Roger Ibbotson, professor of finance at the Yale School of Management, received his bachelor’s degree in mathematics from Purdue University, his MBA from Indiana University and his Ph.D. from the University of Chicago, where he taught for more than 10 years and served as executive director of the Center for Research in Security Prices. A business owner since 1977, Ibbotson has directly managed bond portfolios, traded equity securities and managed asset allocation accounts. He has also co-written numerous books and scholarly articles on financial topics such as “Global Investing: The Professional’s Guide to the World Capital Markets” and “Investments: A Global Perspective.”

Roger Ibbotson Provides Insight on REITs and a Well-Balanced Portfolio

By Dees Stribling

As professor of finance at the Yale School of Management and chairman of the equity hedge fund Zebra Capital, Roger Ibbotson is one of the nation's foremost authorities on capital market returns, cost of capital and international investing. He's also the author of numerous books and articles on these interrelated subjects, including the annual "Stocks, Bonds, Bills and Inflation Yearbook," and founder of the investment research firm Ibbotson Associates, which was recently sold to Morningstar. He spoke with Real Estate Portfolio about REITs' benefits in a well-balanced portfolio and the role they can play in retirement planning.

Portfolio You've been following this industry for some time. When did REITs become an important asset class to investors?

Ibbotson: As an alternate investment, REITs started small in the 1970s. It used to be that there weren't enough of them to invest in to gain commercial real estate exposure in any significant way, but that's a thing of the past. That's been corrected by REITs' tremendous growth in the last 15 years or so.

The problem of size bothered institutional investors in particular. Institutions don't want to buy into anything that's too small, because simply doing so might impact the price. Also, small REITs may not be liquid enough for a big buyer. If they buy a large part of a small REIT, it's considerably harder to sell than a smaller part of a large REIT. However, when REITs were small, they were mostly undesirable to institutional investors. Now they can buy into REITs on a much bigger scale, and of course they're doing so.

From 1995 to the end of 2005, the total capitalization of the REIT market grew from about $50 billion to $300 billion, and a lot of that has been recent growth. Since 2002 there's been approximately $150 billion of growth in REITs, or a doubling in the market.

However, more has changed than just the total size of the REIT market. From 1991 to 2006, the number of listed REITs increased from 136 to 195. Perhaps more importantly, in 1991 there was only one REIT over $1 billion in capitalization. In the first quarter of 2006, there were 97 over $1 billion.

Portfolio Besides the fact that REITs now represent a much larger investment universe, why do investors like them?

Ibbotson: It's basic to investing. People want to invest in real estate. Not only has it had great returns over the years, it provides excellent diversification to stock and bond portfolios.

REITs have enabled investors of all sizes to also invest in commercial real estate. Institutions, on the other hand, generally have the wherewithal to invest directly into real estate, but it isn't a particularly liquid investment. REITs solved that problem too.

Portfolio How do REITs fit into a well-balanced, diversified portfolio?

Ibbotson: We've looked at returns on REITs compared with stocks and bonds, and we've looked at the risks of REITs, also compared with the equity markets. We've studied the interaction of REIT holdings with stocks and bonds and how they affect a portfolio. Our conclusion is if you generally have REIT holdings along with stocks and bonds—as opposed to a portfolio of just stocks and bonds—you'll do better.

For one thing, a lot of the return on a REIT comes from the income. Over the last 20 years, the average annual income return of a REIT has been 7.9 percent, much higher than average dividends in the stock market. In that way, REITs are more reliable and predictable to an investor, and are somewhat like utilities, though in fact REITs have exceeded utilities in terms of returns as well. As an income generator, REITs are hard to beat.

The composed annual total return from 1972 to 2005 for equity REITs was 13.4 percent, compared with 11.2 percent for the Standard & Poor's 500. This was a very good period for stocks, and yet REITs outdid them. I'm not saying that REITs will beat stocks over the next 30-plus years, but it seems reasonable to think that REITs will have a pretty good return going forward.

Portfolio But it's more than just a matter of returns, isn't it?

Ibbotson: Yes. REITs have a role in a well-balanced portfolio for a number of other reasons. Just by the numbers, perhaps they should form 20 percent of a portfolio or more. However, most investors would shy away from putting too much in REITs, because there's no guarantee that they're going to do as well in the future as they have in the past. But REITs still make sense for a portfolio because they're such a good diversifier.

Adding REITs to a portfolio will reduce risk because they aren't especially related to stocks or bonds.

Over the last five years, the correlation of REITs with large-cap stocks is only 0.38. That tells us that only 38 percent of the variance of REIT share prices can be explained by overall movements in the stock market. The other 62 percent can be attributed to other factors, such as the fact that different economic conditions drive the broader real estate market than the stock market. REITs are almost entirely unrelated to the bond market—there's almost zero correlation with bonds.

You put a strong portfolio together by including things that behave differently, and REITs behave differently than either stocks or bonds. A portfolio isn't diversified efficiently if you just buy different types of stocks or bonds, many of which tend to move together.

Portfolio Within the REIT world, have any property types proven to be a better investment?

Ibbotson: The REIT world is made up of a lot of different categories, and here again, a mixed REIT portfolio would be better than loading up on, say, office, residential or shopping centers. It's much better within your REIT allocation to have a diversified portfolio, and it should be diversified not just according to property type, but also geographically—not all in California or New York, for example.

Portfolio How does investing directly in real estate compare with investing in REITs?

Ibbotson: In both cases, you're investing in real estate, so there are going to be some similarities, but direct real estate investing behaves quite a bit differently from REITs. They're good complements to each other. For an institutional investor especially, it would be reasonable to have both REITs and direct real estate. It further adds diversification, because they aren't substitutes for each other.

With REITs, there are direct ways to measure value. After all, they are stocks. Real estate itself, on the other hand, is more difficult to measure, because you don't have frequent quotes.

You could think of it this way: there are four individual markets that move to their own rhythms, namely stocks, bonds, REITs and direct real estate investment. It would be reasonable to buy both real estate and REITs. They overlap, but they aren't mutually exclusive.