REITs, Your Home, and the Asset-Allocation Decision

By Larry Swedroe, Buckingham Asset Management

Diversification across asset classes is an important component of an investment plan. Put very simply, diversification reduces risk by not putting all your eggs in one basket. It is also important to diversify across asset classes that have low correlation. Real estate is an asset class that not only has its own risk and reward characteristics, but also has a relatively low correlation with other U. S. equity asset classes. It is therefore a good diversifier of risk and should be considered when constructing an asset-allocation plan.

For the period 1975-1999 REITs (Real Estate Investment Trusts) provided a rate of return of 16.0%. This compares to a return of 17.2% for the S & P 500 Index. It is worth noting that all of the outperformance by the S & P 500 Index occurred during just the last two years. Looking only at the period 1975-1997, REITs outperformed the S & P 500 by 18.5% to 16.6%. It is also worth noting that in 1977 when the S & P 500 Index was down 7.2%, REITs were up 18.0%. In 1981, the next year of negative performance by the S & P 500 Index (it fell by 4.9%), REITs were up 6.1%. In 1984 and 1992, when the S & P 500 Index rose just 6.3% and 7.7%, REITs returned 21.8% and 28.3%. Of course, there are also periods when the S & P 500 Index outperformed REITs. For example, from 1998-1999 the S & P 500 Index outperformed REITs by 24.7% per annum to -8.9% per annum. The combination of the lack of predictability of returns and the low correlation makes a strong case for including REITs as an asset class in an investment portfolio.

Returns for Composite REIT Index vs. S&P 500 Index

Source: National Association of Real Estate Trusts

September 14th marked the 40th anniversary of the creation of the REIT industry. President Eisenhower signed into law legislation creating REITs on September 14, 1960.

Once a home-owning investor decides to include real estate in a portfolio, he or she must decide how to view their home in the asset-allocation process. In addition, how the home is financed and the nature of the mortgage should be considered in terms of its risk implications for the portfolio.

Let's first address the home itself.

A home is clearly real estate - however, it is very undiversified real estate. First, it is undiversified by type. There are many types of real estate: office, warehouse, industrial, multi-family residential, hotel, etc. Owning a home gives an investor exposure to only the residential component of the larger asset class of real estate. Even then, by excluding multi-family residences, it only provides exposure to the single-family component. Of course, the best way to gain exposure to the broad equity real estate asset class is to own an index or passively-managed REIT fund that invests in all equity REITs.
Another problem is that a home, by its very nature, is undiversified geographically. Home prices might be rising in one part of the country and falling in another.

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