By Art Gering

Over time, REITs have proven to be the missing piece for building a well-diversified portfolio

When capital flows into REIT mutual funds surged from 2001 to 2003, many veteran REIT observers raised an eyebrow. Some were concerned that the new money was simply chasing the superior performance REITs had achieved since the onset of the bear market in early 2000. Many thought the new investors would quickly exit once the broader equity market rebounded. Others insisted that investors were acknowledging the REIT story. That is, investors had begun to recognize the value of REIT stocks and real estate mutual funds as portfolio diversifiers and were now embracing publicly traded real estate securities.

Higher Returns from Real Estate Basis Points
Risk in Percent	REITs and Direct Real Estate Combined	Direct Real Estate Alone	REITs Alone
2	8–13	5–10	6
4	11–20	6–14	10
6	16–27	8–18	13
8	20–27	11–17	17
10	9	0	9
Using annual returns for a 15–year period (1987–2001), Ibbotson Associates determined that expected annual portfolio returns were as much as 27 basis points (.27 percent) higher in portfolios that included both listed equity REITs and direct real estate equity than in portfolios with no real estate allocation. Source: Ibbotson Associates

"Years ago, when I would tell people my job they had no idea what I did," says Karen Knudson, a portfolio manager with RREEF Funds. "Today, I tell people I'm a portfolio manager focused on real estate and they say, 'oh yes, REITs.' I think that individuals have become more knowledgeable about REITs, and, as a result, we're seeing more REIT stocks in portfolios."

Assuming that performance-chasing investors are mostly responsible for ratcheting up fund flows overlooks the progress that the REIT industry has made in communicating its message. Those who cling to the performance-chasing theory, however, took a measure of satisfaction in April 2004, when expectations of rising interest rates drove money out of REIT mutual funds and roiled major REIT indexes. By mid-May, though, REIT indexes were recovering and eventually surpassed the levels reached before the April dip. The sharp decline and relatively rapid rebound of share prices illustrated the futility of trying to time the market and reinforced a convincing body of evidence that investors should maintain a suitable and stable allocation to REIT stocks in diversified investment portfolios held for long-term wealth accumulation.

Asset Allocation

Perhaps no single item has done more to validate REIT investing than a landmark study performed by asset allocation specialists Ibbotson Associates. First released in 2001 and since updated annually, Ibbotson lays out a compelling case for including REIT stocks in long-term investment portfolios. It's unlikely that many individual investors have read the study, but its message resonated with financial planners and advisers who shared the findings with their clients.

		A Block of History Congress created REITs in 1960, and the industry has enjoyed periods when it was enthusiastically accepted by investors and endured trying times when it was out of favor or merely misunderstood.

According to Ibbotson, adding REIT stocks to a portfolio consisting of other stocks, bonds and cash can potentially lead to higher portfolio returns and lower portfolio risk. Upon examining historical REIT returns, Ibbotson found income generated by REIT stocks to be consistent and predictable. Dividend yields have averaged approximately 7 percent and payouts have increased usually at a pace more rapid than inflation. Additionally, REIT returns have had a declining correlation with other asset class returns over the past 30 years.

Correlations between asset class returns are a major focus of modern portfolio theory. Bernard Winograd, president and chief executive officer of Prudential Investment Management, says the primary insight of modern portfolio theory is that the greater number of sources of diversified return an investor has, "the better off an investor is in terms of risk, return and volatility."

Ibbotson tested model portfolios with 10 percent and 20 percent allocations to REITs and found that each produced higher returns at identical levels of risk when compared to model portfolios without an allocation to REITs. Adding REITs to a selection of diversified portfolios from 1972 to 2003, for example, boosted compound annual total returns by as much as six-tenths of a percentage point when compared with non-REIT portfolios. For the period often cited as the modern REIT era, 1994 to 2003, the inclusion of REIT stocks in the asset class mix increased compound annual returns by as much as nine-tenths of a percentage point. The study statistically confirmed what many dedicated REIT investment professionals had long thought to be true.

Real Estate Mutual Fund Flows January 1995-September 2004 Millions of Dollars

Source: AMG Data Services, Smith Barney

"Real estate is an excellent diversifier of portfolios," Winograd says. "It provides an equity-like investment with many characteristics of fixed income. It is an equity investment, but nevertheless, it provides substantial cash flows and, therefore, does not tend to react to changes in market conditions the same way as pure equity or pure fixed-income investments."

Institutional investors have recently dominated investment in REIT stocks. With the evidence from the Ibbotson study in the hands of the financial planning community, the door has opened for greater participation in the industry by individual investors. However, achieving a greater level of acceptance by individual investors remains an ongoing mission for the industry.

"Individuals are definitely more knowledgeable about REITs in part because of REIT performance over the last few years and the fact that investors and the financial press have been focused on diversification," Knudson says. "But I'm of the view that individual investors need much more education about investing—period—and about where REITs belong specifically. So, something needs to be done; it's a huge job and frankly I'm not sure how you get it done."

401(K) Plans

Individuals are primarily exposed to the equity market through their employers' defined contribution plans, also known as 401(k) plans. Only about one in eight plans, however, offer a real estate option to their participants, according to a survey sponsored by the Profit Sharing/401(k) Council of America. The percentage of plans offering a real estate option clearly has moved higher in recent years, but there remains potential for considerable growth. "You hear about more 401(k) plans that have picked up real estate in the last five years to 10 years," says Don Cassidy, a senior research analyst with Lipper, a mutual fund research firm. "There is probably, to some degree, a very moderate level of positive investor education that is going on, and over time people are going to include REITs in their portfolios."

