By Francis Bayes, WCI Columnist
When I started “investing” by buying index funds, my portfolio included VNQ: one of the low-cost, broad-market index ETFs of publicly traded REITs. I had public REITs, aka Real Estate Investment Trusts, because (1) I was excited about maximizing diversification, (2) I felt that I could not go wrong by imitating Dr. Jim Dahle's portfolio (he has 20% of his portfolio in real estate, including some in REITs); and (3) Rick Ferri’s All About Asset Allocation–one of the first investing books that I read–recommended the asset class.
But as I read more books and blogs on investing (like William Bernstein, JL Collins, and Mike Piper), I questioned the complexity of my asset allocation as I learned the value of simplicity. Each asset (or sub-asset) class came with a baggage of questions. Will this asset outperform a total stock market fund, like VTI? Am I buying the best ETF in its class? Should I over- or underweight it this year? After a few years, my own second-guessing annoyed me, and public REITs were the biggest culprit.
In January 2022, as I bought stocks in lump sum in our Roth IRAs, I shed public REITs from my portfolio (maybe I should have sold off crypto, too!)
Although I was selling them high (not low) relative to VTI, I replaced VNQ with VTI because of the following five reasons that I explain below. This column is for those who are writing their financial plan and deciding on the asset allocation for their retirement portfolio. If you own public REITs, you should buy them according to your financial plan because changing your asset allocation can be costly unless you are early in the accumulation phase. Many good portfolios include public REITs. If you don’t own public REITs, I hope my column is not counterproductive.
(Disclaimer: I have no disclosures, but The White Coat Investor has financial incentives to promote some of the real estate investments that I discuss later in the column. Here's what WCI's real estate partners can offer.)
Featured Real Estate Partners
#0 Public REITs Tilt Toward, Not Add, Real Estate in the Portfolio
In part because public REITs are so easy to buy, one thinks that buying more public REITs is akin to “adding real estate” to their portfolio. But most, if not all, of VNQ’s 167 companies are already a part of the total stock market (e.g., 3.85% of VTI). When one allocates 5%-25% of their portfolio to public REITs, they are “tilting,” not adding.
#1 Public REITs May Not Improve the Portfolio’s Return
To determine whether one should tilt toward public REITs, one often compares their past performance to that of the broader stock market even though “past performance does not guarantee future results.” They might compare 20-year returns or returns since 2000, both of which happen to start near the peak of the dot-com bubble. Or they might read about the outperformance of the Nareit REIT index relative to the S&P 500 since the former’s inception in 1972 (which was the year before the stock market had its worst decade since the Great Depression).
But how about 10-year returns? Why not compare the returns since the stock market bottom during the 2008 financial crisis? Different start dates can lead to opposing conclusions. Even Nareit, which is an industry group representing REITs, has the integrity to not mention their own index’s “outperformance” on its website.
I have no idea how public REITs will perform relative to the S&P 500 or a total stock market fund in the future. I continue to tilt toward small-cap value (SCV) stocks based on studies of past performance, as well, but I have more confidence in the SCV because the timeframe of such studies predates 1972 and one can explain the outperformance in different ways. If you think that public REITs will outperform, then I have neither the ability nor the will to convince you otherwise.
More information here:
#2 Public REITs May Not Provide Diversification
When one considers adding real estate to their portfolio of stocks and bonds, they hope for two things: (1) a higher return than that of either asset; and/or (2) a positive return when both assets have negative or zero returns. If one wants to add public REITs for a negative or low correlation to stocks, then I have seen limited evidence. Similar to those of sub-asset classes within stocks (e.g., SCV, international stocks), the correlation of public REITs with large-cap stocks (essentially, S&P 500) has been increasing to around 0.75. Maybe the correlation of public REITs will decrease to near their historical average of 0.59. But buyers beware: when the stock market crashes, public REITs will likely crash as well.
