Real Estate Investment Trusts (REITs, pronounced “reets”), which invest in and manage commercial real estate such as office buildings, shopping malls and apartment buildings and distribute most of their income to shareholders, have risk-return characteristics different than those of stocks and bonds and thus provide valuable diversification benefits in a portfolio. But, there is a variety of opinion on how much REITs (if at all) should be added to a portfolio.

In his book, Unconventional Success, David Swensen makes a strong case for adding REITs to a portfolio. Noting that REITs have characteristics of both fixed-income (due to the regular rents paid by the tenant as per the lease agreement) and equities (due to the renewal risk as leases approach expiry), Mr. Swensen suggests a 20% allocation to real estate in his generic portfolio that has 70% in equities (including real estate) and 30% in fixed income.

The Intelligent Portfolio (review), on the other hand, advises caution on REITs. The author, Christopher Jones, points out that stock owners already have exposure to real estate as large public corporations own most of the commercial real estate in the U.S. Given the short history of REITs, he is not convinced that they provide “meaningful” diversification and points out that home owners already have enough real estate in their household assets. In Canada, REITs are included in the TSX Composite Index and corporations such as Brookfield Asset Management (TSX: BAM.A, NYSE: BAM) are heavily invested in real estate. Due to his misgivings, Mr. Jones suggests that investors allocate no more than 10% of their total assets to REITs.

Due to the conflicting messages, I wondered what William Bernstein had to say about REITs. Here’s what he writes in The Four Pillars of Investing (review): “But with some trepidation, I think that there are two sectors worth considering: REITs (real estate income trusts) and precious metal stocks” and concludes that “the maximum exposure you should allow for this asset class is 15% of your stock component”.

In my personal portfolios (and my benchmark Sleepy Portfolio), I have allocated 5% of the total value to REITs but don’t have a good rationale for that specific number (other than it is the minimum allocation to any asset class in the portfolio). Canadian investors can get exposure to REITs through the iShares CDN REIT ETF (TSX: XRE). The XRE is also a prime candidate for unbundling the ETF and directly investing in the underlying securities as the MER for the ETF is a bit on the higher side.

If you are sold on the merits of adding REITs to your portfolio, now may not be a bad time to do so. After providing double-digit returns for many years, REITs are now well off the previous highs and trade at an estimated 15% discount to net asset value (Source: TD Securities) and yielding an average of 7%, a spread of 2.75% over 10-year bonds.

This article has 21 comments

  1. I just bought some RioCan which is about 4% of my portfolio.

    I think I will buy more REITs in the future (possibly VNQ) but I can’t see having more than 10% REIT allocation.


  2. I subscribe to the Jones argument that many investors (particularly homeowners) have adequate exposure to real estate without having to invest in REITs.

  3. I do not think that 1 residential property is sufficient exposure to real estate for any investor. (In fact, I would say that an argument could be made for not viewing a primary residence as part of an investment portfolio). There is a substantial difference between the performance of commercial and residential property through a market cycle, and surely diversifying across different types of properties in different locations is sensible, and this is easiest achieved through a REIT.

  4. Interesting since I’ve always tried to hold a REIT, even when it tanked on me last year. I didn’t lose money on it because the previous 3 years were so good. But I also never held more than 10% in my old 401k. I did like the regular dividend it paid out. That’s what kept it a positive ROI, even when the NAV tanked.

    I stayed out of them for a while and now I’ve jumped back in on them, but only at 5% of my current 401k’s contributions, which means it’ll be less than <1% of my current portfolio for a while.

  5. Your place of residence should not be considered part of your investment portfolio.

  6. I’ve always avoided income trusts as I couldn’t wrap my head around how they operate. Seems a REIT, a specific type of income trust, may be more of a bond substitute than a stock substitute. I keep my entire portfolio in stock equities. I figure it may have extra volatility, but the return should also be higher, long term.

    I wouldn’t criticize anyone who chose to invest in REITs, and I also am not currently interested in buying any. I do agree that a primary residence shouldn’t be considered an investment. However, it’s a store of equity, so perhaps it’s a special type of asset.

  7. I’d have to agree with NN and Pragmatic. My primary residence isn’t considered part of my portfolio. However, if I had an additional rental/income property, I would buy the argument that no further investment is necessary.