Increased attention on educating both employers that sponsor 401(k) plans and plan participants appears to be a good prescription for remedying the lack of real estate exposure on the investment menus of defined contribution plans. Many plan sponsors look upon REIT mutual funds as sector-specific funds and reason that they have no place on a menu that typically includes large cap and small cap stock options, international equities, one or more bond funds, company stock and cash. This was refuted by the Ibbotson study, which confirmed REITs as an asset class and showed REITs have a low correlation with other stocks and bonds.

Some plan sponsors also reason that since many participants own a home, they already have the real estate exposure they need. A study by the research firm Hartrey Advisors, however, suggests that commercial real estate and homeownership are very different (for more information on this study, click here).

The REIT industry must not only educate plan sponsors but also encourage them to engage third-party investment advice providers to help 401(k) participants assemble appropriately diversified investment portfolios.

"Individual investors tend not to look at things like betas and correlations," Cassidy says. Third-party investment advice firms, such as Morningstar and Financial Engines, have been hired by many employers to assist their workers.

Direct and Indirect Working Together

Building a broader individual investor base is a superb goal for the industry, but challenges in the institutional sector should not be overlooked. For example, it's not uncommon for large defined benefit plans to implement a real estate allocation by investing entirely through direct real estate investments. Moreover, those plans that invest in both direct real estate and real estate securities often lean heavily toward the former. However, there is growing evidence that suggests direct real estate and REITs perform well together as complementary investments.

Further analysis by Ibbotson found that REITs and direct real estate have similar long-term investment characteristics and create more efficient portfolios when combined. Using historical annual returns from 1987 to 2001, Ibbotson discovered that expected future annual returns were as much as 27 basis points higher in portfolios that held both REITs and direct real estate when compared with portfolios having no real estate allocation.

Another study, conducted by Joseph L. Pagliari Jr., Kevin A. Scherer and Richard T. Monopoli, compared historical NAREIT Equity REIT Index returns with returns from the direct property NCREIF Property Index (for more information on this study, click here). The group sought to determine whether investors benefited by selecting either the private or the public real estate platform.

		Cracking the Fund Flow Riddle Each week, capital flows into mutual funds are reported. Equity market analysts, investors, commentators and journalists parse the data to gain deeper insight into the market.

After adjusting for disparities between the NAREIT and NCREIF indexes, and running the historical returns data, the researchers found little distinction between the risk-return attributes of direct property investment and publicly traded real estate equities. "Public and private market vehicles ought to be viewed somewhat interchangeably, offering investors a risk-return continuum of investment opportunities" the researchers concluded.

The findings of the two studies could provide an impetus for greater inclusion of REIT stocks in defined benefit plan portfolios. Certainly, building an adequately diversified direct property portfolio requires an investment capacity greater than $100 million, argues Prudential's Winograd. "That means that only the very largest plans are in a position to build a portfolio," he says.

Nonetheless, defined benefit plans typically allocate much less to REITs than the 5 percent to 15 percent Ibbotson found in its optimal portfolios using both direct property investment and publicly traded real estate stocks. A reason often cited for the low allocations to REITs is a lack of size and liquidity in the sector, according to veteran REIT investor Ralph Block, CEO of Essential REIT Publishing.

"I don't think that's a particularly good reason because we're talking about long-term investments," Block says. "If it takes two months to buy a position in a REIT, I don't see why that should be a big obstacle for them doing so.

"If the only objection to investing in REITs is that the investor wants to be able to trade in and out of $10 billion positions, that's fine," he adds. "The industry is not big enough. But if you're a long-term investor that is interested in diversifying a portfolio, it's a slam dunk."

Looking Ahead

In recent years, the REIT industry has become larger as measured by the number of REITs and by industry market cap, in addition to attracting scores of new investors. In the years ahead, the REIT industry itself and individual firms will continue to evolve.

"Competition for tenants in a world where every business and consumer seeks to reduce costs will continue to be fierce, and being the low-cost provider of any type of commercial space will provide a competitive edge to real estate owners," Block says.

As a result, Block adds, REITs will seek to become larger and more efficient in their cost structures, sometimes by making large company or portfolio acquisitions. A large-scale consolidation of the industry will not occur, he argues, because the synergies available in company to company mergers do not always translate into cost savings. Rather, growth of individual REITs will occur through portfolio or one-off acquisitions or asset recycling.

"It is also likely that more real estate companies will want to become public REITs," Block says. "Although many private real estate owners regard their activity as 'investments' rather than running a business, many others will want to professionalize their organizations and provide more reliable capital sources for expansion and business growth and development. This factor, together with the expected strong demand from investors for securitized real estate, will create a need for a larger public REIT industry."

Knudson lauds the efforts the industry has made migrating from private, entrepreneurial ownership to operating primarily in the public markets. She adds that this transition will only enhance REIT investing going forward.

"There have been changes made to the REIT tax laws over time that have made it a more efficient vehicle, and I think a more value-added investment vehicle," Knudson says. "While there'll be more fine-tuning done over time, it is a big positive for investors to have REITs continuing to be real estate ownership vehicles."