Editor's Note: The following article appeared as part of the 2012 Research Magazine Guide to REIT Investing.
The U.S. economy slowed in the first half of 2012 and is delivering only tepid growth. One segment of the economy that is showing some vitality, however, is commercial real estate. In the first half of the year, apartment, retail, office, warehouse and other commercial real estate vacancy rates continued to decline, rent growth gained momentum and the stocks of Real Estate Investment trusts – REITs ─ fared well, outpacing the broader equity market.
In the first half, the total return of the FTSE NAREIT All Equity REITs Index – with its 128 companies and more than $500 billion in equity market capitalization – was up 14.91% compared to a 9.49% gain for the S&P 500. In the second quarter, the REIT index was up 4% while the S&P 500 fell 2.75%, and for the 12 months ended June 30, REITs more than doubled the performance of the broad market, delivering a total return of 12.48% to the S&P 500's 5.45%.
Favorable supply and demand dynamics are helping to support REITs' declining vacancy rates and increasing rents, and are likely to continue to provide support for these operating fundamentals for the next several years. Commercial real estate construction fell to 20-year lows during the Great Recession and, while construction is slowly ramping up, new supply is scarce across all of the property types owned by REITs. So, even though the economy is growing very slowly, new supply of high quality commercial real estate is growing even slower.
This situation, of course, represents a snapshot in time, but there are good reasons for financial advisors to consider a role for REITs as one of several building blocks for any investor's long-term retirement savings plan. REITs provide four investment benefits that have held up well over time and are relatively simple to explain to the average investor: Diversification, Dividend Income, Inflation Protection and Long-term Performance.
Diversification
Don't put all your eggs in one basket – that's one of the oldest rules of investing, particularly during periods of heightened economic and financial uncertainty like we face today. And REITs provide important diversification benefits for retirement portfolios.
The most common way of looking at diversification is the correlation between asset classes: Over the 20-year period from the end of 1991 to year-end 2011, REITs showed low to moderate correlation with large cap, small cap and international stocks as well as U.S. and international bonds. For example, large cap and small cap equities were 80% correlated, while large cap equities and equity REITs were only 56% correlated. So, diversifying a large-cap portfolio with REITs, for example, is more effective than diversifying it with small cap stocks. REITs help to reduce the risk of overall portfolio losses in volatile markets because they do not always move in tandem with other equities.
A key portfolio benefit of diversification is the potential to increase long-term returns without taking on additional risk. The chart below illustrates how reallocating 10% of a diversified 60/40 portfolio to equity REITs would have improved annual returns by 0.5% per year on average from 1991 to 2011. That could add up to thousands of dollars of additional gains over 20 years without any additional risk.
Dividend Income
When people think of REITs they often think of "Dividends." There's a reason that many financial advisors consider REITs to be well suited for income investors as well as long-term investors. Equity REITs generate a consistent stream of cash mainly by collecting rents from the multiple tenants occupying the properties they manage, and by law, they must pay out at least 90% of their taxable income annually as dividends to shareholders. This high dividend payout requirement means a larger share of REIT investment returns come from dividends when compared with other stocks. REIT dividend yields have historically been a good deal higher than the average yield of the S&P 500 Index. In fact, over the long-term, nearly two-thirds of REIT total returns have come from dividends.
Dividends do make a difference for long-term retirement savings. For investors with a longer time horizon to retirement, dividends can be reinvested to generate future returns, while in later years they can provide a steady income stream to help meet expenses in retirement. An original $10,000 investment in REITs at the end of 1991 would have grown to $79,387 over 20 years if dividends had been reinvested. If dividends had been taken as income, the investment would have paid out $19,698 in dividends and delivered another $23,609 in growth, for a total value of $43,307.
Inflation Protection
People are living longer. A key concern for financial advisors is how to ensure enough income to meet expenses over a retirement period that could last for decades. The dilemma for retirees is that it can be tough to stay ahead of inflation with fixed income securities, while equities – the traditional inflation hedge – are usually trimmed back to minimize investment risk. This is especially true today, when interest rates are historically low.
REITs provide a natural hedge against inflation in ways that match up well with investors' needs. Commercial real estate rents and values tend to increase when prices do, which supports REIT dividend growth, providing retirement investors with reliable income even during inflationary periods.
A practical way of measuring the inflation protection provided by REIT dividends is to directly compare REIT dividend growth with inflation. In all but two of the last 20 years, REITs' dividends have outpaced inflation as measured by the Consumer Price Index.
Performance
REITs essentially are a hybrid investment, embodying aspects of fixed income investments, with their consistent, strong dividends, and equities, with their ability to produce long-term capital appreciation through effective management of the corporation. This combination of characteristics has historically provided REIT investors with appreciably higher total returns – stock price appreciation plus dividends – than most other equities and bonds. REIT total return performance over the past twenty years has outstripped the performance of the S&P 500 Index, the Barclays U.S. Aggregate Bond Index and other major equity and fixed income indices – as well as the rate of inflation.
REIT total return comparisons with other investments hold up well over most investment horizons over the past forty years. For example, U.S. equity REITs as represented by the FTSE NAREIT All Equity REIT Index have outpaced the S&P 500, the NASDAQ Composite, the Dow Jones Industrial and the Russell 2000 indices over the last 1-, 3-, 5-, 10-, 15-, 20-, 25-, 30-, 35-, and 40-year periods ended June 30 of this year. Such a performance record should not be dismissed.
Conclusion
REITs belong in a long-term retirement saving and investment plan. There is no single right answer on what constitutes an appropriate allocation to REITs or to any other asset class. But there are plenty of data to suggest that including REITs in a portfolio benefits investors in a number of ways compared with portfolios that do not include REITs.
For one research view on REIT allocations for investors with varying years to retirement, look to Wilshire Associates. Wilshire recently conducted a portfolio optimization study on target date funds that provides broader insights for retirement portfolio planning in general. Wilshire's model has U.S. REIT allocations beginning at 16% for an investor with a 40-year horizon, gradually declining along with other equities to 7% for someone just entering retirement and then to 1.6% for an investor 15 years into retirement.
Allocations depend on the circumstances, investment objectives and time horizons for a particular investor, as well as the judgment of professional financial advisors. However, the four key investment attributes of REITs – Diversification, Dividend Income, Inflation Protection and Long-term Performance – are a good starting point for discussing where REITs fit into a long-term investment plan.
Editor's Note: This article appeared as part of the 2012 Research Magazine Guide to REIT Investing.