U.S. REITs provide low correlation and high risk-adjusted returns related to equities around the world.

By Eric Corcoran

REITs are notable in their power to add strong risk-adjusted performance and diversification through low correlation with other investments to an investor’s portfolio. Investors should not be surprised: a NAREIT study earlier this year found that no part of the U.S. stock market comes close to REITs in delivering the combination of attributes that investors seek: performance, stability and low correlation with their domestic stock investments.

However, new data illustrate just how much power REITs give investors. A recent NAREIT study looking at the global competition shows that stock market investments around the world can’t offer as strong of a combination risk-adjusted performance and portfolio diversification as U.S. REITs.

“This result is both surprising and powerful,” says Brad Case, NAREIT’s vice president, research and industry information, who conducted the study. “Sophisticated investors scour the world for strong risk-adjusted returns that are uncorrelated with the U.S. stock market. That combination of attributes is very rare. Yet, it turns out that there’s essentially no investment worldwide that performs better than U.S. REITs.”

Looking “Sharpe”

The NAREIT study compared returns for U.S. REITs with 148 U.S. non-REIT stock indexes and 561 global stock indexes, using monthly data for the entire modern REIT era from the beginning of 1993 through August 2007.

The study measured risk-adjusted performance for each investment using the “Sharpe ratio,” and measured diversification potential using the correlation in returns between each investment and the Dow Jones Wilshire 5000, a broad-based index of the U.S. stock market.

“An investor wants strong returns with low volatility that means they want investments with a large Sharpe ratio,” Case says. “Strong risk-adjusted returns are the major way you accumulate an adequate retirement nest egg.”

Over the past 16 years, U.S. REITs have returned an average of 13.4 percent per year, compared to just 11.7 percent per year for the Dow Jones Wilshire 5000. With slightly less volatility than the stock market, REITs have shown markedly better risk-adjusted returns: the REIT Sharpe ratio is 75 percent better than the ratio for the Dow Jones Wilshire 5000.

“Case finds annualized excess returns of 10.95 percent and risk of 3.78 percent for U.S. REITs over the 15-year period ending in August 2007,” says James D. Shilling, a real estate professor at DePaul University. “These results produce a Sharpe ration of 2.89 for the period. In contrast, the Sharpe ratios for domestic stocks and most global stock market indexes are all considerably lower, implying that U.S. REIT returns more than justify the level of risk assumed.”

Diversification is just as important as risk-adjusted performance. Every investment has ups and downs, but a well-diversified portfolio combines investments with low correlations. To get a well-diversified portfolio, investors who already own U.S. stocks wants investments that have a low correlation with the Dow Jones Wilshire 5000 and other U.S. stock indexes.

Most of U.S. domestic stock indexes had correlations between 76.6 percent and 93.9 percent, on the right side of the graph, while the five U.S. REIT indexes are in the left with correlations between 31.3 percent and 37.1 percent.

Diversification Benefits

Global stock markets typically have lower correlation with the U.S. stock market, which explains why investors look to non-U.S. stock markets to diversify their domestic stock holdings. “The surprise is that global stock investments are more highly correlated with the U.S. stock market than U.S. REITs,” Case says. He adds that most global stocks have produced lower risk-adjusted performance as well.

The correlations of most of the 561 global stock market indexes with the Dow Jones Wilshire 5000 were between 52.3 percent and 72.4 percent, much higher than REIT correlations. Moreover, most of the global stock market indexes had Sharpe ratios of between 1.09 and 1.95—similar to the values for most U.S. domestic stock market indexes—while the Sharpe ratios for all five available U.S. REIT indexes were between 2.89 and 3.34.

“This study finds that U.S. returns have lower correlation with U.S. stocks than most global stock market indexes,” Shilling says. “These results are quite interesting. They suggest that U.S. REIT excess returns are such that the portfolio variance-reduction benefit of REIT diversification is not offset by lower returns.”

Helping investors understand diversification and risk-adjusted return has always been a challenge, according to Glenn Mueller, professor of real estate at Denver University and real estate investment strategist for Dividend Capital Group. “It used to take 10 minutes and 3 charts to explain, but Case’s chart allows us to explain the combined return and diversification concept in one shot. It is a tremendous tool.”

U.S. REITs are better diversifiers than 95 percent of global stock market indexes and have better risk-adjusted performance than 98.6 percent of global stock market indexes, according to Case. “Over the past 16 years—a period that included two downturns in U.S. REIT stock prices—not a single one of 561 global stock market indexes was better than U.S. REITs in terms of both risk-adjusted performance and low correlation with domestic stocks.”

“The NAREIT research demonstrates that REITs improve portfolio Sharpe ratios and provide portfolio variance-reduction benefits,” Shilling says.

Erin Corcoran is Portfolio’s managing editor.