Including REITS in Portfolio

[eytonxav]

For some further diversification and inflation hedge, what does everyone think of using REITS in a portfolio, and if your portfolio is currently 65% fixed income/35% equity, over >$1M, what % would you allocate to REITS?

 

[John Galt]

I think REITs are a great idea for most investors. I do not hold any myself and have no suggestions for
allocation. I have considered REITs in the past as I
am naturally inclined toward real estate.

John Galt

 

[Cut-Throat]

DFW,

I have a 60/40 equity to Fixed portfolio and will have about 5% total in a REIT Index Fund, which will be around 8% of my total equity portion.

There is no right number, but I think no more than 7% of your total portfolio should be in REITs, or 20% of your total equity position. But that is just a WAG on my part.

 

[renferme]

looks like I'm about 10% Reits right now, about 30%stocks (including the Reits) and 70% other stuff.

 

[Ted]

The "independent" financial columnists whom I respect (such as Jonathan Clements) seem to recommend putting about 5% of total assets in REITs. Personally, I consider a 5% allocation to be too small to make much of a difference in a portfolios performance (unless it is in some very high risk asset, including the stock of a person's own company).

Over the past 15 years or so, in which REITs have become "established" investments, the return has been about equal to large company stocks, with no noteworthy correlation in annual returns. So I see no reason why a person shouldn't potentially put as much into REITs as into stocks.

It would not be possible for all investors to allocate more than about 5% to REITs without greatly inflating the capitalization of REITs (since the total capitalization of REITs represent only a few percent of the total stock market capitalization). However, this is no reason why any individual couldn't do so.

If a person owns real estate directly -- including their own home -- it would be a reason to limit their holdings of REITs, since REIT returns are likely to correlate with real estate values over the long run.

 

[WilliamG]

5-10% of total portfolio is a range I've seen often.

Larry Swedroe, author of "What WallStreet Doesn't Want You to Know", recommends REIT as an equal weighting with 4 other asset classes within US stock allocation. (the other classes being large cap blend, large cap value, small cap blend, small cap value). If you accept his 70/30 recommendation split between US and international, this works out to 14% of your stock allocation.

The most ambitious REIT advice I've seen is Burton G Malkiel in "A Random Walk Down Wall Street". He treats REIT as separate asset class in recommended portfolios and recommends the following REIT % of overall portfolio:

10% mid 20s-early 40s
12.5%mid 50s
15% late 60s & beyond

Regards Bill

 

[unclemick]

Dick Young's Intelligence Report - 15-20% real estate including REITs and Timber as a REIT, stock or other holding - Timber is supposed to be great should inflation come back.

 

[cute fuzzy bunny]

Ted - regarding your comment on owning REITS if you also own a home...isnt it true that for most people in the US the local RE market is fairly stagnant most of the time, while REITS invest in a broad range of properties in areas that are appreciating rapidly? In that case, even if one owned real estate (their home), isnt it still a good diversification tool and income generator to own REITS?

I ask because I own two homes outright, in an area that HAS appreciated significantly and is likely to continue to do so. I still own REITS at about 10% of my total portfolio, in my IRA. I did this because I considered ownership of apartment and office buildings and strip malls to be quite different than owning my home, and to move differently in value.

I also understand that indexing REITS (which I am doing through vanguards product) produces a broad enough spectrum of reits that the funds tend to move similarly to US small cap stocks, somewhat ruining the diversification benefits. I still break down my own asset classes because I havent found a tool that does it the way I like it, and I break out REITS into a separate class from small caps. I'd like other opinions on the REIT indexing and its relation to small caps as asset classes and in how they might move in relation to each other.

 

[sgeeeee]

. . . If a person owns real estate directly -- including their own home -- it would be a reason to limit their holdings of REITs, since REIT returns are likely to correlate with real estate values over the long run.

I'm not sure I understand the reasoning here, Ted. For most people, their home is not an investment except possibly under the most catastrophic conditions. Also, individual properties are subject to very specific localized market conditions and do not necessarily act like diversified REITs. My inclination is to neglect my home in calculating my investment net worth and in plotting my retirement strategy.

