Diversification is among the most celebrated concepts in modern finance. You need it to reduce investment risk and increase the odds you'll earn a decent return over time. For most individuals, the main assets in a diversified retirement portfolio are stocks, bonds, and cash. But institutional investors have long added another major asset to the mix: commercial real estate.
They have good reason for doing so. Long-term studies suggest the correlation between movements in commercial real estate and equities is very small, while the relationship with long-term bonds is almost nonexistent, according to Barton Biggs, global investment strategist at Morgan Stanley Dean Witter. But it's a hassle to own commercial real estate. Not only do you have to worry about upkeep and collecting rent, but you need a huge nest egg to accumulate enough varied properties to protect you against individual ones going bad.
That's why REITs--real estate investment trusts--intrigue investors as a portfolio diversifier. REITs are investment pools that own and run hotels, office buildings, and other commercial real estate. Their shares trade like any other stock on an exchange. What's more, dividend yields are relatively lush, since by law these trusts pay out most of their income to shareholders to avoid being taxed at the corporate level.
Although REITs have been around for more than four decades, only since 1991 has the industry's market capitalization soared from $13 billion to $130 billion. But will a REIT give you the same diversification benefits as actual property? "If you bundle up real estate and trade it on the stock market, does it behave more like a stock or a separate asset class?" asks William Goetzman, a finance professor at the Yale University School of Management.
The answer is far from conclusive. But evidence suggests that rather than being a distinct asset class, REITs are mostly another stock group. That has implications for anyone who thinks buying a REIT will afford protection against the stock market's ups and downs. "In a mixed portfolio of stocks and bonds, REITs are no substitute for real property," says Hugh Kelly, chief economist at Landauer Associates, a real estate consulting firm in New York.
REITs put on a spectacular performance in 1996 and 1997, along with the rest of the market. Investors flocked to REITs in anticipation of a strong upturn in commercial real estate values, and to take part in a rash of REIT initial public offerings. Then the stocks went into a precipitous decline starting in 1998 over fears that property values had become inflated and some REIT managements were not up to snuff. So far this year, REITs have sported a total return of -7.92%, vs. a 4.36% gain for the Standard & Poor's 500-stock index. But that doesn't mean REITs have a negative correlation with stocks. Eric Hemel, a REIT analyst at Merrill Lynch, says a third of that abysmal performance is because REITs more closely resemble small-cap stocks at a time when investors are enamored of big caps (table). REITs also share attributes of value stocks at a time when investors prize growth.
PARTIAL EXPOSURE. REITs can still make a good long-term addition to an equity portfolio. For one thing, they give you exposure to a single industry. They also appear to act as a counterweight when big caps are soaring. And REIT "betas," a risk measure based on a security's sensitivity to stock market moves, are very low, according to Yaniv Tepper, an equity REIT analyst at Aeltus Investment Management in Hartford, Conn. What's more, REITs are attractively priced, selling at around a 15% discount to their net asset value. Since REITs pay an average 7% dividend yield and cash flows are projected to grow by 7% to 8% a year, Merrill's Hemel estimates they'll show a total return of 12% to 15% over the next five years. Of course, well-heeled investors who want true diversification can invest in pooled real estate accounts that buy commercial properties.
Still, as the commercial real estate market shifts from private to public ownership, the relationship of REITs to the property and stock markets is evolving. That alone may make REITs intriguing bets. But if your goal is diversification, don't count on REITs to balance out your equity portfolio.