REITs (and REIT index funds in particular) are a good diversifier of performance within an index portfolio. Here are four reasons why adding a “separate slice” to REITs might be a good idea.
Real estate investment trusts (REITs) are companies that own and normally operate real estate properties that generate income from leases and financing of property purchases. If you already own a U.S. Total Stock Market Index fund, you already own them, as they trade on stock exchanges like the rest of the stock market.
In fact, many index investors do not own a separate REIT fund because the total market index already provides the “market weight” for them, and to own more would be a sector bet, not passive investing. Another argument against is that homeowners are already overweight in real estate based on their home equity, and that the volatility of REITs is higher than the rest of the stock market.
I take an opposing view for four reasons:
(1) The U.S. real estate market is far larger than the representation given in the stock market index, and is therefore under-weighted in investor portfolios. Rick Ferri looked at this question in an article “REITs and Your Portfolio.” He found that: “US Equity REITs have a market capitalization of about $605 billion according to FTSE NAREIT. This is about 3% of the total US stock market of which the REIT market is a part of. Commercial real estate represents about 13% of the US economy.”
(2) The home is not an investment. Everyone has to live somewhere, and so one’s home should not be included in an asset allocation. Even if you did include it, it is a single concentrated investment in residential real estate, and it excludes other types, such as apartments, shopping malls, hotels, etc. These are excluded without an additional investment in REITs.
(3) REITs have unique tax advantages, making them a unique asset class for investors. They currently have a high correlation to the stock market, and critics use this to say over-weighting REITs is a sector bet, but correlations are not static, and there are times when REITs perform differently than stocks. REITs are required by law to pay out 90% of their income directly to investors via dividends. In return, the REIT can deduct the the income and avoid paying income tax, while that income is taxed against the investor’s income from the dividends. Since investors should only hold REITs in tax-advantaged accounts, their tax is deferred until needed for retirement withdrawals, at which time it is taxed as ordinary income (or not at all if it is a Roth account, funded with after-tax dollars).
(4) REITs are interest rate sensitive. Why is this an argument for adding REITs? Because during times of high inflation, you will have a larger than normal income stream funded by underlying rents that can be increased to keep up with inflation. This means that REITs are, to an extent, indexed for inflation, again due to its unique tax status. While stock dividends can serve this purpose, it is much more direct with REITs.
As explained in the slice and dice part of Seven Simple Steps to Investing, a REIT index fund (and you should use only REIT index funds, not single REITs) should be no more than 25% of your domestic stock allocation. So, if you have 60% in equities, and the U.S. portion of equities is 40% of the total portfolio, REITs should be no more than 10%. Since 3% is already in the Total Stock Market index fund, you might want a REIT index fund holding at no more than 7% (of the total portfolio), in this example.
Will a 7% slice of stocks tilted to REITs make an actual difference going forward? I have no idea, and if someone tells you they do know, run for the hills. I will say it is a valid approach to indexing, and the decision not to add a separate slice to REITs, while not my choice, is also valid. In the words of John Bogle:
“Simplicity is the master key to financial success. When there are multiple solutions to a problem, choose the simplest one.”