You may not realize it, but if you’re a Common Sense Investing fan, you probably already invest in real estate. For example, the iShares Core S&P/TSX Capped Composite Index ETF (XIC) includes a 3.44% allocation to real estate. The iShares Core S&P U.S. Total Market Index ETF (ITOT) has a 3.89% allocation, and the iShares Core MSCI EAFE IMI Index (XEF) has 5.06%.
Is that enough? Historically, real estate has been one of the best-performing global asset classes … at least it has been if you view Real Estate Investment Trusts, or REITs, as a distinct asset class (as many do).
I can see how it may be enticing to add REITs to an existing portfolio of index funds. They’re a special type of fund that invests primarily in income-producing real estate assets. Their income earnings flow through to unit holders, who also get to participate in the buildings’ capital appreciation. REITs are convenient too. They give you access to a liquid, diversified portfolio of real estate assets, without the need to manage anything on your own. This eliminates some of the biggest issues with investing directly in real estate. And just like with stocks, you can buy a low-cost index fund of REITs.
But here’s the crux of it: If you decide to add REITs to an existing portfolio of index funds, we are really talking about adding real estate in excess of its market-cap weights, as described above. If REITs really are a distinct asset class, generating distinct returns, there may be some logic to overweighting them. But before you go all in, let’s unpack that assumption.
Do REITs Deliver Distinct Returns?
If REITs are a distinct asset class, adding them to a stock/bond portfolio should add a diversification benefit. At first glance, there appears to be evidence supporting the strategy. REITs do seem to have exhibited relatively low historical correlation with stocks and bonds, and their returns are not well explained by market beta alone. It also doesn’t hurt that their returns have been pretty great. From July 1989–June 2019, the S&P Global REIT Index (gross div.) returned 9.24% per year on average, while the MSCI All Country World Index (gross div.) returned 7.77% per year on average, both in CAD. Over the same period, there was low correlation between these indexes – just 0.513.
Combining the two indexes together in a portfolio seems like a compelling proposition. But “seems like” and “is” are two different things. Let’s consider what recent academic literature has to say on the matter
If REITs are truly a distinct asset class, we would not expect known risk factors that explain stock and bond returns to also explain REIT returns. In a 2018 paper, Real Estate Betas and the Implications for Asset Allocation, Peter Mladina studied this very comparison. He used a modified version of the Fama/French Five-Factor Asset Pricing Model to examine how well five known risk factors explain the risk and return of both REITs and private real estate. In his modified model, he looked at three common equity factors – market beta, size, and value – plus fixed income term and credit (default) factors. His study covered the period from 1986–2015.
His findings were surprising. The factor exposure of real estate roughly resembles that of a portfolio consisting of 60% small-cap value stocks and 40% high-yield bonds. This tells us that REITs are not necessarily going to give us something we could not already get by investing in stocks and bonds.
But there’s more to know. One of the study’s most important findings also suggested that real estate risk is primarily driven by the idiosyncratic risk of the real estate sector. This point is crucial to understanding why REITs might not fit into a portfolio as perfectly as presumed. Put another way, Mladina found that REIT returns were explained by priced risk factors, but real estate risk was primarily driven by the idiosyncratic risk of the real estate sector, which is not a priced risk. That is, it is not a risk that you expect a positive return for taking.
More Data Heard From
Let’s recap. The returns of real estate, including REITs, can be explained by exposure to risk factors that we can already get from stocks and bonds. Using real estate to get exposure to those risk factors adds the idiosyncratic risk of the real estate sector, which adds extra risk without an extra expected return.
Mladina also compared his factor benchmark to his chosen real estate indexes along an efficient frontier curve, which charts out the set of optimal portfolios that offer the highest expected return for any given level of risk. He found that none of the real estate indexes earned a spot in the optimal risk-adjusted portfolio, which was dominated by the five-factor real estate benchmark.
This suggests that the most efficient way to gain exposure to these five factors is through a portfolio of stocks and bonds, rather than through REITs.
Mladina’s findings were consistent with those of Jared Kizer and Sean Grover in their 2017 paper Are REITs a Distinct Asset Class? They used a slightly different factor model consisting of the market beta, size, value, and momentum equity factors, plus the term and credit fixed income factors. They also found that REIT returns could be explained by stock and bond factors.
Based on this information, they constructed a portfolio of stocks and bonds designed to match the factor exposure of REITs, using 67% small-cap value stocks and 33% corporate bonds. They found that this stock/bond portfolio produced better general and risk-adjusted returns than REITs.
Real Estate Lessons Learned
Collectively, these studies suggest that REITs do offer exposure to common risk factors with positive expected returns. But stock and bond ETFs offer a more efficient approach to accessing those same risk factors without adding exposure to uncompensated real estate sector risk. Kizer and Grover recommended maintaining something closer to a market-cap weight in REITs.
There are two more reasons an overweight REIT allocation may just weigh you down:
1. Tax-Efficiency. REITs are relatively tax-inefficient. They distribute fairly high income yields, most of which is fully taxable as income – even for Canadian REITs if the income is distributed in a taxable account. And in a tax-free account, any income yield from U.S. or foreign REITs is subject to foreign withholding taxes.
2. Cost/Availability. There aren’t many good REIT products to choose from in Canada. The Vanguard FTSE Canadian Capped REIT Index ETF (VRE) has only 18 holdings and an MER of 39 basis points. The BMO Equal Weight REITs Index (ZRE) has 22 holdings and an MER of 61 basis points. iShares S&P/TSX Capped REIT Index ETF (XRE) has 19 holdings and an MER of 61 bps.
Bottom line, if you want to access the excess exposure to the factors that drive REIT returns, you may consider adding more small-cap value stocks and lower-credit bonds to your portfolio instead:
1. Small-cap value stocks. While it’s not as easy to add this sort of exposure for Canadian or international stocks, it can be readily done with U.S. equities by turning to U.S.-listed ETFs like the iShares S&P Small-Cap 600 Value ETF (IJS) and the Vanguard Small-Cap Value ETF (VBR).
2. Lower-credit bonds. Instead of using a Canadian corporate bond ETF, it might make more sense to seek global bond exposure. Relative to the global market, the Canadian fixed income market has a high concentration in government and high-credit-quality bonds. Adding more global bond exposure offers more exposure to the credit premium without adding the more concentrated risks of the Canadian corporate bond market. We do have options for this in Canada, such as Vanguard’s Global ex-U.S. Aggregate Bond Index ETF (CAD-hedged) (VBG) and U.S. Aggregate Bond Index ETF (CAD-hedged) (VBU). Together, they offer global bond market exposure, hedged to Canadian dollars.
Are you reconsidering whether you should have REITs in excess of market-cap weights in your portfolio?