Investing in real estate is a popular wealth-building strategy. As it would take the average first-time buyer nine years to save a deposit, buying even one property may seem like a pipe dream. Real estate investment trusts (REITs) are often billed as a way for the everyday investor to stick a finger in the property pie, to become a ‘lazy landlord‘. Should REITs form part of a diversified investment portfolio?
Returns from REITs
It’s important to avoid conflating the returns of REITs with those of real estate. The latter are difficult to divine and can be manipulated to support one’s argument (1). Although in the long term the returns may be similar, I’ve tried to keep things purely ‘REIT’ for my own research.
Similarly, the time period examined is all-important, and it can also be subtly twisted to fit a narrative. For example, anyone looking at REITs’ performance c. 2008 wouldn’t touch them with a barge pole. I’ve mitigated this by quoting the relevant time period where possible.
UK REITs recently celebrated a fifteenth birthday following their advent in January 2007. How has this fairly nascent market fared in that time?
UK REITs have provided annualised returns of between 3.9% and 5.1% since 2016, depending on which source you use (2,3). It was a bumpy ride too. The FTSE EPRA Nareit UK REIT index has a 5yr volatility of nearly 17%, provided negative returns in four of the past ten years and had a maximum drawdown of -38% during that time.
Over a 2009-2019 timeframe the outlook was a little rosier, with 10yr returns of 9.7%. This was greater than both UK equities (9.1%) and gilts (8.5%). REITs paid out dividends at inflation-beating rates too.
The UK REIT market remains a relative fledgling space, one that “needs to grow” (4). If you do buy UK REITs, be careful about which day of the week you buy them on (5)!
Perhaps you don’t want to invest exclusively in UK REITs though – what about returns from the country with the longest running REIT market?
US REITs have been around since the 1960’s. The Nareit Equity REIT Index (an index of US REITs) had an annualised return of 7.1% for the fifteen years 2006 – 2020. Returns lagged behind those of large-cap & small-cap stocks, and high yield bonds, and with greater volatility to boot (7).
Since 2008 the returns (7% vs. 9%) and volatility (24% vs. <20%) of the Vanguard Real Estate ETF were worse than iShares’ large- and mid-cap US equity ETFs (8). Over a longer timeframe (2001-2020), however, REITs had a greater annualised return (9.7%) than all other asset classes (9). They still had the highest volatility though.
Expanding the timeframe even further (1994 – 2019), the returns from US REITs remain about 9-10% (10), similar to portfolios of entirely US equities or a 50/50 blend of equities/REITs. The catch is in the risk however, with more volatility from a 100% REIT portfolio (19% vs. 15%), and a maximum drawdown of -70%, which was at least 10% greater than the other portfolios.
In the long run, returns between US REITs and the S&P500 are fairly similar. Since 1972 annualised returns of the FTSE Nareit All REIT Index have been 11 – 13% (11, 12). Over the same time period the S&P500 returned 12.2%. In general, US REITs appear to match or outperform US equities over longer periods, typically those of more than 15 years (11, 13 – 15).
|Time period||Fund/Index||Annualised Returns||Volatility||S&P500 returns/volatility|
|2006 – 2020||Nareit Equity REIT Index||7.1%||23.1%||9.9% / 16.7%|
|2008 – 2021||Vanguard Real Estate ETF||7%||24%||9.8% / 17.8%|
|1994 – 2019||US REITs||9.3%||19.3%||9.3% / 18.0%|
|1972 – 2019||FTSE Nareit All Equity REITs||13.3%||–||12.2% / 17.4%|
|1972 – 2020||FTSE Nareit All REIT||11.4%||–||10.8% / 17.2%|
What does the future hold? Blackrock predict 30yr annualised returns from US core real estate of 6.4% (range 2.5% – 10.4%) and 12.3% volatility (16).
If you’re following a globally diversified, passive investing approach then you may prefer to sample REITs from all corners of the Earth rather than those from any one region.
Between 2005 and 2014, global REITs had an annualised average return of 6.7% (17). The FTSE EPRA Nareit Developed REIT index, which comprises a blend of North American, European and Asian real estate markets, has had a reasonably up-and-down time over the past 20yrs (18).
The iShares Global REIT ETF has an average annual return of 4.9% over five years, or 6% over seven years, similar to the FTSE EPRA Nareit Global REITs Index (3) Over ten years the price returns are similar from both the S&P Global REIT Index (4.7%) and MSCI World REIT Index (5.5%). The latter’s volatility was 1% higher than the corresponding global equity fund in that time. Consequently the equity fund had a Sharpe (risk-return) ratio that was nearly twice as high. In general, REIT returns carry more volatility risk than their corresponding equity indices across multiple developed markets (20).
