Investors have been wary of real estate investment trusts and related exchange traded funds as the Federal Reserve cogitates on an interest rate hike. However, people should not passover the asset class altogether.
Some investment experts argue that since commercial property has a larger presence in the U.S. economy than REITs do in the equities market, investors could benefit from a 5% to 10% allocation to REITs to bring their investments more in line with commercial property’s significance in the overall economy, reports Joe Light for the Wall Street Journal.
“Philosophically, do you want to invest in the stock market or invest in the economy?” Rick Ferri, managing partner of Portfolio Solutions, said in the WSJ article. “I think most would say you want [your portfolio]to look like the economy.”
Investors can gain exposure to the broad REITs category through ETFs. For example, the Vanguard REIT ETF (NYSEArca: VNQ) and SPDR Dow Jones REIT ETF (NYSEArca: RWR) track a group of REITs, excluding mortgage REITs and non-real-estate specialty REITs. The iShares Dow Jones US Real Estate Index Fund (NYSEArca: IYR), though, takes a broader view and includes the more specialized REITs. [Sticking With a Popular REIT ETF]
The investments also come with attractive yields. VNQ has a 3.76% 12-month yield, RWR has a 3.12% 12-month yield and IYR has a 3.59% 12-month yield.
REITs are securities that trade like a stock and invest in real estate directly through property ownership or mortgages. Consequently, revenue are mainly generated through rents or interest on mortgage loans. To qualify for special tax considerations, the asset also distributes the majority of income, about 90% of taxable profits, to investors as dividends.
Some broad stock indices include REITs exposure. However, REITs make up a very small percentage of broader benchmarks – only about 2.4% of the SP 500 is in REITs.
In contrast, about 13% of gross domestic product is attributed to real estate, rentals and leasing in 2014.
Consequently, investors are likely underweight the real estate sector and could miss out on the benefits of diversifying into the asset.
Additionally, REITs provide diversification benefits as the asset shows a lower correlation to stocks and bonds. Over the past three decades, REITs’ rolling 36-month correlation to other stocks ranged from 0.89 to negative 0.16 – a value of 1 translates to perfect lock step while a negative value means the two assets moved in opposite directions. The correlation between REITs and Treasuries was 0.74 to negative 0.66 over the same period.
Nevertheless, some investors fear REITs will act negatively in rising interest rate environment. The high dividends in REITs are attractive in a low-rate environment but are less enticing once safer Treasuries show higher rates. [Don’t Overload REIT ETF Allocations]
Rising rates, though, does not spell the end of REITs. Gregg Fisher, chief investment officer of Gerstein Fisher, found that in the five periods since 1978 when the Fed hike drates, U.S. REITs had an average monthly return of 1.28%, compared to the 1.21% for U.S. stocks and 0.47% for U.S. bonds.
“The idea that REITs are bad when interest rates go up can be answered empirically,” Fisher said. “There’s no evidence of that.”
For more information on real estate investment trusts, visit our REITs category.
Max Chen contributed to this article.