A reader writes in, asking:
“I noticed that you no longer include REITs in your portfolio. [Mike’s note: See here for the post explaining the portfolio change he’s discussing.] Do you feel that you’re giving up some degree of diversification? And, for those of us who do include REITs, how would you suggest we count them toward an overall stock/bond allocation?”
I liked this question because it gives us a chance to address a couple common misconceptions about REITs.
What is a REIT?
Real estate investment trusts (REITs) are companies that invest in real estate — sometimes commercial real estate, sometimes residential estate, sometimes both.
REITs are unique because of the way they’re taxed. Specifically, they are not subject to corporate income tax, provided that they satisfy a few requirements. For example, REITs must distribute at least 90% of their taxable income to shareholders every year.
Should REITs Be Counted as Stocks or Bonds?
Despite their unique tax treatment and their high yield, shares of ownership in a REIT are still, by definition, equity investments. In other words, when considering your overall stock/bond allocation, a REIT fund should be counted as a stock fund because it is a stock fund — a sector-specific one, much like a health care fund, for example.
REITs Are Included in Total Market Funds
While my portfolio does not include a REIT-specific fund, it does still include REITs. REITs are included in broad “total stock market” index funds in proportion to their market weight — just like stocks from every other market sector.
REITs are included in many other stock index funds as well. For instance, as of last year, the S&P 500 included 15 different REITs.
REITs as a Diversifier
Because of their high-yield characteristic and because of the fact that REITs are often more closely correlated to real estate prices than to the stock market, REITs are often thought to be a good diversifier for a typical stock portfolio — the idea being to overweight them relative to their market weight in the hope of reducing overall portfolio volatility.
Personally, I’ve found the “REITs as a diversifier” argument (just barely*) convincing enough to include a REIT fund in the index fund portfolio my wife and I were using until recently. That said, having now moved to an all-in-one LifeStrategy fund that does not overweight REITs, I’m not worried that we’re missing out in any way that’s likely to meaningfully impact our long-term success as investors.
*It’s useful to remember that imperfect correlation doesn’t in itself make something a useful diversifier — otherwise you could take a total stock market index fund and overweight any stock in it (on the basis that each individual stock has an imperfect correlation to the rest of the portfolio) and thereby reduce the portfolio’s volatility.
Hi. I'm Mike Piper, the author of this blog. I'm 
I find the question a bit odd but then I spent years in Australia so I come from a different background.
The question and answer both make the assumption that there are only two asset classes: “Equity” and “Fixed Interest” (call them what you wish). Discussions here in North America always seem to be along the lines of whether there should be a 60-40 split or 40-60 split and how they should vary with age etc etc etc.
In Australia, there are three asset classes as far as most investors are concerned “Equity”, “Fixed Interest” and “Property” with the latter including both “Investment Property” (i.e. a secondary house/apt owned for the purposes of renting out) and also – of course – REITS. The discussions there re the Equity/Fixed/Property allocation are along the lines of “How much should you invest in Property/Reits”? Should it be 5% in Reits, 10% or what?
From that background, you’ll understand why I find the question needs a different sort of answer: REITS are neither “Equity” or “Fixed Interest” but should be in a separate asset class with the real question being “how much should I allocate to Property though an investment in REITS?”
David F. Swensen, he who is the chief investment officer of Yale University. in his book, unconventional success has the following allocation:
30% in U.S. stocks
20% in real estate,
15% in U.S. Treasury bonds,
15% in U.S. Treasury Inflation Protected Securities
15% in foreign, developed stocks
5% emerging market stocks
Maybe david know something that we don’t, he has 20% in REIT which is very close to the US stock allocation ?
Mark,
I respectfully disagree.
Given the choice to categorize REITs as either “stocks, bonds, or real estate,” I would categorize them as stocks. On a very literal level, they are stocks, and they are not real estate.
By way of analogy, some people invest in precious metals, while others invest in funds that own stocks of companies that mine precious metals. But the two are meaningfully different. True, precious metals mining companies will be more closely correlated to precious metals prices than other stocks will, but there are still meaningful differences in performance (and taxation).
Same goes for owning real estate directly as opposed to owning companies that build/buy/sell/rent/manage real estate. REITs will be more closely correlated to real estate prices than other stocks will, but they’re still not the same thing as owning real estate.
Thanks for the comment to Howard. Using the standard Australian breakdown of asset classes, then Yale is 50% Equity, 30% Fixed Interest, and 20% Property which I suspect would be a tiny bit on the high side as far as most Australian Financial Advisors would go re recommending a percentage to Reits but not unheard of I suspect.
Mike, I appreciate your point but then I guess part of my purpose was to highlight that you have an entire country out there (i.e. Australia) that considers there to be 3 asset classes not just 2. Having lived in NZ as well decades ago, I seem tor recall that they go for the 3 asset class breakdown as well and I have a suspicion that UK might be the same but please don’t hold me to the last.
Ultimately, REITS (at least most class REITS let’s say) are backed up by what Australians refer to as “Bricks and Mortar” with a value that at least historically does not move with equity markets and thus the reason they could arguably be viewed as being different from traditional equities. If a REIT wants to sell an office building, they usually have no difficulty doing so. Not so Kodak trying to sell patents, or RIM trying to sell whatever it is trying to sell these days. Reits are different.
But your point is understood. And that is perhaps why you’ll find many advisors throwing in yet another, fourth asset class: “alternative investments”. Into that very large “bucket” you might throw such things as “hedge funds”, “commodities” (e.g. including gold of course) and anything else that doesn’t quite fit into the common view of what constitutes an “equity”.
But getting back to your reader’s original question: assuming he had a 60-40 equity/fixed interest split, would you recommend to him that his ENTIRE 60% equities be REITS? Of course not. Would you suggest that he have a 0% allocation to REITS? Perhaps, but certainly not in Australia and I wouldn’t be happy with that if he wanted a well diversified portfolio. Which gets back to the original point he was trying to make: what might be the appropriate allocation to property/REITS? – and thus my point of why one (including the entire country of Australia!) might want to view it as a separate asset class.
Mark,
At least for a US index fund investor, 0% REITs would actually be difficult to achieve, as you’d have to do it by hand-creating a portfolio using all of the other sectors.
I think, as with most stocks, a reasonable starting point for analysis would be to allocate to REITs in proportion to their market weight. Then (possibly) adjust from there based on personal circumstances.
Bottom Line? : Asset Allocation ain’t easy and to anyone discussing potential splits between equity, fixed interest and anything else we would care to name, as well as the usual “simple” argument as to whether it should be 60-40 40-60 or some other split entirely different: Investing is a little bit more difficult than that!!!
Oh and I completely forgot to mention earlier that the definition of a REIT in the USA is a bit more generous than the definition in Australia. Something like Toll Brothers I believe is classed as a REIT whereas it would probably be viewed as Equity in Australia. Australian Reits break down into “commercial” (which own and operate office buildings), “industrial” (owning and operating industrial buildings), and “retail” (owing and operating shopping centers and the like) as well as the giants who have a mixture of the above. All of them “bricks and mortar”. You don’t see builders, health care operators, etc in Australian Reits as far as I recall. Perhaps that puts a slightly different complexion on my earlier posts.