Monevator’s ‘slow and steady passive portfolio’ provides a useful case study of asset class performance (19). Their global property allocation has gained 38% since 2011, which lags significantly behind other sectors such as emerging market equities (59%), global small cap equities (79%) and developed world ex-UK equities (89%). Indeed only their bond and UK equity holdings have performed worse. Their real estate fund, however, doesn’t contain exclusively REITs.
My take home is that, in the short term, the returns on REITs have historically fallen short of those on equities, with the unwelcome addition of greater volatility. Over longer time periods the returns may approximate to (or even surpass) those of equities, though the volatility risk remains.
I wondered whether REITs perhaps offer a diversification benefit for equities, which might merit their inclusion in a portfolio even if their risk-adjusted returns did not.
Unlike returns, the timespan doesn’t appear to greatly affect REITs’ correlation with equities. During a 40 year period (1970-2010), REITs were highly correlated with both equities and bonds (21). Of interest, commodities offered the greatest diversification hedge in that time.
Multiple sources demonstrate high (typically ≥0.7) correlation between US REITs and US equities (7, 8, 13, 22 – 25). Other findings include:
• Moderate-to-high correlation with global equities
• Variable correlations with bonds, ranging from moderately negative to moderately positive
• Low-to-moderate correlation with commodities
• Low/no correlation with cash
This relationship isn’t confined to US REITs, with a similar picture across European, Asian and Global REIT markets too (26 – 28).
Ben Carlson hit the nail on the end when he concluded that “investors say they want non-correlated assets but what they really want is non-correlated assets that don’t get crushed when stocks fall” (29). The evidence suggests that REITs aren’t going to offer that sort of benefit, correlating highly with equities during market downturns (30). Indeed Larry Swedroe has called REITs an “equity security with only marginal diversification benefits” (31).
There’s a smorgasbord of different types of REIT, but correlations among them also appears to be high (28, 32). Despite this there’s evidence to suggest that a global REIT portfolio performs better than one that’s country- or region-specific (33, 34).
Real estate is often lauded as an inflation hedge – could REITs provide a similar benefit? One analysis found conflicting results among six studies that assessed the ability of REITs to act as an inflation hedge (35). Dipping into said studies, the theme appeared to be that REITs are a better inflation hedge over the long-term, as are global REITs rather than US-only ones.
Smoke and mirrors
There’s some doubt as to whether REITs even constitute an independent asset class. According to one study (36), the returns of REITs could be achieved by using a portfolio of small cap value stocks (2/3rds) and long-term corporate bonds (1/3rd) – this blend even had better risk-return characteristics than REITs. It does indeed appear that REITs behave like equities in the short-term, only acting as a real estate asset over longer time periods (35, 37 – 38).
I would hazard that the average retail investor is probably uninterested by this. Sure they could gain the same returns from REITs, without the idiosyncratic real estate market risk, by using a blend of small cap equities and corporate bonds. But they’re probably more interested in feeling like they have some real estate exposure. So that if real estate explodes in value then they’ve already put their finger in the pie.
Space for REITs in your portfolio?
Taken in isolation, REITs appear to offer equity-ish returns but with higher volatility. They function as neither a diversifier for equities nor an inflation-hedging asset. Could they still be some use as part of a multi-asset portfolio?
One paper, from 2006, suggests that the difference in returns between REITs and equities should influence portfolio allocation, rather than their price correlation (39). However we know that the time period over which REITs’ performance is assessed can lead to higher or lower return figures, and consequently a different optimal allocation in a portfolio (40).
Adding 10% REITs to a 60/40 portfolio [i.e. making a 52/38/10 portfolio of equities, bonds and REITs] marginally improved annualised returns (+0.1%) and reduced volatility (-0.1%). Looking at ten year rolling periods from the 1990-2014 timeframe, the addition of REITs improved returns 80% of the time and reduced volatility 65% of the time (41).
A different analysis found that before 2006 adding 10% or 20% to a 60/40 portfolio did not significantly impact upon returns. After 2006, doing so only increased the value at risk (42).
One blogger publishes their REIT-containing USD growth portfolio. It consists of 27% REITs, as well as equities (27%), bonds (22%), gold (22%) and cash (1%). It boasts 16.1% annualised returns since 2005 (44). They’ve back-tested it against other portfolios:
• A 1/3rd each equity/bond/gold portfolio
• A 50/50 equity/bond portfolio
• An S&P 500 ETF
The 27% REIT portfolio had a CAGR of 10%, which was comparable to the other three (9.5%, 9.5% and 10.2% respectively). It did so with comparatively middling volatility of 9.9% (vs. 8.9%, 8.3% and 15%) and a lesser maximum drawdown of -15% (vs. -17%, -18% and -50%). This would appear to support the case for REITs as part of a multi-asset portfolio, although this is a USD-denominated portfolio that is unlikely to suit those wanting a global approach.
