Liquid Real Estate Investing

By: S. G. Lacey

For many Americans, a large portion of their net worth is tied up in their primary residence.  This has worked out well in the past decade since the 2008 Financial Crisis, with residential housing prices in the US appreciating by 50% or more depending on what part of the country you live.

However, a home should be thought of more as a living requirement than an investment.  It’s not feasible to liquidate your house if you need extra cash, and if you’re forced to sell in the realty market it can take several months.  For those looking to gain real estate exposure without buying physical property, real estate investment trusts (REITs) may be a good option.

REITs are essentially pooling of investor capital used to purchase and manage buildings like apartments, malls, office space, storage units, etc.  This allows an individual investor to gain access to a piece of a much larger property or asset than they would be able to afford on their own, while also providing diversification. 

Returns for REITs, specifically equity REITs as opposed to mortgage REITs, can come via either the income generated from renting the collection of properties owned, or the appreciation of the underlying real estate holdings.  As shown in the graph below, US REIT values have generally mimicked private real estate prices over the past few decades, albeit with higher volatility through the turbulent 2006 thru 2010 period.

One interesting structural rule surrounding REITs is that they are required to pay out 90% of their income on an annual basis, revenue which unlike most traditional businesses is not subject to corporate taxes.  As a result, these investments can have fairly high yields, usually between 3% and 8% annually.  Most distributions are taxed at a combination of ordinary income and qualified dividends, which fall under long terms capital gains treatment, so REITs are typically better structured for tax-deferred accounts.

However, considering these mandatory annual distributions, REITs are often used in a portfolio as an income stream; this feature can be particularly valuable for investors in retirement even when held in a taxable account.  The graph below shows the yield for private and public global real estate investments compared to worldwide stocks and bonds.  Most noticeable on this graph is the recent drop in global bond yields which has left income investors searching for alternative cash flow streams like REITs.

Another note is that these REIT’s are publicly traded equities so are subject to the volatility of the stock market, regardless of the value of the underlying physical real estate assets.  Therefore, the REIT asset class usually acts as a blend of the private real estate and public equity markets.  Data varies depending on the timeframe and scope of the study, but general in global markets REITs historically offer a correlation of approximately 0.7 with stocks and an even more diversifying 0.2 correlation with bonds.

To demonstrate the effect of this asset uncorrelation, a detailed study from Burland East and Creede Murphy of Altegris looked at REIT performance dating back to 1976, not long after the original inception of this investment vehicle.  As shown in the diagram below, East and Murphy found that adding REIT exposure to a traditional 60% stock and 40% bond holdings increased returns for the same level of risk as measured by overall portfolio standard deviation.

One of the main risks of REIT investing is that they are heavily leveraged; with only 10% of their income available for reinvestment, funds must turn to debt for the capital needed to make new real estate purchases.  As a result, a financial market episode like 2008 can put a lot of pressure on individual REITs depending on their real estate portfolio.  This can be a major concern for income investors relying on the typically steady stream of cash passed along by REITs. 

Also, REITs are sensitive to interest rate changes, especially in the short term, since rising interest provide a risk-free yield option plus influence mortgage rates, and consequently buyer versus renter demand for real estate.  Over the long run, these interest rate moves are less influential on REIT valuations, therefore even though REITs are liquid public market vehicles short term trading should be avoided.

While interest rate movement can be a drag on REIT returns, since these companies own real assets, investing in real estate properties can be a useful inflation hedge; both property appreciation and the ability to raise rents contribute to beneficial inflation tracking performance.

ETFs focused on holding primarily REITs provide many of the same benefits as other ETF offerings; high liquidity, low investment amounts, and portfolio transparency.  In real estate, more so than pretty much any other category of equities, these investing traits are extremely valuable.

In terms of REIT investing via ETF’s, there are a lot of different approaches. There are some very large, easily tradeable ETFs that offer broad exposure to REITs, both domestically and globally; this can provide additional diversity beyond individual REIT holdings. 

However, it’s important to remember that there’s a wide range of real estate assets globally which rarely move in tandem from a valuation standpoint.  As a result, there may be some value in concentrating on a specific industry or geographic of the real estate landscape.

The tables below shows a few of the more relevant fund performance metrics to consider when comparing REIT ETF’s.  It should be noted that while larger distributions look enticing, this usually represent more tax burden, and more importantly a higher level of volatility (beta) in the underlying real estate holdings.

It’s valuable to provide some context on a few of the columns in the tables above which are important specifically to equity REIT selection.  The price to earnings ratio provides a measure of how cheap or expensive the underlying REIT holdings are; KBWY holds very high valuation, small market capitalization companies while SRET and VNQI are much more value oriented since they display lower P/E ratios. 

As discussed in the past, beta is a measure of price movement relative to the benchmark with 1.00 value signifying perfect correlation.  Combining the beta with trailing 12-month (TTM) yield and 3-year performance can provide some guidance on the risk-adjusted return characteristics of each REIT ETF listed.

The second table shows the same 7 REIT offerings, with their holdings broken down by industry and geography into self-explanatory categories.  Most noticeable here is the trend towards investment in properties under development for more global offerings; these real estate companies are typically concentrated in the economically growing Asia-Pacific region.

As broken down in the tables above, the landscape of REITs is broad.  For an investor just entering the REIT space, REET from iShares offers a nice balance of global exposure, industry diversification, and sustainable yield in a low-cost wrapper. 

Some of the REIT offerings listed above provide more nuanced access to higher yield, region specific focus, or lower valuation holdings.  Drilling down even deeper into the REIT ETF landscape reveals explicit sector (REZ) or demographic (OLD) plays, with much more concentrated holdings and investment theses.

Real estate can also be speculated on directly by buying individual stocks of homebuilders, hardware retailers, and other publicly traded companies with business models related to building construction and maintenance.  A final real estate investment option that bears mentioning is crowdfunding, FundRise and PeerStreet are two of the biggest players in this space and currently many sites only accept money from accredited investors; this policy will hopefully change in the future.  With any of these real estate investment alternatives, due diligence in needed and it’s much tougher to get a diversified portfolio when compare to the REIT ETF approach.

For those with interest in learning more about real estate investing, and specifically REITs as a piece of your portfolio, please review the contrarian article linked below.  It’s a little technical, but worth the read if you have more questions about what REITs can contribute to a diversified asset portfolio while presenting several additional, more nuanced considerations.

As always, the goal of this column is to simplify investing, using fundamental terms and concepts, while still being accurate and comprehensive; don’t hesitate to reach out if you have any additional questions or thoughts. 

Invest wisely and don’t forget the power of low fee, automatic investment combined with compounding growth over time.

Disclaimer: This article is for informational purposes only; investments or strategies mentioned may not be suitable for everyone and the material does not take into account individual objectives or financial situations.  The author may own shares of some of the funds discussed.

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