 

[Ted]

I'll try to respond to both TH and Salaryguru.

REITs are essentially "stocks" of the industry that owns income-producing real estate, which includes commercial, industrial, and multi-family residential. Vanguard's REIT Index fund is an excellent means of getting broad exposure to this industry nation-wide at low cost. Fidelity's Real Estate Fund has performed similarly.

The value of any individual home is certainly dependent on various local factors, but is also subject to some of the same national economic factors that affect other types of real estate. Certainly inflation is one of these factors. Thus, it is reasonable to expect a fair amount of correlation between the long-term price appreciation of single family houses in general and the return on REITs. But the appreciation of any single house may be substantially different. So by owning both a house and REITs, a person is reducing their "diversifiable risk" in real estate.

As I stated elsewhere, I could find no meaningful correlation between the annual returns of REITs over the past decade and any other asset (or even inflation!)
Specifically, over the 11 year period 1992 through 2002, the correlation coefficient between the Wilshire REIT Index and the Russell 2000 small cap index was -.08. Although this data is somewhat limited, the lack of correlation is striking.

Even though a person is not receiving income from their house (other than "imputed rent"), it is nevertheless a valuable asset that COULD be converted to cash if necessary, either by selling and moving to a smaller, less expensive house, or by taking a reverse mortgage. So it is prudent to both diversify one's exposure to real estate, and to limit it by at least "informally" recognizing their "investment" in their house. By this, I mean that the value of the house should not be "counted" the same as an REIT, but that a person with a valuable house should maybe limit their REIT exposure to 10% while someone who does not directly own property might allocate 15% to 20% of their assets to REITs.

 

[wzd]

I noticed that the allocation suggested by WilliamG's reference increases with age. This seems to indicate that a REIT is more like a bond than a stock. In fact, since they do produce cash flow, and that the cash flow is a key valuation measure for REIT's, this makes sense!

Does anyone have inflation correlation information on REIT's? I suspect that it has some inflation protection and may be more akin to TIP's than other bonds.

Wayne

 

[cute fuzzy bunny]

Good info Ted. Somewhere someone opined that REIT funds that pick a smaller clump, or purchase of a few individual REITs was superior to the index because the index funds were so broad they started behaving like small cap indexes. Your findings are that this is not so. Good. Now I just need to get tools like vanguards portfolio tool and quicken to understand that a REIT fund is NOT a small cap stock fund. Actually what I need to do is dump quicken...it doesnt even recognize the vanguard wellesley fund and calls it an "unknown asset class". Perhaps I should cut them a break, the fund has only been around for 34 years in its current incarnation...

I've been doing so much stuff ad-hoc in OpenOffice's spreadsheet that I dont need quicken for much anymore anyhow...OpenOffice by the way is highly recommended for someone who wants a Microsoft Office sort of package without paying for it. Free is a good price. The spreadsheet is quite decent.

 

[Ted]

 Actually what I need to do is dump quicken...it doesnt even recognize the vanguard wellesley fund and calls it an "unknown asset class".  Perhaps I should cut them a break, the fund has only been around for 34 years in its current incarnation...

I'm no expert on software, other than to know that most of it is "dumb" in some respects. A couple of reasons why it might not correctly count the Wellesley Fund are:
1. Spelling it is kind of tricky and you may have entered it incorrectly (although the above spelling is correct).
2. Since it is a "balanced" fund, the software is probably not designed to allocate a part of the fund's value to stocks and a part to bonds. (I can do this manually with my own asset allocation analyzer in Excel.)

 

[cute fuzzy bunny]

Oh I spelled it correctly, or more correctly quicken downloaded the fund information from vanguard directly. I agree it cant know to the detail what the fund contains, but at least it can use the funds stated objective of 60% bond, 40% large cap value stock rather than showing me that 60% of my portfolio is "unknown".

Perhaps these guys should spend more time working on proper data representation and analysis rather than the 2004 july edition of quicken premier super duper deluxe.

I ended up with my own allocation spreadsheet into which I can also factor in ranges of expected return and risk. Being able to calculate risk vs return on an asset by asset basis, along with collective return and risk, then fiddling with it is mighty handy. Took me 4 hours to put together, but then my time is rather available...