#3 TBD: Public REITs May Not Outperform with Inflation
One year cannot tell the whole story, but so far in 2022, the YTD returns for ETFs of public REITs are either worse or nearly identical to that of the S&P 500. If one focuses on the years when inflation exceeded 4%, REITs outperformed stocks, so the pattern could continue in 2022—or in 2023 if inflation continues to exceed 4%. In his book, Rational Expectations, Bernstein suggests that the dividend yield of REITs, which predicts future returns, grows more slowly than inflation because REITs cannot reinvest more than 10% of their earnings.
#4 Public REITs Are Not Representative of ‘Real Estate'
Because we say that we own the entire stock market when we buy VTI or VTSAX, you might think that you own the entire real estate market when you buy public REIT ETFs, such as VNQ or FREL. But you only end up owning a slice. According to Nareit, the size of the professionally managed real estate market (including both residential and commercial) is approximately $4.5 trillion, of which publicly held REITs own around $3 trillion. In contrast, the size of the commercial real estate market exceeded $20 trillion in 2021, and the residential real estate market is also in the trillions. If we focus on “REIT-like properties” that Nareit defines as institutional-grade properties, then public REITs own about 20% of such commercial properties.
When one tilts toward public REITs, they concentrate in two ways: (1) 100-200 companies among thousands in the US and (2) less than 20% of the real estate market that such companies can own. By comparison, domestic small-cap value index funds own anywhere from 172 to more than 1,400 stocks. The risk of such concentration with public REIT ETFs is much greater than that of SCV.
#5 Public REITs Create Asset Location Headaches
Public REITs are not tax-efficient, because they are required to distribute at least 90% of their income in the form of dividends. The dividends are nonqualified and subject to ordinary income tax. Thus, one should have public REITs in tax-sheltered accounts, such as a traditional/Roth IRA or a 401(k).
But for many savers, fitting their public REITs into their tax-sheltered accounts can become a headache (especially if a suitable index fund is not available in their 401(k) account). Public REITs should be the last asset class to be in a taxable account. Table 1 shows the asset location with Rick Ferri’s “Core-4 Portfolio” for a dual-income household that maximizes their retirement accounts. As one’s taxable savings increase, they need to have more of their large-cap stocks (e.g., VTI, VXUS), which are the most tax efficient, in their taxable account (unless they own bonds in taxable).
If they want to add asset classes that are less tax-efficient than large-cap stocks (like SCV stocks), then they may need to exchange the large-cap stocks in their tax-sheltered accounts for their less tax-efficient counterparts. In the above examples, adding just 8% of domestic SCV stocks would require one to own the asset class in multiple accounts: at $150,000 annual savings, one would have to figure out where $4,700 should belong (after buying $7,300 in their HSA). But given the reasons 1-4 above, any benefits of owning public REITs may not outweigh the hassle of optimizing tax efficiency.
What Are the Alternatives?
A detailed section on the alternatives to public REITs is beyond my level of expertise. The White Coat Investor website and other blogs have courses and mountains of content on real estate investing. Private REITs, funds, and syndications may have specific advantages in addition to the “illiquidity premium” (or illiquidity problem!) How about direct ownership and management of residential property? According to the Federal Reserve Bank of San Francisco (FRBSF), the returns on housing, if unleveraged, were as high as that of stocks with less volatility from 1950-2015 (not accounting for transaction costs, maintenance costs, and taxes). But the FRBSF’s study equally weighted the returns in 16 countries. The difference between the two total returns was the greatest in the US, as the mean real returns of equity and housing were 8.39% and 6.03%, respectively. When Big ERN used the source data to calculate the geometric means, the difference was 0.9% for 1870-2015 and 1.92% since 1950.
Unlike stocks and bonds, the alternatives to public REITs are not for every saver. All of the above also comes with additional hassles, whether it is K-1 tax forms or tenants. But most importantly, I want to stress that with any real estate investing—but especially with direct investing into residential real estate—one should beware of the survivorship bias when they hear about returns on real estate investing that exceed that of the stock market. One should not “add” real estate because of FOMO.
