the gains in returns more than offset the increase in volatility on a risk-adjusted basis

Source: Morningstar Direct and Loring Ward Model Portfolio Weights, May 2016


Bottom Line

Physical real estate exposure has historically presented an investing and financial planning quandary – given the known problems with the valuation and incorporation of physical properties into a liquid portfolio of traditional securities. One solution is to consider the use of traded REITs.

Traded REITs are offered on exchanges which evaluate them by the same standards applied to any stock. REITs are closely monitored by Wall Street analysts and institutional investors whose analysis subject the prices of REITs to the same scrutiny and market forces applied to traditional stocks and bonds.

Indices of REIT prices help us see, better than indices of physical real estate properties, how the true underlying economics of real estate impact our portfolios.

Our quantitative analysis shows that:

  • The presence of REITs in our current asset allocation recommendations increases return while also raising the Sharpe Ratio
  • REITs generally offer higher levels of income generation than traditional portfolio holdings, while simultaneously providing a lower level of correlation to stocks than other specialty stock classes (meaning that their prices move up and down differently at different times)

Combined with all the other differentiators that Loring Ward brings to its investment approach (Emerging Markets, Small Cap, Short-Duration High Quality Bonds and a Value tilt), REITs take their place as yet another value-added asset class for portfolios.


Real estate securities funds are subject to changes in economic conditions, credit risk and interest rate fluctuations.

All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution.

A publicly-traded Real Estate Investment Trust (REIT) is a company that owns and manages real estate properties and related entities (e.g. mortgages). Shares of the company trade publicly on stock exchanges under terms similar to the trading of shares of other corporations on the same exchange and are subject to the same listing criteria by the exchange. Like most stocks, REITs are affected by the economic conditions that affect their specific industry, in this case real estate. As such, REITs may fluctuate sharply with changes in interest rates due to the role that rates play in financing the ownership of the underlying physical real estate. REITs will also likely fluctuate with broad macro-economic factors such as employment, business investment, retail sales due to the role those economic factors play in driving the value both of land and of the structures built on that land that engage in retail sales, business productivity, and the employment of workers. REITs generally pay dividends driven by the rental and lease income provided by their underlying real estate holdings. Investors of publicly-traded REITs generally experience similar tax consequences faced by an investor in any dividend-paying domestic US stock. An investment in REITs is not guaranteed by any public or private entity. Both the price and the dividend yield of a publicly-traded REIT will fluctuate with market conditions. A REIT company is likely to have used leverage (i.e. borrowings) to establish its current holdings of real estate. The use of leverage in any business enterprise, including REITs, will increase the level of volatility of an investment.