Conversely, a study found that REIT allocations of 10 – 30%, as part of an equity/REIT portfolio, did not improve risk-return or drawdowns compared to the 100% equity portfolio (27). Delving a bit deeper, REITs were the only strategy in their analysis that would have decreased risk-adjusted returns of an equity portfolio (2010 – 2019). Other strategies, e.g. dividend stocks, high-yield bonds or low-volatility portfolio, provided better risk-adjusted returns than REITs. In fact one paper found that no optimally risk-adjusted portfolio featured a real estate index (45).
In a series of copy-paste papers, Newell and Marzuki examined the portfolio diversification benefits of various country-specific REITs. They found that UK, German, French and Spanish REITs all demonstrate limited diversification benefits (46 – 48), although the same isn’t necessarily true of Irish or Belgian REITs (49, 50). This is supported by a similar finding across the European REIT market (51).
I had a play around with the portfolio-finder tool over at Portfolio Charts. I asked it to find the portfolios with the best historical risk-adjusted returns. Sadly the modelling is constrained by having equal asset class weighting and only up to ten different assets.
Nevertheless, US REITs featured in eight of the ten best risk-adjusted return portfolios. The best portfolio [US all-cap equities, ex-US intermediate bonds, gold and US REITs] had a conservative long-term return of 4.9% and an ‘ulcer index’ (a composite measure of drawdown depth, length, and frequency) of 5.4%.
Tinkering even further, I added 5, 10, 15% or 20% US REITs to a 100% global equity portfolio:
|REIT allocation (%)||0||5||10||15||20||25|
|Average return (%)||6.8||6.9||7.0||7.0||7.1||7.2|
|Loss Freq. (%)||29||29||29||29||29||27|
|Ulcer index (%)||21||20||19||18||18||17|
|Start date sensitivity (%)||28||28||27||27||26||26|
|SWR (40yr; %)||3.3||3.4||3.4||3.5||3.6||3.7|
It was a similar story when I back-tested various portfolios using Portfolio Visualizer. The addition of REITs provided some benefits, but nothing earth-shattering.
How much is enough?
You can find recommendations for just about any allocation to REITs in your portfolio. They are entirely absent from a number of classically described portfolios, which may be reassuring to the REIT-less investor.
Of the 19 ‘professional’ portfolios on Portfolio Charts, ten contain REITs. At the lower end of the spectrum is a 4% allocation in the global market portfolio, although the original paper features a portfolio of 3.3% real estate and not explicitly as REITs (52). Most of the portfolios contain 5 – 8% REITs. The highest allocation is 20% (Ivy League and Swensen portfolios), although Swensen later revised his suggested REIT allocation to 15% following the global financial crisis.
Among the personal finance bloggers who publicise having REITs in their portfolio, there’s a trend towards a slightly higher allocation – the median value is closer to 10%. Various sources (38, 53, 54) suggest optimal allocations of 15 – 25%, although of note none contain data from the past ten years, which makes their applicability debatable.
Index investing guru Jack Bogle supposedly said of REITs: “I could see an investor owning the Vanguard REIT fund, but I don’t think they should make it more than 10 percent of his or her portfolio. No one should get overexposed to any one sector, and I’d be especially cautious when that sector is hot.”
It may be that you don’t require a dedicated REIT in your portfolio if you’re already in possession of a global index fund. Many of the popular funds already contain a small wedge of real estate:
HSBC FTSE All-World Index Fund – 1.1%
iShares MSCI ACWI ETF – 2.7%
Vanguard FTSE All-Word ETF – 2.9%
Vanguard FTSE Global All Cap Index Fund – 3.7%
A different story
In my opinion, REITs shouldn’t be seen as the direct surrogate for property investing they are sometimes made out to be. Their relationship to real estate (and equity) returns is nuanced.
Globally the REIT market is still fairly juvenile, especially outside of the US. As more countries adopt the approach both the performance characteristics of REITs and their correlation with other asset classes may change.
I personally found little compelling evidence that REITs are a must-have in a portfolio. To be fair there wasn’t a great deal to suggest including them would be too perilous either. Overall I suspect there could be a strong behavioural element in the decision to invest in a REIT, especially for the investor otherwise devoid of (physical) real estate.
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