Over the past few weeks, we’ve been discussing several interesting aspects of asset allocation and portfolio design. For example, we’ve explored how gold/precious metals, international equities, short-term bonds, and intermediate-term bonds perform as asset classes and if/how they should be weaved into your asset allocation.
Continuing this investigation on portfolio construction, I wanted today to look into the question of “what level, if any, of your portfolio should be allocated to Real Estate Investment Trusts (more commonly referred to as REITs in an effort to reduce the mouthful of words!)?”
Let’s get started!
Why Bother Considering the Addition of REITs at All?
To begin, the first question that I suppose we should address is the question of why it’s even worth considering adding REITs to your portfolio in the first place.
As is the case with many elements of Modern Portfolio Theory and portfolio construction in general, REITs provide a favorable diversification benefit when incorporated with other components of your portfolio.
More specifically, this diversification benefit comes from the fact that the average return statistics of REITs are not perfectly correlated with other commonly-included asset classes of a portfolio. In mathematical terminology, we can say that the diversification benefit is obtained because the correlation coefficients of REITs with the other asset classes are not 1.
The demonstrate this in tabular form,
I ran a correlation coefficient analysis of the annual returns of the Total US Stock Market, REITs, and Short-Term Treasuries between the ~40 year period between 1972-2011 (using data from the Bogleheads.org
Simba backtesting spreadsheet).
The correlation coefficient results can be seen in the table below. As you can see (green highlighted cells), the correlation coefficients between REITs and the Total US Stock Market / Short-Term Treasuries are quite favorable at 0.62 and 0.01, respectively. What this means in English is that the returns of REITs move in sync with the stock market in general a little over 1/2 the time and with Short-Term Treasuries almost none of the time.
According to Modern Portfolio Theory principles, adding a poorly correlated asset class into a portfolio can often decrease volatility while possibly, increasing returns. Thus, this is the motivation for looking at including REITs in a portfolio/asset allocation.
What Do the Experts Say About Adding REITs to Your Portfolio?
Before getting too far into my own asset allocation analysis, I generally like to quickly review and summarize the thoughts that people much more qualified than I am have on a subject.
As such, listed below is a summary of what has been recommended in the books of several well-respected asset allocation authors regarding the incorporation of REITs into a portfolio:
- Larry Swedroe (probably my favorite investing author I have found to date)
- In Larry’s book, What Wall-Street Doesn’t Want You to Know, Swedroe recommends an allocation towards REITs equal to 10% of the equity portfolio (NOT total portfolio). So, in a 70/30 split equity/fixed income portfolio, for example, REITs would make up 7% of the total portfolio.
- In Larry’s other book, The Only Guide to a Winning Investment Strategy You’ll Ever Need, Swedroe recommends an allocation of 6-10% (of total portfolio) towards REITs, depending on your risk tolerance being moderate to highly aggressive.
- Burton Malkiel
- In his famous and amazing book (2003 edition), A Random Walk Down Wall Street, Malkiel provides example asset allocations with between 10-15% of the total portfolio allocated to REITs.
- William Bernstein (my 2nd favorite investing author I have found to date)
- In his 2002 book, The Four Pillars of Investing, Bernstein displays sample portfolios/asset allocations with REITs representing 6-10% of the total portfolio.
- He also mentioned that because REITs are poorly correlated with the total stock market, investors generally will have tracking error if their REIT allocation is greater than 15% of your equity position. In other words, REITs should be kept to less than 15% of the equity allocation.
- This perspective was approximately echoed in his 2001 book, The Intelligent Asset Allocator, as well.
- Rick Ferri
- In his 2006 book, All About Asset Allocation, Rick provides sample portfolios containing 10% allocation to REITs during working years, and 5% allocation during retirement.
Conclusion from Literature – So, after looking through all of the books that have helped me build my portfolio over the years, the consensus seems to be that REITs should make up between 10-15% of an investor’s equity allocation in order to get the diversification benefit but not risking the introduction of tracking error. Of course, this number will change as your life cycle allocation adjusts during different life stages.
How Have REITs Performed in the Past Compared to Other Portfolio Components?
In this case especially, the literature seemed to provide rather definitive guidelines about what is a good amount an investor should allocate to REITs. This is nice, since it takes some of the guesswork out of my analysis.
