By Matthew Bechard

Jack Goodman provides economic and demographic research to the real estate industry through his firm, Hartrey Advisors. Most recently, he has written the report "Homeownership and Investment in Real Estate Stocks." Goodman shared his thoughts with Portfolio on the diversification benefits of home ownership versus REITs.

Portfolio: What would you say to those investors who feel home ownership provides sufficient diversification, making investing in real estate stocks unnecessary?

Goodman: It comes as a surprise to many investors to find out that the correlation between changes in house prices and total returns on real estate stocks has been very low over the past 25 years. However, this simple fact means that real estate stocks deserve consideration by homeowners seeking to diversify their asset holdings.

Portfolio: How have REIT returns compared to the returns on owning a home over the past 10 years?

Goodman: We know from the NAREIT Equity REIT Index that the total annual return of REITs has averaged about 12 percent over the past 10 years. That’s the easy part. Measuring the total return of houses is more complicated. The return of a home comes in part from price appreciation and in part from the income return of rental revenue net of operating expenses.

House prices nationally have increased about 4 percent annually over the past decade. However, that figure varies so much from year to year and place to place that it is virtually meaningless for the individual owner-occupant, who bears a risk analogous to a large position in a single company’s stock. And if the house is mortgaged, there is the additional risk of a leveraged investment—analogous to buying stock on margin.

As for the income return, owner-occupants do not receive cash rent, but rather housing services for which they would have to pay for if they were not the owners.

Portfolio: How do you see this continuing going forward? What fundamentals exist that make, or do not make, REITs a critical component of a diversified investment portfolio?

Goodman: History is an imperfect guide to the future, but the data from the past quarter century clearly show that investment portfolios that included REITs could have outperformed portfolios from which REITs were excluded. I don’t see any reason to expect that historical experience would be reversed in the future.

Portfolio: Do you think the confusion over home ownership as diversification versus owning real estate stocks is a factor in why more investors do not have real estate stocks as part of their retirement plans?

Goodman: The misconception that "real estate is real estate" skill has intuitive appeal and probably does contribute to investors’ decisions. But this is one of those situations in which the intuition simply is wrong, and investors pay a real price for going with their intuition.

Portfolio: How much of an allocation do homeowners, or non-homeowners for that matter, need to allocate to REITs in order to see performance gains? Is there an "optimal" allocation you have found in your research?

Goodman: The optimal allocation will depend on the investor’s risk tolerance, investment horizon and other considerations. But I have found that investors with mid-level risk tolerances—homeowners and renters alike—historically could have improved the average annual return on their portfolios, without increasing the volatility of those annual returns, by adding even small positions in diversified REIT stocks to their investment portfolios.

Portfolio: There has been talk about the bursting of the real estate bubble. Do you see a "bubble" and does that impact REITs at all?

Goodman: The bubble most often mentioned lately has referred to house prices, and many analysts question whether house prices have in fact moved up to speculative levels. Income properties have not been immune to weak performance of late, but speculative pricing of these assets does not seem to be one of the bigger problems facing commercial real estate right now.