 

[Jarhead*]

iRe: Including REITS in Portfolio

Re Reits:

If you look at the last 10 year performance of reits, you will see quite a bit of volitilty.
I (Last 3 years), had a pretty high position in reits. But they have had an a big runup in that period of time, ala real estate prices in general. (Including owner occupied homes).
I don't remember who it was, but someone stated that if you have a large base in real estate, that it probably makes sense to go a little lighter on Reits. I totally agree with that, and in fact, recently sold off half of my reit holdings.
Again, I think you should take a look at the last few years of the performance of reits, and proceed with caution. In my opinion, a position in reits makes sense for a diversified portfolio, but if you have an inflated equity position on your personal residence, or rental real estate, I don't think you should take a large position in reits. (I will continue to hold about 10% of my position in reits, but if it increases over that, unless I sell some real estate, will continue to sell off the overage.
Jarhead

 

[Bob_Smith]

Jarhead hits on an issue that is important to me. As one who has zero REIT exposure and wants to have some, is now a bad time? With stocks there is a long history I can study to try to get a feel for whether the market is overpriced. Not so with REITs. What's the best approach? Dollar cost average over a year or two? Just take the plunge now? Wait for a big price decline?

 

[cute fuzzy bunny]

My thoughts on this, because I just did the same exercise:

REIT's are quite expensive right now, and a lot of folks are thinking they'll decline. See: market timing again. That having been said, while the NAV will go up and down, the yields are still good and should remain good indefinitely.

Sooo...I bought a 10% total portfolio stake using already inflated money from another fund that has had a hard run-up, and bought it in my IRA where it will act as a nice uncorrelated portfolio stabilizer. If the NAV's drop, my yields will be buying fat loads of shares. If it REALLY outperforms on a regular basis, it'll give me good fodder for rebalancing to other asset classes that have more upside. In 20-25 years when I'm eligible to tap the IRA it should be up a nice amount.

I did the same thing with some emerging market index, some vanguard explorer and international explorer. They're all run-up pretty good, but the fund I sold out of was already run-up.

 

[Ted]

As one who has zero REIT exposure and wants to have some, is now a bad time? With stocks there is a long history I can study to try to get a feel for whether the market is overpriced. Not so with REITs. What's the best approach? Dollar cost average over a year or two? Just take the plunge now? Wait for a big price decline?

The "market" always believes that every asset is fairly priced. There are always arguments why an asset is "over-valued" and why it is "under-valued."

Decide what your long-term "target" allocation to REITs should be, invest in about half of that now, and wait to see what happens before deciding when to invest the rest. That is the rational approach for people who are smart enough to know what they don't know about how any particular asset class will perform.

 

[Cut-Throat]

Ted is spot on here with his advice as usual. This is exactly the advice of Swedroe in his book "What Wallstreet does not want you to know"

Ted - Are you sure you didn't write this book?

 

[wabmester]

For some further diversification and inflation hedge, what does everyone think of using REITS in a portfolio, and if your portfolio is currently 65% fixed income/35% equity, over >$1M, what % would you allocate to REITS?

I allocate zero to REITs, but I have about 25% in real estate.

My play is a bit different from most. I only buy desirable (waterfront/view) SFRs. Rental income isn't great -- about 5% from a cap rate perspective, but appreciation has been excellent, and downside risk (based on the bubble popping back in 1990) appears to be limited.

I'd be very careful around REITs and real estate in general. A lot of the appreciation has been driven by low interest rates, so if rates go up, all bets are off. Also, a lot of REITs are heavily leveraged, a lot of commercial properties have historically high vacancy rates, there has been a fairly recent building boom leading to increased supply, etc.

Disclaimers: I'm a big fan of market timing when there's clear data that suggests I should time. I don't believe most markets are efficient. And I don't buy lottery tickets.

 

[wzd]

A few more thoughts on REIT valuation. These are just my observations, and I claim no great insight on the subject.

REIT valuation is heavily tied to payout rates, and payout rates are considered good or bad relative to the interest rates. Rising interest rates will lower valuations, but not by the degree bonds are affected because of the underlying assets and of the effect inflation will have on rents (assuming interest rates and inflation stay correlated).