More information here:
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‘No Called Strikes in Investing'
Only the likelihood of following a good financial plan matters, and a good financial plan does not need public REITs. One does not need public REITs to have a diversified portfolio, because if they own the total stock market, they already own some real estate. Adding an allocation to public REITs may not accelerate one’s journey to financial independence or achieve other objectives. The less stressful your financial plan, the more likely you are to follow it for 20-30 years, year after year. In the end, one should remember Warren Buffet’s advice: there are “no called strikes in investing.”
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Do you have public REITs in your portfolio? If so, what do you like about them? If not, why are you avoiding them? Are there other reasons not to own any public REITs? Comment below!
Fantastic post, very informative. Would love to see a counter-argument post!
Would you go so far as to say (as the article implies) that general investors who are unwilling or unable to invest in syndications or direct real estate ownership should scrap real estate altogether?
Several counterpoints I can think of that can be made:
Yes, TSM includes REITS. But publicly traded real estate is a much smaller percentage of real estate than publicly traded non real estate businesses is of business. So you can argue that real estate is underrepresented in the public markets. So you can adjust for that by owning more REITs.
REITs have historically high returns and only moderate correlation with the overall market. These are good things when building a portfolio, not bad things. If moderate correlation isn’t enough, consider private real estate instead.
There’s not that much difference in “concentration risk” between 100 stocks and 1000 stocks. Yes, there is some more, but it’s not very much.
REITs are not as tax-inefficient as many think. While the taxable dividend portion of the distribution is taxed at ordinary income tax rates instead of qualified dividend rates, some of the distribution is return of principal, essentially how depreciation is passed through to the owners. Plus, the taxable dividend qualifies for the 199A deduction. Don’t get me wrong. Mine are all still in tax protected.
I do agree with the overall point though. You don’t HAVE to have a dedicated publicly traded REIT allocation in your portfolio. It’s optional. I have 5% of mine in them though (via VNQ/VGSLX).
I own individual Reits. The problem w VNQ is you own the bad with the good. With some research, for example, on Seeking Alpha, you can really boost your returns with some decent 4-5% dividend payers. Of course, owning individual stocks goes against WCI’s general philosophy. 😀
Yea, because figuring out the good and the bad and whether they’re priced appropriately for how good and how bad they are turns out to be really hard.
Good post, a few counters.
The alternative to REITs are more concentrated exposure in few assets: private RE deals, SFH, MFH rentals, debt/notes, etc.
Taking returns as a cash dividend can be helpful when compared to bloated companies who “reinvest” with stock buybacks to keep CEOs flush with options to exercise (keeping shares outstanding and thus per share earnings higher). Similarly, investments in pricey but low returning improvements by companies when cash is “cheap” lowers investors yields when those dollars might better be spent by the investor.
Moderate correlation is better than high correlation (like right now, which you mentioned in your article). Correlation matters when you rebalance. But not much until then.
Low minimum investment. Private funds or individual properties are typically much more expensive as initial investments.
Yeah, dump that crypto…why speculate in a currency with zero long term return?
1. Re dividends, where is the evidence that “investors” do better than companies with cash dividends? Buybacks are arguably superior to dividends, but I think enough has been said about the latter. This article debunks myths about buybacks such as buybacks propping up EPS and hindering investments: https://alphaarchitect.com/2019/07/debunking-myths-about-stock-buybacks/
2. Pros and cons. The extra juice from rebalancing is debatable anyway. For me, given all the other “cons,” the marginal benefit of rebalancing with a moderately correlated asset class is not worthwhile.
3. Again, pros and cons.
4. Re crypto, I wrote a column about why I still keep buying crypto (this column has a hyperlink to that column)…
You misunderstand about the dividend yielding REIT just out and out being “better” than yield retaining (reinvesting) stocks. It’s, rather, an investor protection against a company’s misuse of profits. Phil DeMuth in the overtaxed investor makes this argument, and there are multiple examples of companies wasting money to keep corporate perks.
https://www.reuters.com/investigates/special-report/usa-buybacks-pay/
Sorry, cons of rebalancing? Bernstein, whom you quote in your article calls it one of the only “free lunches” in investing.
