Many people use REITs both to diversify their portfolios, and as a hedge against inflation. They did work well for both purposes up until the 2000s. But in this article (http://news.morningstar.com/articlenet/article.aspx?id=624535), Samuel Lee of Morningstar notes their correlation with the broader market has increased significantly since the turn of the century. While asset class correlations go up and down all the time, Lee argues that in the case of REITs the change is structural (REITs became more accessible and liquid with the real estate bubble)--and therefore permanent. He believes the inflation-fighting power of REITs is still intact, but that with REITs no longer providing diversification benefits and a poor outlook for their expected returns, there are better inflation hedges (including conventional equities).
I used to own a REIT fund for diversification, but dumped it a few years ago. In addition to reaching a conclusion similar to Leeís, there was another aspect of REITs I didnít like. Because they are required to pay out 90 percent of their earnings as dividends, they have to rely less on retained earnings and more on debt financing. This makes them particularly vulnerable to credit crunches. REIT losses during the 2008 credit crunch were significantly larger than the S&P 500ís losses. Financial crises have been at the root of the worst economic calamities of the past century, including not only 2008 but the Great Depression. So even if Lee is wrong and REIT correlations with the broader stock market return to low pre-2000 levels, the possibility that they might sustain catastrophic losses during the worst market crashes would still make them, to my mind, unsuitable as portfolio diversifiers. (I learned much of this the hard way, as I still owned that REIT fund back in 2008. )
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