"Diversification is an established tenet of conservative investment." - Benjamin Graham
Real estate has always had a storied place as a popular asset class with numerous uses: Owning homes and building equity; buying rental properties to generate income; investing in value-add projects or growth communities to accrue gains from capital appreciation; the list goes on.
The universal appeal of real estate as an investment is in the diversification it provides. The stock market swings day to day – and sometimes violently during periods of extreme exuberance or terrible fear – but physical properties are not inherently correlated to those movements. For that reason, adding real estate to a portfolio generally results in lower volatility and often greater yield as well.
Sticking to the classics
For decades, the go-to vehicle of real estate investing has been the public real estate investment trust, or REIT. Public REITs trade on stock exchanges and shares are just as liquid as the equity of public companies. The appeal of public REITs is obvious: Providing exposure to a wide variety (both materially and geographically) of real estate assets that an individual investor could not hope to obtain on their own.
Even for the more well-heeled individuals and families that can afford to buy and operate income-generating properties, few can own anywhere close to the same diversity – and they find it much harder to sell out when they need cash.
Historically, REITs have done a solid job of performing as advertised, namely they deliver returns not correlated to the broader stock market. During the market downturn in 2000, REITs really shown. Even as the Standard & Poor's 500 tumbled 10%, the REIT sector was up by an astounding 30%.
Diversification dulled
The lesson of 2000 was taken to heart by many worried investors, and REITs have been growing in number and size virtually nonstop since. In fact, they grew so fast that some began gaining admittance into the S&P 500 Index in large numbers, the very thing they are ostensibly meant to be diversifying against. When Equity Residential (EQR, Financial) was added to the S&P 500 toward the end of 2001 to become the second REIT in the index – and the first added since the 1970s – it began a veritable flood. Today, there are 31 REITs in the S&P 500. Unsurprisingly, the rapid rise in the correlation between REITs and the stock market has had a negative impact on the asset class’ value as a diversification tool.
That growing correlation between REIT performance and that of the broader stock market was felt as recently as 2008. During the financial crisis and subsequent Great Recession, REITs failed to deliver the uncorrelated – or even countercyclical – performance that made them the darlings of battered markets post-2000. In 2008, REITs actually did worse than the stock market, dropping 39.6% while the S&P 500 fell 37%. Correlation has only continued to grow over the past decade, diminishing the likely benefits of diversification in the next market downturn or correction – whenever it eventually comes.
No signs of improvement ahead
The growing size and impact of public REITs looks set to continue. A survey of industry sentiment going into 2018 reveals expectations of industry consolidation in the next year as REITs invest more in mergers and acquisitions within the sector rather than focusing on new property acquisitions.
The motivation for such activities is reasonable; properties are not cheap and we are in the point of the real estate business cycle where harvesting gains takes priority over new investments. The inward direction of investment also carries benefits for the individual REITs, allowing them to expand their asset bases while streamlining operations and improving efficiencies. But at the same time, such actions serve to create bigger and bigger REITs, making them an ever more substantial component of the principal stock index.
What’s an investor to do?
Diversification is not the only reason to invest in a REIT. They can be analyzed for the same benefits as any stock, with the caveat their purpose is much more narrowly focused than a conventional operating company on generating income via regular, generous dividends. Thus, income-focused investors can still find bargains in the sector if yield is what they are after.
But for those investors hunting for a way to use real estate as a hedge against the broader market and to round out a diversified, less volatile portfolio, then public REITs are gradually losing their luster. Are there other alternatives? Thankfully, the answer is yes. We will explore some of the most exciting and innovative alternatives in the second part of this series.
Disclosure: I/We own no stocks mentioned in this article.