To say “pro/con” to the minimum investment comment is dismissing the very fact that it was brought up as a counter point. It’s not to say you’re wrong; it’s just the other side of your argument.
Best of luck with your crypto. Hope it wasn’t in FTX
Re buybacks, protection for whom? Plenty of savers buy high-yield stocks whether REITs or not because they don’t understand why they are high yield and don’t reallocate the cash well. It’s a topic that reasonable people are going to argue both sides with good data (like in your Reuters article). The problem is that most use anecdata. Another perspective on why banning buybacks is a bad idea: https://www.pragcap.com/banning-stock-buybacks-stupid/
Re rebalancing, it’s one thing to rebalance between stocks and bonds and another to rebalance among correlated assets…If I remember correctly, Bernstein makes the distinction clear, and this was also my point.
Re fees…everyone weighs pros and cons differently. Some think that fees can be justified by higher returns while others disagree. That’s all I meant, and enough people have written on the matter.
Re crypto, nope! Also, if you ever read the column, it’s less than 2%!
Fair points for sure. Protection for investors regarding receiving income as a dividend vs future capital gains in cases of corporate malfeasance. I definitely don’t think government should ban buybacks. Heck, apple and Berkshire two (three?) years ago definitely did and probably for the benefit of all. But when things are frothy, and money is cheap, management has a tendency to become a bit spendthrift. I think that’s when the more reliable returns of REITs shine. Which brings up the rebalancing question, you want to rebalance between assets with similar returns, which REITs and total US stocks have. Rebalancing in anything outside of a retirement account probably isn’t worth doing unless (like you mentioned) you’re adding. I did read the article you wrote (well-written btw) but I’ll have to pass. Maybe I’m wrong!
Dude Great post man and I myself do not add REITs to my portfolio 🙂 as you mentioned in the article, one can accomplish their goals just taking equity risk without having an allocation to REITs. I also do not think the correlation difference will help an investor stay in the game either given the correlation is high. Is there any evidence that this is otherwise? Are there any investors that you know personally that stayed in the game during a bear market because they had an allocation to REITs in their portfolio?
The other thought about when to add REITs to your allocation is during drawdown/retirement. Any evidence that you might boost the 4% rule because you have an allocation to REITs that slight difference in correlation? I believe Bill Bengen may have mentioned that the 4% rule is actually 4.7% when you add other equity subasset classes like small cap value but I do not remember if he mentioned REITs as well?
I can’t imagine “staying the course” has any correlation to public REITs exposure or any other risky asset class; I guess one’s behavior during prior bear market and exposure to cash and bonds (or more specifically, Treasuries) would be the only correlated factors.
Again, noooooo idea. If I have the nest egg to withdraw at 4%, I would only own TSM/S&P500, Treasuries, and cash. Why bother with a life to live. During my research for next column, I saw that Big ERN only uses S&P500 to show that 4% withdrawal is possible. Also, right now, you can create a 30-yr TIPS ladder and withdraw at 4%! https://www.advisorperspectives.com/articles/2022/10/24/the-4-rule-just-became-a-whole-lot-easier
REITS helped in the dot com bust, but didn’t in 2008 or this year.
We all engage in security selection. If you own a market cap index fund, you are selecting securities based on market capitalization. If you tilt to small and/or value, you are selecting securities based on factors. You can pick stocks at the individual level, using fundamental analysis. Dividend investors use dividends to stock pick. It is common to pick stocks at the country level; most people have a home bias. If you tilt to emerging markets, you’re picking stocks at the regional level. You can pick stocks at the industry level. William Bernstein used to talk about investing in gold mining stocks, and such stocks are an industry within the metals and mining sector. If you tilt to public REITs, you are picking stocks at the sector level.
I’ve seen good evidence for security selection based on market cap and factors. And there are a few individuals who can pick stocks at the individual level using fundamental analysis. Stock picking at the country level can in some situations make sense. To invest outside your own country can result in increased tax along with uncompensated currency risk. But I haven’t seen good evidence for other stock picking strategies.
