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Real Estate: The New Twist on Portfolio Diversification

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November 22, 2016
Real estate: Diversifying a portfolio with REITs

Move on over, stocks and bonds: there’s a new kid on the block and its name is real estate. In a historic move this fall, the folks at S&P Dow Jones Indices determined that real estate had become significant enough as an asset class to deserve its own stock sector, the 11th overall.

Real estate’s elevation to its own sector underscores the growth in the exchange-listed real estate marketplace in recent decades. Over the past 25 years, the equity market capitalization of the U.S.-listed equity REIT industry has surged from $9 billion to nearly $1 trillion, according to the National Association of Real Estate Investment Trusts (NAREIT).

Popular Among the Income Crowd

For years, real estate investment trusts (REITs) seemed to have second-tier status on Wall Street—present, but not fully noticed, and perhaps not fully understood. In recent years, income-seeking investors have turned toward REITs as a potential way to generate an income stream.

In their most basic structure, REITs are holding companies that own income-producing properties such as apartment buildings or commercial strip malls. REITs typically pay out all of their taxable income each year to their shareholders as dividends; the IRS requires them to pay out at least 90% annually. 

REIT subsectors include:

  • Office REITs—commercial office space
  • Industrial REITs—these include warehouses and distribution centers
  • Retail REITs—these include shopping centers
  • Lodging REITs—hotels
  • Residential—apartments and single-family homes
  • Timberland REITs—properties that harvest and sell timber
  • Health care REITs—senior living communities, hospitals

Low Correlation to Stocks

Proponents of REITs point to the low to moderate correlation between stocks and real estate as a reason you might want to consider owning some in your portfolio. Although investors can buy and sell REITs on a stock exchange, they represent a different asset class from stocks, and so they may help with diversification.

Historically, REITs may not move in tandem with the broader stock market because of the time difference between the real estate cycle and the business cycle. The expansion phase of a typical business cycle lasts just under five years, while the real estate cycle runs for about 18 years. These cyclical differences could contribute to lower correlations to the broad stock market.

The economy is growing, albeit slowly, which may be supportive for the real estate market. For example, demand for apartments has been high throughout the country in recent years, which has given landlords pricing power to raise rents. Rents for single-family homes are likely to rise by 1.7% in the year ending August 2017, according to Zillow.

Looming on the horizon, rising interest rates are traditionally interpreted as a negative for REITs, as they can mean higher borrowing costs. But rates are quite low by historical standards, and perhaps a long way from achieving a normalized rate. Besides, although rising interest rates have the potential to make home-buying more expensive, they also could boost demand for rentals. 

Sift Through Sector Candidates

Use Stock Screener to narrow selections based on sectors like real estate and its 12 subsectors. Log in at tdameritrade.com > Research & Ideas > Screeners > Stocks.

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