The Verdict on REITs

And now, the end is near, REITs will face their final curtain: Should they be included as an asset class in a RP portfolio? Are they even an asset class at all? What might work better for making profitable and resilient portfolios?


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This post originally ran on August 18th, but since then, there have been two developments: 1) a mistake in one of the posts has now been corrected and the post revised, and 2) a new post comparing individual equalities in a RP portfolio has been written and released. In turn, this post has been revised to reflect the new and corrected information.

This is the last post in my deep dive into Real Estate Investment Trusts. I began the series with some doubts about REITs, but at the same time, an assumption that they can be a productive and diversifying part of a portfolio. I began not knowing which way the evidence and the tests would lead me, but knowing that I would question some long-held assumptions in the process.

Here is what I have learned. One note about the style - in order to make sure it’s readable, I’m going to speak in more general terms without the detail of my previous posts. Since those are more specific and transparent with my sources and backtests, I will refer you to them instead of repeating myself.

The posts in this series are:

  1. The intro post, in which I discussed Ray Dalio’s three criteria for inclusion in a RP portfolio and assessed whether I thought REITs met those criteria.
  2. My collection of six expert opinions on REIT as a distinct asset class. This one was part of my Risk Parity Resources series, as well.
  3. Turning to alternatives to REITs, this post did some backtests with two propositions: one, you just drop REITs, and two, you replace them with a mix of Small-cap Value and Intermediate-term Bonds.
  4. The next alternative I tested was how REITs compared to utilities ETFs.
  5. I then tested whether the problem might be REIT funds, not REITs themselves, so I did a screen to find the REITs best suited for a RP portfolio and then backtested how they might have done.
  6. I then went outside of the world of equities and looked at various “semi-direct” real estate investing methods, including crowdfunded syndication-type deals, “hard money” private lending, and fin-tech based agricultural and commercial real estate investing services.
  7. Recently, I looked at how individual utility stocks and small-cap value stocks would do instead of individual REITs, in sort of a counterpart to post 5 above.

When you see a number in parentheses, check the relevant post to read more.

And so…

Do REITs deserve a place in a RP portfolio?

Simple answer: no.

More nuanced answer: REITs aren’t bad… but you can probably do better. Certainly, they aren’t a problem in a portfolio. It’s just that in every situation I can think of in which an investor looks to REITs for reasons X, Y, or Z, there’s probably a better way to get those things in your portfolio. Let’s go through those reasons:

“I want REITs because I want a way to invest in real estate through the equity market”

This has always been the core of my motivation for investing in REITs, and is probably the most common. It deserves some unpacking:

The first issue is why that would be important - in what ways is investing in real estate through the stock market better than just doing so directly (or semi-directly)? I guess convenience could be one way, but there are fin-tech businesses like Groundfloor, Fundrise and others which are easy to use and have a stronger claim to represent the pros and cons of the real estate market (6).

Secondly, assuming that the equity approach is what you’re looking for, then REITs don’t necessarily represent the real estate market all that well. Essentially, REITs are businesses with some connection to real estate that are grouped together by their corporate tax structure. There are plenty of even more obviously real estate-connected businesses that aren’t REITs (like homebuilders), and just as many REITs that could just as easily be classified in other sectors (like companies that manage cell phone towers - why is that not a communications company?). What unites REIT is not what they invest in, but how they have elected to deal with corporate taxes (1).

Third, recall that if you follow a board-based index fund strategy for your equity investing, you are already investing in REITs in proportion to their market cap weighting. When the issue of investing in REITs as a separate class comes up, it means overweighting them. Investing in REITs has some benefits, for sure, and if you have VTI, VT or some other total market fund, you’re getting those benefits! There just isn’t much reason to decrease other allocations to make special room for REITs. In fact, I did test the idea of what would happen to portfolios if you didn’t have them - turns out, not much (3).