A counterbalance is that both residential and commercial vacancy rates are high right now. I just got a Denver newsletter by one of the real estate brokerages with rent survey information. The vacancy rate for multifamily housing has dropped from a high of 13% early last year to 11.2%. This should drop as the economy improves and that will create an increase in cash payouts of REITs, which will help offset the effect of raising interest rates. Commercial vacancy rates have much more room for improvement.

So, I guess I would agree with Ted, Cutthroat, and Swedroe, about knowing what I don't know about how any particular asset class will perform.

My particular real estate investment is $250k equity in a 20 unit apartment building that I manage. I feel it will give me an inflation adjusted income stream, I have a fixed 5 year mortgage, and pay a residental manager and maintenance person to do most of the work, although I do some myself to cut costs. I think real estate is a good investment to diversify with, but just have an adversion to using REITs as I feel they have been bid up by the stock market relative to individual properties. I also own 2% of a shopping center via a local real estate company. Not really diversified enough, but these are my higher risk/reward investments. I feel the ability to do hands on management mitigates the risk somewhat, or at least allows me to transform some of the monetary risk to a time cost if need be.

Wayne

 

[wabmester]

I think real estate is a good investment to diversify with, but just have an adversion to using REITs as I feel they have been bid up by the stock market relative to individual properties.

I think this is a healthy aversion. REITs are strange animals. You can't use stock market metrics to value them, and you have to know what's inside. A REIT can be anything from a shopping mall to an interest rate arbitrage play.

Don't go by historical data -- I just don't understand how anybody could find a valid trend or correlation in historical REIT data since a REIT can be so many things, and the mix changes quickly.

I took a look at a couple of Vanguard's top REIT holdings, and they are mostly household names, but I don't understand buying a shopping mall REIT at a high price/book ratio. What's the premium for other than speculation?

 

[Ted]

In attempting to assess the value of individual REITs, you and other investors are making the market in them efficient, so that "lazy" people like me can simply invest money in a broad-based collection of them like Vanguard's REIT index fund, knowing that we are eventually likely to make a decent return on the investment.  So keep it up, and perhaps your diligence will net you a fraction of a percent extra gain (or perhaps not), but "free riders" like me will benefit either way.

In looking at "price to book ratios," it is important to understand how book value is calculated.  The book value is simply the price at which an asset was acquired, minus depreciation as defined by the IRS.  This "depreciation" often has absolutely no relationship to the change in the fair market value of an asset.

For example, a piece of raw land may have been purchased in 1980 for $100,000, and have a value today of $10,000,000.  But its "book value" would still be $100,000.  This huge difference is possible despite the fact that the value of land can't be depreciated.

Likewise, a commercial building might have been purchased in 1980 for $100,000, and have been depreciated such that its "book value" is now, say $10,000 (the 1980 value of the land that it sits on) even though it might have a current market value of $10,000,000 or whatever.  Thus, an REIT with a high price to book value may or may not be a good value.

 

[wabmester]

In attempting to assess the value of individual REITs, you and other investors are making the market in them efficient.

Ted, I'm impressed that you still believe in efficient markets and rational investors after the wild ride of the last six years or so.

Just as retail investors were chasing the hot money in dot-coms a few years ago, I think REITs started to gain momentum when investors started chasing yields, and that the resulting cap gains fed the fire.

I'm wary of the stock market primarily because it doesn't seem to move based on the available data. Something else is moving the market, and until some smart economist comes out with a new theory that incorporates the vast masses chasing hot money, and more vast masses taking a "disciplined" approach by ignoring all data and piling money into index funds, and the growing masses who trade based on TA of daily price movements, I have to heavily discount conventional wisdom.

But I do enjoy reading your posts

 

[Cut-Throat]

I'm wary of the stock market primarily because it doesn't seem to move based on the available data. Something else is moving the market,

This is no different than any other market. If everyone in the World decided that Diamonds were worthless pieces of rock - They would be! - The only value in them is that people want them.

If you look at the Stock Market this way, the wild rides are not that hard to understand.