  8. Canadian Capitalist

    Mike: I’m not sure if I’ll ever add US or foreign REITs to our portfolio. The current allocation to REITs is only 5% and the valuations on Canadian REITs seems to be better.

    Dillon, NN: I don’t count the family home as part of my portfolio and think there is merit in adding REITs to a portfolio. Still, I have allocated just 5% to this asset class.

    mapgirl: I waited till earlier this year to pick up REITs. The valuation seems reasonable these days (discount to NAV estimates, spread over bonds etc.).

  9. 5-10% should be the most you want to allow to reits.

    My personal opinion is that they do not have a good rate of return.

  10. It all depends upon what you are investing for… If you are investing for capital gains, then real estate including REITs have historically only barely kept pace with inflation – in which case REITs are NOT for you. If you are investing for yield (income), then REITs should form the core of your portfolio – along with dividend paying banks and insurance companies.

    For me personally, I invest for yield, so I love REITs and I currently have 14% of my total portfolio in REITs and another 7% of my total portfolio in real estate companies structured as corporations instead of income trusts.

    Unfortunately, as a yield hungry investor, I was also whalloped by our government during the Nightmare on Halloween a couple years ago… So what do I know?

  11. Phil S: Very true, except that a capital gain that keeps pace with (or beat) inflation, added to a recurring distribution (that should also keep pace with inflation, at least) results in inflation beating returns (hopefully you use a tax efficient vehicle for REIT’s such as a RRSP?) The high yield nature of REIT’s should make them more popular with yield hungry investors, such as retirees and yourself. Personally, I prefer real estate because it is a tangible asset, unlike much of the ‘value’ in bonds and stocks. Investing during times of apparent discount to NAV (i.e. now) should also increase the likelihood of beating inflation with REIT’s.

    I have some doubts about the utility of the risk/return basis for asset allocation, as the variance/covariance matrix of asset classes can deviate considerably over the medium term from the long term average. Added to that, the only risk I am willing to consider for my investment portfolio, is the risk of underperforming inflation over the long term. Volatility is nothing to the investor still building his portfolio (it can, of course, hurt the retiree or investor living off his investment returns) Therefore, I am quite keen on replacing cash and bonds in my portfolio with real estate.

    CC, I would like to hear your thoughts on this.

  12. Canadian Capitalist

    Moneymonk: REITs don’t have a long history but data from 1978 to 2003 quoted in Unconventional Success shows that REITs returned 12% compared to 13.5 for the S&P 500 and 8.7% for intermediate Treasury bonds. I don’t know where you are getting the “do not have a good rate of return” comment from.

    Phil: Looks like you are taking Swensen’s recommendation to heart!

    NN: I agree with you that long-term investors should be most concerned about inflation. Bonds are not very attractive holdings as their expected real returns is quite low. But I think a little bit of short-term bonds (20% in my portfolio) serve as a hedge against financial distress or unexpected deflation. Volatility doesn’t faze some people, it terrifies others. The benefits of stocks accrue only if an investor has the fortitude to withstand periods of terrifying losses. Bonds could provide ballast to get through such periods. Whether investors want to give up a little return for these benefits is a personal choice.

  13. I recently bought H&R REIT and it is doing quite well. Capital gains plus a 8% yield sounds pretty good to me. Plus I think commercial real estate is much safer than residential.

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  15. I totally agree with Phil S that REIT’s are a great way to generate dividend income because they offer a nice yield as well as the opportunity to increase their payment to shareholders.
    But at the end of the day aren’t REIT’s a type of stock asset, not a completely different asset class. In other words if you treat REIT’s as a separate asset class ( although they are stocks), then financial stocks, utility stocks, telecom stocks and all the stocks in gazillion other sectors should be asset classes.

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  18. Canadian Capitalist

    DGI: What’s an asset class? David Swensen defines it as a “combination of securities that collectively provide a reasonably well-defined contribution to an investor’s portfolio”. REITs can’t be grouped with equities because they “contribute diversification to a portfolio with lower opportunity costs than fixed-income investments”.

    REITs are quite different from equities in the sense that: (1) their returns are not correlated (2) Most of the returns is in the form of current income (3) Their returns are expected to be lower than equities and higher than fixed-income (4) The volatility of returns are less than equities and more than fixed income (at least, according to Swensen).

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