“OK, well they are profitable so they’ll help boost returns”

Yes, true, they have done well enough, but…not in a way that is materially better than other types of equity investing. In one academic paper, for example, the authors found that if you replace REITs with two-thirds small-cap value stocks and one-third intermediate corporate bonds, you can replicate the performance of REITs in a portfolio (2). I ran the backtests and found that such a move would have led to higher returns and less volatility (3). Although I didn’t backtest it, I suspect that you’d get better overall returns by increasing your small-cap value allocation instead of devoting funds especially to REITs.

You could also replace a REIT index fund with one from the utilities sector, such as VPU. I ran two tests of utilities ETFs: one compared to REIT index funds (4) and one compared to a basket of individual REITs (6) and found that utilities provided higher returns AND less volatility compared to REITs when using index funds. Investing in individual REITs did beat out indexed utilities (5), but I later showed that if you compare individual REITs to individual utilities and individual small-cap value, you get mixed results (7).

When talking about index funds only, the secret lies in the fact that utilities have had higher returns over the last two decades and are simultaneously less correlated with other equities, improving portfolios in terms of return and risk. If you introduce investing through stock selection, then there may be a benefit in focusing on REITs as opposed to utility stocks, but not as much as a benefit focusing on small-cap value (7). These tests are really just a function of how good someone is at stock selection. That’s not in my skill set, but your mileage may vary.

If you wanted to get away from equities, you could also look at real estate investments such as syndications, private lending, and crowdfunding. These do carry their own risks (especially, illiquidity, which is a big one), but if liquidity is something you as an investor can sacrifice, then returns can exceed that of REITs (6). Recently, their returns have, but past results… yada yada yada.

“Well yeah, but you get dividends from REITs, which are awesome.”

First off, dividends may not be the best thing for your portfolio. Without wading too far into the waters of this debate, dividends are when companies or funds decide to make you have a taxable event. In the evidence I have seen, investors are better off creating their own income when they need it by selling shares. I agree with Common Sense Investing and Optimized Portfolio in not caring too much about dividends.

Even if you still value dividends from REITs, there are still some issues. REITs pay out dividends which are classified as ordinary, and for Americans, those dividends are then taxed at one’s income tax rate. Utilities ETFs, though, pay out qualified dividends, meaning they get taxed as long-term capital gains, which is a lower rate (here is a good explainer). Yes, the dividend yield from a REIT ETF like VNQ was slightly higher than for VPU in my tests. But, the difference was not large enough to account for the higher taxation of those dividends (speaking generally here - there are lots of specific issues that each taxpayer should consider), so even the dividend-loving investor would probably be better off with utilities instead of REITs (4).

If the investor is really hungry for dividends and doesn’t care about them being qualified or not, then they may as well go full on for income generating assets in the actual real estate market. Groundfloor and Fundrise, to name two, have higher projected dividend payouts than REITs (6), and I’m sure you could find other dividend paying stocks, covered call strategy ETFs, preferred shares or what have you that would pay out higher dividends than REITs.

“Well, one thing about REITs is that they are less correlated with the other parts of my portfolio.”

Not really. I think they are assumed to be, but the correlation numbers just don’t bear that out, as I go through in great detail in the first post. For REIT index funds, their correlation tends to range around .75, and recently, has gotten up to .9 (1).

Utilities are typically much less correlated with equities, around .4 to .5, so if you do want to try to find the sweet spot of “still an equity but unique” then utilities are better in just about every way I can test. They have had a greater diversifying effect in my tests of the RPC Income portfolio (4).

Interestingly, in the one test I did where REITs did perform better than alternatives - when I used individual REITs instead of VNQ - one of the parameters was they could have a correlation to VTI no higher than .58 (5). This suggests to me that if you do watch the correlation figures closely, and only invest in REITs under a certain threshold, there may be some benefit, though at the same time, this logic is more about general low-beta strategies than it is about REITs, per se (7).

Again, you could find the benefits of non-correlation in semi-direct real estate investing, such as with Groundfloor. This is really just a psychological trick, as I explain in the relevant post, since the true correlation of these assets with the stock market is simply unknown. They are not marked to market, so we don’t know if the actual value rises or falls, but psychologically at least, the returns from these investments can certainly feel like a non-correlated asset stream (6).

