Potential Diversification Strategy: Considering Real Estate Investment Trusts (REITs)

S&P Dow Jones Indices added real estate to its list of sectors in 2016. Perhaps it’s time to explore real estate investment trusts (REITs).

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2 min read

Key Takeaways

  • Real estate investing got a higher profile when it became a new S&P sector in 2016
  • In recent years, some income-seeking investors have turned toward REITs as a potential way to generate an income stream
  • Proponents of REIT trading point to the low to moderate correlation between stocks and real estate

In 2016, the folks at S&P Dow Jones Indices determined that real estate had become significant enough as an asset class to deserve its own sector, the 11th overall. This move helped elevate real estate investment trusts (REITs) into the spotlight for many investors who might not have considered REITs in the past.

Real estate’s elevation to its own sector underscored the growth in the exchange-listed real estate marketplace in recent decades. Over the past 30 years, the equity market capitalization of the U.S.-listed equity REIT industry has surged from $11 billion to more than $1 trillion, according to the National Association of Real Estate Investment Trusts (NAREIT).

What Are REITs?

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

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 investors as dividends; the IRS requires them to pay out at least 90% annually. A list of REIT subsectors is shown in figure 1.

Low Correlation to Stocks

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

REIT subsectors: office, industrial, retail, lodging, residential, timberland, health care
FIGURE 1: AN OVERVIEW OF REIT SUBSECTORS. For illustrative purposes only.

Historically, real estate investment trusts may not always 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.

When the economy picked up steam in the mid-2010s, it helped lend support to the real estate market. Demand for apartments started to rise as home prices went up, giving landlords pricing power to raise rents. Rental prices began rising more quickly as economic growth picked up, according to Zillow.

High Correlation to Interest Rates

The rate hike cycle that began in 2015 might appear negative for REITs, as rising rates can mean higher borrowing costs. But even after a number of rate hikes between 2015 and 2018, borrowing costs remained relatively low by historical standards. Besides, although rising interest rates have the potential to make home-buying more expensive, they also could boost demand for rentals, potentially helping real estate sector stocks.

However, all that said, the real estate sector struggled in its early years as an S&P sector, rising more slowly than the broader S&P 500 Index (SPX). That could be partly because of rising interest rates in the late 2010s that weighed on the real estate industry.

Despite the sector’s relatively slow start, everyone still needs shelter, whether it’s your home, office, or when you visit the local indoor shopping mall. In addition, many investors seek diversity in their portfolios. That combination isn’t going away anytime soon, making the real estate sector, and perhaps real estate investment trusts, one that you might want to learn more about.

Investments in REITs and other real estate securities are subject to the same risks as direct investments in real estate, including loss of principal. The real estate industry is particularly sensitive to economic downturns. Be sure to consider your own financial situation, perform thorough research and consult with a qualified tax professional before making any investment decisions concerning REITs.

You may also want to review this SEC Investor Bulletin concerning REIT investing. 

Asset allocation and diversification do not eliminate the risk of experiencing investment losses.

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