By Matthew Bechard

REITs Bring Diversification Home

Jack Goodman provides economic and demographic research to the real estate industry through his firm, Hartrey Advisors. He is the author of "Homeownership and Investment in Real Estate Stocks," which appeared in a recent issue of the Journal of Real Estate Portfolio Management. Goodman shared his thoughts regarding the diversification benefits of home ownership versus REITs.

Portfolio: There are some individual investors who feel home ownership provides them sufficient diversification and adequate real estate exposure. As such, they feel owning real estate stocks is unnecessary. How would you address those thoughts?
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 listed 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, which they would have to pay for if they were not the owners.

Portfolio: 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 listed REITs could have outperformed portfolios which excluded REITs. I don't see any reason to expect that historical experience would be reversed in the future.

Portfolio: We have increasingly seen real estate stocks incorporated into more retirement plans, but there are still many plan participants without any real estate allocation. Do you think the confusion over home ownership compared with owning real estate stocks as a source of diversification plays a factor in more investors not seeking out a REIT option?
Goodman: The misconception that "real estate is real estate" still 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 listed REIT stocks to their investment portfolios.