Is there any benefit to diversification?

For decades, when investment advisors talked about “diversifying their portfolios to include real estate,” they usually meant adding REIT for your stock portfolio.

Don’t get me wrong, real estate investment trusts (REITs) have their advantages. They are extremely liquid and easy to buy or sell with the click of a button in your existing brokerage account. And you can invest for the price of a share, which could mean investing $15 instead of $50,000.

But do publicly traded REITs offer true diversification from the stock market at large? Maybe not as much as you’d like to think.

What are REITs?

Real estate investment trusts are companies that either own real estate investments or have loans secured by real estate. in fact, to qualify as a REITs under the IRS CodeThe company must earn at least 75% of its gross income from real estate in one way or the other, and at least 75% of its assets must be related to real estate, among other technical requirements.

As the names suggest, equity REITs hold property directly, and mortgage REITs hold loans secured by real property. Hybrid REITs own both.

REITs usually specialize in one real estate niche, For example, a REIT may focus exclusively on self-storage facilitiesOr on multifamily properties in gateway cities, or a hundred other places.

certain real estate crowdfunding companies Offer private REITs sold directly to investors. But most REITs trade on public stock exchanges.

This exposes them to the same volatility and violent mood swings as the stock market at large. Prices can fall in a single day even though there has been no jump in the value of the underlying real estate assets. But we are getting ahead of ourselves.

REIT Rules

As noted above, companies must generate the majority of their income from real estate in order to qualify as REITs.

REITs must pay out at least 90% of their taxable income in the form of dividends. In practical terms, this means they typically pay a high dividend yield but sometimes see limited share price growth because they cannot reinvest profits in growing their portfolios.

There are other rules that apply to REITs, such as being governed by a board of directors and having at least 100 shareholders after the first year, but I can feel the beginning now, so we don’t need to focus on those. .

So why would a company go through all these hurdles to qualify as a REIT? Because they get special tax treatment: they pay no corporate tax on money distributed as dividends to investors. As a result, many REITs pay out 100% of their earnings to shareholders and pay no corporate taxes.

REIT returns

Real estate investment trusts have actually done pretty well over the past half century.

From 1972-2022, US REIT Gave an average annual return of 11.26%. that is comparable S&P 500With an average annual return of 11.98%. Both figures include dividends and price growth, and both are simply mathematical averages of annual returns, not the more precise compound annual growth rate (CAGR).

So where’s my beef with publicly traded REITs, if not their returns?

Correlation Between REITs and Stocks

The problem with REITs is that they provide little diversification from the stock market. They are very closely correlated.

A morningstar study found a correlation of 0.59 between US REITs and the broad US stock market over nearly two decades. If your middle-school math needs a little clearing up, a correlation of 1 means lockstep, while a correlation of 0 means no correlation at all.

The 0.59 correlation between real estate stocks and the larger stock market is similar to other sectors of the economy. For example, telecom stocks share a 0.62 correlation with the broad market. The correlation for consumer goods is 0.57, and energy stocks is 0.64. You can also think of REITs as just another sector in your broader stock portfolio.

Just take a look at this chart and tell me the correlation isn’t obvious:

Why does correlation matter? Because it means that a fall in the stock market will also cause a fall in your REIT. Eggs and baskets and all that.

Consider that the average return on US REITs in 2022 was -25.10%. Yes, you read the minus sign right—they lost more than a quarter of their value. meanwhile, Average US home price up 10.49% In 2022.

This is quite a different matter. This is of course the point of diversifying across different asset classes: When one collapses, you can expect that you can still collect strong returns on the other. This especially matters for retirees, who depend on their investment returns to pay their bills.

In fact, that figure for residential property prices does not include the income side of real estate returns. Good rental properties often earn cash-on-cash returns of 8% or more, and short-term rental yields can be even higher in the right markets. When I compared long term and short term rental returns mashwiserI sometimes see yields as high as 12% on Airbnb rentals.

Alternatives to Public REITs

If you want a low correlation between your stock and real estate investments, you need to look no further than publicly traded REITs.

Consider the following options to reap the benefits of real estate along with true diversification.

• private REITsYou can invest in non-traded REITs through crowdfunding platforms such as Fundrise and Streetwise. Do your own due diligence, but at least they have little to do with stock markets.
• Non-REIT Funds: Not all real estate funds meet the legal definition of REIT. For example, Groundfloor offers a fund of asset-backed short-term loans with perfect liquidity and no explicit correlation to the stock market, called Stairs.
• Fractional ownership in rental: Platforms like Arrived and Ark7 let you buy fractional shares in single-family rental properties for $20-100 per share. You collect the rental income in the form of distributions, and receive your share of the profit when the property is sold.
• Real Estate Syndication: Syndications provide partial ownership in commercial properties, such as apartment complexes. mobile home park, self-storage facilities, and more. On the downside, they usually require a higher minimum investment, typically $50-100K. But some real estate investment clubs like mine help investors pool their money to invest less.
• Direct Ownership: There’s always the old fashioned way: buying the property yourself. But again, this often requires $50-100K in down payment, closing costs, repair costs, cash reserves, and so on. This makes it difficult to diversify your real estate portfolio.

Should You Invest in REITs?

It is not my cup of tea to tell you how to invest. If you prioritize liquidity the most and want to get started with some real estate-related investments for $100, buy some REIT shares.

I personally want my real estate investments to balance my stock investments. I don’t need liquidity from my real estate holdings – I already have liquidity in my stocks.

Actually, I invest in real estate as a substitute for bonds in my portfolio. It does most of the same things: diversification from stocks, passive income, and low risk of default. real estate offers even better inflation protectionAnd although its value may drop 5-10%, it may not drop 100% (like a bond value can drop if the borrower defaults or declares bankruptcy).

Invest in the way that is best for you. I’ve found my own happy place, a balance between passive real estate syndication and diversified stock funds from around the world.

Note by BiggerPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.