Move on over, stocks and bonds. It is time to make room in the portfolio.
Real estate is gaining significance as an asset class worthy of a spot in a diversified investment portfolio. In September, S&P Dow Jones Indices introduced an 11th Global Industry Classification Standard sector. Real estate investment trusts and real estate development companies, which had been in the financials sector, are now classified in a sector of their own.
The move was a long time coming, says Charles Sizemore, founder of Dallas-based Sizemore Capital Management. “REITs have been a popular asset class for years, particularly among individual investors looking for income. It never made sense to lump REITs and financials together. They have essentially nothing in common. Banks lend money. REITs borrow it to buy properties,” Sizemore says.
“The creation of the GICS real estate sector reflects recognition by investors that real estate is a distinct asset class, with fundamentals and investment characteristics different from financial companies and other sectors,” says Brad Case, senior vice president, research and industry information at National Association of Real Estate Investment Trusts in the District of Columbia.
[See: The 10 Best REIT ETFS on the Market.]
It also reflects the growth of the stock exchange-listed real estate marketplace, Case says. “Over the past 25 years, the equity market capitalization of the U.S.-listed equity REIT industry has grown from $9 billion to nearly $1 trillion. The real estate sector will be the eighth-largest sector in GICS, larger than materials, utilities and telecommunication services,” Case says.
REITs are entities that invest in physical property, like apartments, retail strip malls or office buildings, and then receive rental income from the investments. A unique twist is that REITs are required to pay out to shareholders at least 90 percent of their taxable income. That has made them attractive in the current low-interest rate environment and they have performed well.
An improving macro economy is good news for REIT investors and the numbers bear it out. For the first three quarters of 2016, the total return of the FTSE NAREIT All REITs index, the broadest index of the U.S. REIT market, was 12.57 percent, Case says. That compares to the total return of 7.8 percent for the Standard & Poor’s 500 index.
When the economy is growing, demand for space in commercial properties is high and landlords have flexibility in setting rents, Case says. “The economy has been growing slowly but steadily, and is expected to continue to do so, which bodes well for REITs. What really sets the real estate market apart, though, is supply conditions. There is no oversupply in the commercial property market. New construction has lagged demand since the recession and continues to do so,” Case says.
Historically, REITs have performed well beating returns of the broader market. “REIT stocks are known for strong, stable dividends. They have produced highly competitive total returns, averaging 10.89 percent annually over the past 25 years compared to 9.34 percent for the S&P 500,” Case says.
Why consider REITs for a portfolio? Real estate investments offer the opportunity for income returns through rent and the potential for long-term capital appreciation as properties gain in value. An important factor is that REITs offer a diversification component as the real estate market cycle differs from the general business cycle.
Full real estate market cycles generally have been about 18 years versus about four years for the general business cycle, Case says. “Because REITs follow a different economic cycle, the correlation of their stock returns with those of the broad equity market are quite low. Low correlation of returns of assets in a portfolio is what provides effective diversification,” Case says.
REITs tend to do well during inflationary times, whereas most stocks do not, Sizemore says.
[Read: Real Estate: How to Invest in Wall Street’s ‘New’ Sector.]
Real estate is one of the four core investment assets — stocks, bonds, cash and real estate — that all investors should have in their portfolios, Case says. “REIT returns tend to zig when returns of other equities zag. REIT stocks provide important diversification that reduces the overall volatility of investment portfolios without reducing returns,” Case says.
REITs typically pay a higher yield than general equities, says John Snowden, managing director, global portfolio manager at Resource Real Estate, headquartered in Philadelphia. “Retail investors are thirsty for yield and many find the sector attractive.”
How much space could investors devote to REITs? “I consider 10 percent prudent, and I think as high as 20 percent could be reasonable for investors focused on yield and current income,” Sizemore says.
REITs have had a strong run already this year, so it is important to be choosy. Be careful not to chase returns and look for good fundamentals. “As a sector, REITS are fairly pricey right now, so I think you have to be selective. It’s a stock picker’s market, as they say,” Sizemore says.
Sizemore points to Realty Income (ticker: O) as a top pick. He calls this REIT “safe enough to buy and hold forever. This is one that I own personally and intend to hold until the day I die.” However, he adds that Reality Income is pricey at current levels. “I would wait for a pullback before making any major new purchases. He likes Realty Income at a yield of 4 percent or higher.
For less expensive options to buy now, Sizemore suggests to Vereit ( VER) and W.P. Carey ( WPC). “All three of these REITS operate primarily in the triple-net retail space, which tends to be pretty close to recession-proof and also tends to have high yields.”
If the Federal Reserve hikes interest rates late this year or next, it could hurt REITs at least initially.
“History shows that if the Fed hikes rates there will usually be a knee-jerk downturn market reaction with REITs, and the broader equity markets. This is followed by a rally over the subsequent months as investors realize that rates are rising because of an improving economy and that this is likely positive for real estate fundamentals, which includes increasing rents and lower occupancy,” Snowden says.
[Read: Where Investors Can Look for Yield.]
Wealthy investors and large institutions have always invested in income-producing real estate by buying and owning commercial properties directly, Case says. “REITs give all investors the opportunity to gain these same basic investment benefits affordably by buying REIT stock,” Case says.
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Diversification 101: Stocks, Bonds and Now Real Estate originally appeared on usnews.com