“Maybe the problem is you are assuming the way to invest in REITs is through a fund, when actually returns of individual REITs would be better.”

Yes, this is entirely possible. My test of this showed that my basket of ten individual REITs was much better than VNQ and also beat VPU in the two timeframes I studied (5). In the backtest to 2018, the basket beat VNQ in terms of CAGR by 244 basis points and beat VPU by 176; in the 2015 version, it beat VNQ by 262 and VPU by 177.

One of my very tentative conclusions is that it might be the construction of VNQ which is a bit of the problem, and that if you confine your investment in REITs to only the ones that are less correlated with the market, you may be onto something. Even five years ago, this may have had practical limitations with transaction fees and the need for whole shares, but with free trades and fractional shares (with some brokerages), you can essentially do a DIY version of an index fund, if you put in the time. This is essentially direct indexing, and is not too much trouble to do, actually.

My hesitation here is that, for me anyway, once I go down the road to stock selection, my worst behavioral finance flaws (overconfidence, herd mentality) might start to appear. I use ETFs almost exclusively because they help me to be a better, calmer, more long-term focused investor by removing questions about stock selection entirely. I say this with experience - I used to try to find the hidden gems, time my buys and sales, move from one stock to another. This produced a lot of stress and sub-par results.

Practically speaking, if someone leaves the index investing framework to invest in individual REITs, then additional issues come up: Why REITs? What is special about that sector? If you want something with low-beta, then why not just pursue low-beta, regardless of sector? I tried this and found that I could do a simple screen and find small-cap value stocks that outperformed REITs, but there was nothing magical in my selection process, and I could have just as easily found different results (7).

“Ok, what I really want is a kind of ‘Jack of all trades, master of none’ asset that fits a very particular set of criteria:

  • I don’t want to have any liquidity issues, so semi-direct real estate is out.
  • Due to my very particular tax situation, the difference between ordinary and qualified dividends is meaningless,
  • Despite the dissenting evidence, I still do want dividends, though.
  • I’m not primarily interested in maximizing returns and will overweight my allocation to an asset class with a lower expected return compared to small-cap value, for example.
  • I’m really attached to the idea that my portfolio has to have some real estate in it, even if it is a tenuous connection and what I wind up getting is really just another type of equities.
  • …and I believe in my ability to select the right equities to accomplish these goals.”

Ok, for this person, I guess you could make a case for REITs. Portfolio construction is complex and without knowing every person’s investing goals, it is hard to give categorical advice. Perhaps there are other reasons I have not considered, and indeed, I’m sure if someone does enough backtests, they might be able to find the specific times when REITs have increased returns and smoothed portfolio volatility.

But for just about everyone, I can say that after this deep dive into REITs that they just don’t measure up. I think investors assume they do things that they don’t, and have unique benefits which they don’t.

I would welcome a pro-REIT counterpoint, but would like to really know the criteria one is tested, and why REITs meet those criteria better than other investments. I’m especially eager to hear one that looks at indexed REITs, as I feel the case for individual REITs would just come down to which ones were chosen. As mentioned, some people may have the ability to pick the best stocks out of the field. I know that I do not.

Whether you subscribe to Risk Parity principles or not, there are better alternatives to REITs, as I have tested (3, 4, 6, and 7). Admittedly, the question of what you should have instead of REITs is difficult to answer and one size will not fit all. Based on the posts in the series, or even just this summary, hopefully you have an idea about fixes you can make.

But…

… if you were to press me on the topic…

… and I had to make one simple recommendation…

…I’d say: You’re probably better off with utilities!!!!


This is a revised version of this post. The original version may be found here:

Original version of “The Verdict on REITs”
And now, the end is near, REITs will face their final curtain: Should they be included as an asset class in a RP portfolio? Are they even an asset class at all? What might work better for making profitable and resilient portfolios? This is the last in my deep dive into Real Estate Investment Trus...