Should You Make Room in Your Portfolio for REITs?

With significant uncertainty looming over the global economy and securities markets, now may be a good time to review your portfolio strategy with an eye toward diversifying outside of traditional stock and bond markets. One alternative that may be worth exploring: real estate investment trusts (REITs).

Since their creation in 1960, the REIT industry has grown in size, impact, and market acceptance. Today, some 80 million Americans own REITs through their retirement accounts or other investment vehicles.¹

What are REITs?

The unique structure and features of REITs may benefit potential investors in several ways.

• Highly diversified. Modeled after mutual funds, REITs typically hold diversified portfolios of real estate assets in a range of sectors such as apartment complexes, shopping malls, office buildings, etc., in varied locations, so that exposure to any one property type or geographic location is limited.
• Flexibility. Like stocks, REITs trade on major public exchanges, which means they are liquid assets that can be bought or sold daily at the owner’s request.
• Size advantage. As large owners of real estate, REITs typically have secure access to capital for improving or adding to their existing portfolios of properties.
• Income producing. According to the National Association of Real Estate Investment Trusts (NAREIT), to qualify as a REIT, “a company must pay at least 90 percent of its taxable income in the form of shareholder dividends each year.” For this reason, REITs may be an effective way for income-oriented investors to gain exposure to commercial real estate while leaving the management to investment professionals.

The Performance Potential of REITs

When income-producing dividends are coupled with real estate’s capacity to appreciate in price, REITs begin to reveal their potential value from a total return perspective (i.e., dividend income plus share price appreciation). Indeed, over both short and long time periods REITs have posted total returns that generally match or beat the broader market, as measured by the S&P 500.

Stocks vs. Equity REITs

(Total Return, Annualized)

Source: FTSE-NAREIT All Equity REIT Index and Standard & Poor’s. For 1-, 20-, and 30-year periods ended December 31, 2018. Past performance is no guarantee of future results. Individuals cannot invest directly in an index.

…With Enhanced Diversification

A portfolio that holds REITs also has the potential to benefit from enhanced diversification as evidenced by low correlation to the broader stock market. Correlation measures how strong the relationship is between two types of assets. A low correlation indicates that assets may work well when used together in a portfolio.

As the chart below indicates, for the 12 months ended May 31, 2019, All Equity REITs posted a total return of 16.15%, compared to 3.78% for the S&P 500.² Perhaps an equally telling story from a diversification standpoint is that of the 18 property sectors tracked by Nareit, 13 delivered double-digit returns over the same time period, while four were in negative territory.

The diversification benefits of REITs are notable over longer time periods as well. For instance, for the five years ended May 31, 2019, All Equity REITs trailed the S&P 500 by a slight margin, while individual REIT sectors exhibited widely varied results (see Five-Year Total Return chart).

REITs and Inflation Protection

Another potential benefit of REITs – and commercial real estate in general – is the capacity to provide a hedge against inflation. When inflation rises, real estate prices (and rents) generally follow suit. But what does history tell us about REITs and rising prices? According to researchers at Nareit, since 1978 REITs have outpaced inflation in 68% of the 6-month periods when inflation has trended higher than its long-term median of 3%. That places REITs in second place after commodities for their inflation-fighting features.

Inflation protection can be a significant factor for all investors, especially income-oriented investors who rely on investment income to help fund their retirement cash flow.

Downside Considerations

As with any investment, REITs are not without risks. Real estate is a cyclical sector that – as we are all aware – can go down as well as up. While REITs tumbled dramatically during the financial crisis of 2007-2009, recent history has shown that they can recover and rebound.

REITs also can be sensitive to shifting economic trends, such as rising interest rates. Investors often perceive a rise in rates as having a negative impact on their future asset values. Yet rising rates are a byproduct of economic growth, which can buoy real estate prices and REIT earnings. Industry researchers report that in the past REITs have often outperformed the S&P 500 in periods of rising interest rates.³

Given their unique investment characteristics and current market and economic conditions, REITs may represent an opportunity for long-term investors seeking dividend income and modest price appreciation -- not quick capital gains.

Your asset manager at Fifth Third would be happy to answer your questions and help you decide whether a REIT is a good fit for your overall risk profile, time horizon, and asset allocation strategy.

^1,2,3National Association of Real Estate Investment Trusts, nareit.com. As of January 31, 2019.