Real estate has historically been a great investment for long term price appreciation, income generation, and inflation protection; but, it is risky! For investors who want liquid exposure to this asset class, the capital markets provide the real estate investment trust (REIT) legal structure. When you buy a REIT you are buying into the REIT organization’s management skill to manage the properties successfully to generate price and income return.
The major real estate sectors include industrial, office, retail and residential, but there are other minor sectors like resorts, health care, self storage, and timber. For example, if you want to have investment exposure to large shopping malls in the U.S., you could buy shares of the giant retail REIT, Simon Property Group (SPG), that owns and manages over 200 retail malls and properties. Or, if you preferred cell phone towers, you could buy shares of American Tower Corp. (AMT). And the list goes on, including almost any other type of real estate you can think of!
However, as we all know, real estate goes through boom and bust cycles and is a risky asset class. Moreover, just like with regular stocks, buying an individual REIT exposes the investor to “idiosyncratic” risk, i.e., a risk unique to that specific investment that can not be diversified away. Because of this, it is much preferable to own real estate through a portfolio of REITs. There are a few very large low-cost passively managed exchange-trade funds (ETFs) that provide good diversified exposure to the REIT sector.
REIT offerings from Vanguard, Schwab, and iShares round out the top few passively managed REIT ETFs. As seen from chart below, their performance over the past five years has lagged the S&P 500, while having more risk! REITs still have a place in a balanced portfolio due to its low correlation (about 0.5) to the S&P 500 and its historically relatively high income generation (as shown from their higher SEC yield compared to SPY).
A key component driving returns are the underlying sector exposure of each of the ETFs. As can be seen below, VNQ and IYR tend to underweight the Residential sector compared to SCHH, thus impacting the return profile. There is no reason, however, to believe that one weighting approach is better than the other over a full business cycle.
As always, our philosophy is to have a well-diversified global multi-asset class exposure that includes the real estate asset class through the liquid low-cost passively managed ETF structure. We expect to be rewarded over a long term time horizon.