It’s not a bad post, but I take issue with a couple of points.
Regarding #1, if the author has no idea whether REITs will outperform the TSM, then that’s actually a strong argument for owning some REITs for the sake of diversification of returns.
Regarding #3, stocks AND real estate have historically been among the best long-term investments that outperformed inflation. Regarding this year’s performance, as Paul Merriman says, ‘a year in the market is just noise’. An investor focused on a single year’s performance is setting him/herself up for a lot of pain.
Thank you for your comment. The column could’ve been clearer about my point: public REITs are not worthwhile if you have to hope that the points 1 and 3 are false (i.e., public REITs outperform TSM and inflation). E.g., if REITs are in fact correlated with TSM, one would at least want REITs to outperform TSM, but if REITs don’t…is it worth it? One might as well not own them and not worry about their performance whether inflation is high or not.
According to Portfolio Visualizer, REITs have returned nearly as much as U.S. stocks, only trailing by about 1% annually (and all of stocks’ outperformance has been over the last three years), but more importantly, they’ve only had a .62 correlation with U.S. stocks. That’s not a strong correlation at all in the investment world and means that the two asset classes only share about 40% common variance.
Again, we shouldn’t put too much weight on short-term performance unless we’re using some type of trend following strategy.
Both public and private real estate are highly correlated with stocks. The only direct comparisons I have seen showed public REITS to be in the low to mid 60’s for correlation coefficient and private real estate to be in the high 50’s to low 60’s. Private gives the illusion of low correlation because the assets are not marked to market. Switching from public to private real estate accomplishes essentially nothing for diversification.
With the high correlations with stocks there is some diversification benefit of real estate, just not much. For comparison, bonds have correlations with stocks of about zero. There one gets a diversification benefit.
One could weight real estate, public or private above their representation in the market because they represent a larger share of the investable universe than they do of the stock market. It gets tricky to determine how much to add to one’s portfolio because some of the companies you own in your stocks themselves hold real estate as part of their business. It would take a LOT of research that I have not seen to figure out how much real estate there is in your VTI.
There is also indirect ownership that will be tough to tease out. An office building might be legally owned by its own private corporation, likely to isolate liability risk and perhaps for other tax or regulatory reasons. But that corporation, in which you cannot invest, may be owned by a public company, which is in VTI. Do you count that as public, or private?
There might be a stronger argument for investing in small real estate- individual properties that are PROBABLY too small for companies to bother with. But if so, why do companies not bother? If there are reliable profits to be had, why would an individual investor be able to capture them, while public company could not? The economies of scale would argue in favor of the larger entity. Unless, of course, the costs are so high that it is not worth owning and managing such properties.
I have not seen systematic data on the performance of these small real estate deals, so I have no basis for assuming they do better than large ones, or that they have low correlations with large real estate.
I agree that in smaller scale real estate, there might be an opportunity to get more alpha. This is somewhat similar to microcap stocks, which are too small for most larger investors. But as we all know, alpha is a zero sum game. Unless your fundamental analysis skills in small scale real estate are materially better than average, I doubt it will be easy to get that alpha.
I agree that in smaller scale real estate, there might be an opportunity to get positive alpha. This is somewhat similar to microcap/nanocap stocks, which are too small for most larger investors. My impression is that private microcap/nanocap companies – in real estate and other sectors – are much greater in number than their public counterparts. If there was easy money to be made, larger investors would be interested. It comes down to how your fundamental analysis skills in small scale real estate compare to the average of others in small scale real estate,
I wouldn’t call a correlation of 0.5-0.6 to be “highly correlated.” I mean, US to international stocks is more like 0.8% these days. I’d call that moderate correlation.
The problem with bonds is not that the correlation with stocks is high. It’s the low returns. I mean, you can get low correlation with stocks with manure too. The key is to get low correlation AND high returns. That’s much harder.
