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Do REITs (Real Estate Investment Trusts) Belong in Your Portfolio?

I recently received the following question from a reader:

“In all the books about index fund investing, the example portfolios generally look very similar to each other. But they differ on REITs. Some authors recommend a REIT index fund, while others do not. What are your thoughts: Do REITs belong in a portfolio?”

Background info: Real estate investment trusts (REITs) are companies that own real estate (or mortgages on real estate) for the purpose of generating income.

First, just to be clear, if you own an index fund that tracks a broad stock market index, REITs already are in your portfolio. So the real question is whether or not it makes sense to overweight REITs relative to other stocks by holding a specific REIT-only index fund.

Reasons to Own a REIT Fund

The primary reason that an investor might want to have a separate allocation to a REIT fund is that REITs have historically had a low correlation to the rest of the stock market. That is, they sometimes perform well when the rest of the market performs poorly (and vice versa). As such, including REITs in a portfolio often results in lower total portfolio volatility.

In his The Only Guide to Alternative Investments You’ll Ever Need, Larry Swedroe provides an excellent explanation as to why REITs tend to perform differently from the rest of the stock market:

“The long-term nature of many leases results in rents being more stable than corporate earnings. [And] since landlords are not generally trying to bring new technologies, new products, or new services to the market…REITs face fundamentally different business risks than do equities in general.”

And, conveniently, REITs bring this diversification benefit to the portfolio without sacrificing much in the way of expected returns. Because REITs are businesses (that is, because they entail risk), their long-term expected returns are closer to stock market returns than to (low-risk) bond returns.

Reasons Not to Own a REIT Fund

One disadvantage of REIT funds is that they often carry higher costs than other stock index funds. However, if you stick to the lowest-cost REIT funds, this difference is small enough that it shouldn’t be a major concern. For example, Vanguard’s REIT Index Fund has an expense ratio just 0.08% higher than that of Vanguard’s Total Stock Market Index Fund.

Another disadvantage of REITs is that they’re tax-inefficient (because they’re required to distribute 90% of their taxable income to shareholders each year). For most investors, this isn’t necessarily a problem–they can simply hold their REIT funds in tax-sheltered retirement accounts. But, if you’re in a situation where your tax-sheltered accounts are only a very small portion of your overall portfolio, REITs become somewhat less desirable.

Depending on who you ask, a third potential reason not to own a REIT fund is that doing so will overexpose you to the risks of one particular industry. Of course, others would argue that the fact that REITs carry different risks than other stocks (as explained above in the quote from Swedroe) is exactly why you would want to hold a specific REIT fund.

Lastly, every fund you add to your portfolio increases the complexity of managing it. For investors who place a particularly high value on simplicity, I’d argue that it’s better to forgo owning a REIT fund rather than a bond fund, a U.S. stock fund, or an international stock fund.

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Comments

  1. Both domestic and international REITs should be in a well-diversified portfolio. The Vanguard ETFs are probably the cheapest way to participate.

  2. It also depends upon if you already own real estate as an investment. If you own investment property (not your primary residence mind you) then adding REITs does not make sense. If you say own residential properties, you may want to diversify with REIT that owns commercial properties.

  3. I have the Vanguard REIT index fund in my portfolio. It has worked well in producing an income stream (reinvested) and diversifying the portfolio risks. However, I would add a reason not to add a REIT fund to an otherwise diversified portfolio. That would be volatility. Although we are all supposed to look at the volatility of a portfolio as a whole, sometimes we can’t help noticing the volatility of its individual components. If you only look at a REIT fund by itself, its volatility can be scary. During the crisis days in 2008-2009, it was not unusual for the Vanguard REIT index fund to go up or down nearly 10% in a day. Even at calmer times now, the volatility of the REIT fund itself is still higher than say a total market stock index fund. If that bothers someone, he/she should reconsider adding a REIT fund to a portfolio. Otherwise the investor may sell the fund when it keeps dropping.

  4. Investor Junkie: You raise a good point about investment property. I might argue that in some cases it makes sense to still own REITs, though. For instance, if your investment property is all in one geographical location and it consists only of one type of property (say, residential property in Boston), I could see a benefit to using REITs to add diversification.

    TFB: Wow. Not being one to check fund performance daily, I hadn’t seen that. I’d bet that most investors would have a hard time brushing off a 10% decline unless the fund makes up just a small portion of the overall portfolio.

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