The first thing that is interesting to examine when seeing how REITs have performed compared to other common asset classes is to see how an investment made a long time ago (~40 years in this case) would have grown.
As such, shown below is the hypothetical growth of a $10k starting investment in REITs (red line), the Total US Stock Market (blue line), and US Short-Term Treasuries (green line) between the years of 1972-2011.
As you can see, the investment in a REIT surprisingly produced a MUCH higher ending portfolio value than the investment in the Total US Stock Market ($400k vs. $850k with the REIT).
If we look at the actual return data that produced the graph above, the superior performance of REITs during this time period is also confirmed. REITs had an average return of 13.4%, compared to only 11.3% for the Total US Stock Market.
Intriguingly, REITs delivered this higher return with almost exactly the same volatility as the Total US Stock Market, meaning that it was highly efficient. Of course, this efficiency was likely what caused the ending portfolio value to be so much higher for REITs compared to the Total Stock Market.
REIT Allocations in a 3-Component Portfolio Design
More important to us as portfolio design “engineers” is how an asset class will behave and/or benefit us when incorporated in a realistic portfolio/asset allocation.
To assess this for the REIT asset class, I re-ran the portfolio analysis during the 1972-2011 period using a portfolio consisting 30% of fixed income Short-Term Treasuries and then varying allocations of REITs (between 0-70% of the total portfolio). The remaining allocation was filled up with the Total US Stock Market asset class.
Shown below is the average annual return vs. risk graph that resulted from the analysis.
And, shown below is the exact data that was used to construct the return / risk curve above.
If we examine this data a little more closely, we see that every increase in REIT allocation results in an increase in average return, as we might expect since this asset class did better than Total Stock Market during the time period analyzed.
However, more importantly, we see that adding up to 70% allocation to REITs results in the same risk level as a non-REIT portfolio. In terms of return/risk efficiency, we see that a portfolio containing 40-50% REITs is the most efficient.
You can view the complete set of numbers/calculations for my analysis by accessing the Google Docs Spreadsheet here.
Conclusions from 3-Component Portfolio Analysis –
Unfortunately, just because this analysis I ran above shows that a 40% REIT asset allocation is most efficient, it doesn’t mean that we want to rush out and buy as many REIT shares as we can.
This is due to two things – historical data and tracking error.
- During the past 40 years (even though this is a huge chunk of time), REITs have performed phenomenally well compared to historical standards for real estate.
- For example, in Rick Ferri’s book, All About Asset Allocation, he provides long term returns for real estate and the total stock market between 1930-2004. The data shows that the Total Stock Market (9.7% average annual return) has outperformed real estate (9.3% average annual return) by 0.4% per year.
- In general, the consensus in almost every other long term study I have read indicates that real estate / REITs should be expected to have long term returns roughly the same as common stocks.
- Thus, we cannot rely on the stellar REIT results from the past 40 years to continue.
- Next, we must also consider tracking error.
- Since REITs have low correlation with the general stock market, myself (and likely other investors) would not have the discipline to stick with a 40-50% REIT allocation over a long term period.
Conclusions about REIT Asset Allocation and My Personal Path Forward
So, after sifting through all this analysis, what’s the overall verdict on what asset allocation should be committed to the REIT asset class?
Listed below are my key takeaways from this investigation:
- REITs provide a strong diversification benefit due to their low correlation of returns with other asset classes, and thus, are good to include in your portfolio. They also have an attractive return / risk efficiency profile.
- Even though REITs have nicely outperformed the total stock market in the past 40 years, over the long run, history suggests that we realistically should expect REITs to produce returns more equivalent to common stocks.
- An appropriate asset allocation to REITs is between 10-15% of an investor’s equity allocation in order to get the diversification benefit of the asset class, but not risk the introduction of tracking error. This is the recommendation from the literature as well.
My Personal Path Forward – I want to lastly share how this analysis affects me personally. I currently use a 70/30 equity-fixed income asset allocation. 10% of my total portfolio (or ~14% of my equity position) is allocated to REITs. Thus, I’m pretty much already in line with my conclusion above. So, no action is needed at this time. I do, however, need to make a note to track this asset class as a % of my equity position going forward.
How about you all? Do you have any exposure to real estate or REITs in your investing portfolio?
If so, what % of your portfolio does it constitute?
Share your experiences by commenting below!