Big public REITs are moving more into the SFH market, but that’s a relatively new change.
I agree that adding international to domestic stock has even less diversification benefit than does overweighting REITS.
Remember that, as stated in the article, if you hold the market, you already hold REITS. Adding more of them means betting the market is wrong about the optimal weights.
To pick another market component at random, the Vanguard Energy etf, VDE, has a correlation of 0.68. Adding this did not improve the Sharpe ratio or reduce the volatility of a 100% VTI portfolio.
On the other hand, still random, the Fidelity utilities sector fund FUTY, has a market correlation of 0.48. Adding that to VTI, does reduce portfolio volatility. How much should one add of each sector to get diversification? One could add every sector fund there is. Would that really be a better portfolio? Or would one expect market returns minus higher fees and turnover costs?
Part of what one gets with bonds is lower volatility than stocks, along with near zero correlation.
What percentage of utilities or energy companies are private vs public? Now compare that to real estate. That’s the difference.
“I agree that adding international to domestic stock has even less diversification benefit than does overweighting REITS.”
It depends on how you measure diversification. If diversification is measured by correlation coefficient, then you’re right. But consider the situation of a Ukrainian investor prior to 2022. Overweighting Ukrainian REITs might have resulted in more diversification benefit than adding nonUkrainian stocks to domestic Ukrainian stocks. But in 2022, nonUkrainian stocks would have been a much better diversifier.
Real estate is a stock bond hybrid. I’ve heard the case made for real estate as substitute for bonds. I’ve also heard the case that private estate diversifies stock bear markets, although I haven’t seen data for that. It’s stated that as interest rates decline in a bear market, mortgage rates decline, so liquidity increases. Do public REITs convert this stock bond hybrid into a stock?
I think it’s a mistake to consider real estate to be a stock/bond hybrid. It is its own thing, but it’s far more stock like than bond like. You want “bond-like” real estate, take a look at a debt fund or similar lending vehicle, but even there realize that in a real estate downturn your debt fund can turn into an equity fund as it forecloses on its properties.
From “Unconventional Success” by David Swensen:
“Real estate asset combine characteristics of fixed income and equity. Fixed-income attributes stem from the contractual obligation of tenants to make regular payments as specified in the lease contract between tenant and landlord. Properties encumbered by long-term lease obligations exhibit predominately bond-like qualities”
Two books I’ve recently read mention the possibility of real estate as a bond substitute. Gerald Fitzgerald in “Zero to Financial Freedom” mentions that in his own portfolio, he substitutes real estate for bonds. That is his only mention of it. Sam Dogen in “Buy This Not That” advocates substituting real estate for bonds for some investors. He also mentions that there is a tendency for tenants to renew leases, because of the effort associated with moving. So cash flows stay steady for more than just leases.
From the second book:
“real estate tends to outperform in a downturn because people seek the basics of food, clothing, and shelter. Owning a company stock that produces a gadget we don’t need becomes low priority in a bear market. As stocks sell off, bond prices rise and interest rates fall. As a result, even more capital tends to flow to real estate due to lower borrowing costs. During the 2008–9 financial crisis, although the value of my San Francisco rental properties probably declined by ~15%, my rental income stayed steady because my tenants didn’t move. They kept paying the same amount right through the eighteen-month downturn.”
Both authors don’t give references. These are the only two authors that I know of that make the case for real estate as a bond substitute. And I’m not aware of research that has tested this hypothesis.
The idea of substituting real estate for bonds is intriguing. Bonds are an excellent risk management tool, but I can’t make money with them. However, a positive aftertax real return is possible with real estate. I’m reasonably confident though that public REITs and public REOCs act like stocks. What about private real estate? Is it possible to create a private real estate portfolio with bond like properties?
I guess I disagree with all three of those folks. Bonds don’t drop 78% in a bear market like publicly traded REITs did in 2008. Far more stock like than bond like in my book.
Obviously a NNN, long-term lease to a very big, stable company is going to be less volatile, but I still wouldn’t consider it a bond.