- Real estate has historically been one of the best performing
global asset classes. Real estate investment trusts,
more commonly known as REITs, are a special type of fund
that invests primarily in income-producing real estate assets. The income that a REIT earns
flows to the unit holders and the unit holders also participate in the capital appreciation
of the buildings. Investing in a REIT gives you access to a liquid diversified
portfolio of real estate assets without the need to manage
anything directly on your own. This makes some of the biggest issues with direct real estate investing, like illiquidity,
management intensiveness, and the inability to properly
diversify, go away completely. Just like with stocks, it is possible to buy a low
cost index fund of REITs. I'm Ben Felix, portfolio
manager at PWL Capital. In this episode of Common Sense Investing, I'm going to tell you how
real estate investment trusts fit into your portfolio. (upbeat electronic music) The first thing that we need to understand in thinking about adding a REIT index fund to your existing portfolio of index funds is that any total market equity ETF will already have an
allocation to real estate. Canadian, US, and
international stock markets have somewhere between 3
and 5% of their total assets in real estate. When we are talking about adding REITs to an existing portfolio of index funds. we are really talking about adding REITs in excess of market cap weight. A major reason for over-weighting
REITs in a portfolio is that REITs are often viewed
as a distinct asset class. If REITs are in fact a
distinct asset class, then adding them to a
portfolio of stocks and bonds should result in a
diversification benefit. This idea of a diversifying asset class seems to be backed up by the
relatively low correlation that REITs have historically
had with stocks and bonds, and by the fact that the returns of REITs are not well-explained
by market beta alone. When considering REITs in a portfolio, it also doesn't hurt that their returns have been pretty great. Going back to July 1989 through June 2019, the S&P Global REIT Index gross div returned 9.24% per year on average, while the MSCI All Country
World Index, also gross div, returned 7.77% per year on
average both in Canadian dollars. The correlation of these indexes
over that period was 0.513, which is low. Combining the two indexes
together in a portfolio seems like a compelling proposition. Let's consider this proposition in the context of the academic literature. If REITs are truly a distinct asset class, we would not expect the known risk factors that explain stock and bond returns to be able to explain REIT returns. In a 2018 paper titled Real Estate Betas and the Implications for Asset Allocation, Peter Mladina studied how
distinct the returns of REITs are from good old stocks and bonds from the perspective
of known risk factors. Mladina used the modified version of the Fama French Five Factor Model to examine how well the risk
and return of both REITs and private real estate investments are explained by known factors. The factors in the modified model were market beta, size, and value, which are equity factors that I've talked about many times before, plus the term and default factors, which are factors that
explain fixed income returns. The study covered the period from January 1986 to December 2015. The findings were surprising. The factor exposure of real estate roughly resembles that of a portfolio consisting of 60% small-value stocks and 40% high-yield bonds. This tells us that REITs
are not necessarily going to give us something
that we could not already get from stocks and bonds. One of the most important
findings of the study is that while stock and bond factors explain the returns of real estate, the risk of real estate
is primarily driven by the idiosyncratic risk
of the real estate sector. This point is crucial to understanding how REITs might fit into a portfolio. Mladina found that the factors that explain the returns of
real estate are priced risks, risks with a positive expected return. They are also risks that we can access through stocks and bonds. While the returns of REITs are explained by these priced risk factors, the risk of real estate
is primarily driven by the idiosyncratic risk
of the real estate sector, which is not a priced risk. It is not a risk for what you would expect a positive return from taking. Let's recap quickly. The returns of real
estate, including REITs, can be explained by
exposure to risk factors that we can already get
from stocks and bonds. Choosing to get exposure
to those risk factors through real estate adds
the idiosyncratic risk of the real estate sector, which is a risk without a
positive expected return. Mladina also compared his factor benchmark to real estate indexes
that he used in the study along the efficient frontier, which is the set of optimal portfolios that offer the highest expected return for a 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 tells us that the most efficient way to get exposure to the
factor returns of REITs is through a portfolio
of stocks and bonds. The findings in Mladina's
paper were consistent with the findings 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 market beta, size, value, and momentum equity factors, and the term and credit
fixed income factors. They similarly found that REIT
returns could be explained by stock and bond factors. Based on this information, Kizer and Grover constructed a
portfolio of stocks and bonds designed to match the
factor exposure of REITs. They accomplished this
using 67% small-value stocks and 33% corporate bonds. They found that the
portfolio of stocks and bonds produced better returns and risk adjusted returns than REITs. This finding is consistent with the idea that REITs are not adding
any expected return in excess of what could be achieved through stocks and bonds, but they are adding
additional uncompensated risk. It is also consistent
with Mladina's finding that REITs would not earn any
allocation in the portfolio that falls on the efficient frontier. The findings from Mladina
and Kizer and Grover suggest that while REITs do offer exposure to common risk factors with
positive expected returns, a more efficient approach to
accessing those risk factors is through stock and bond ETFs, which do not result in exposure to the uncompensated
real estate sector risk. Kizer and Grover recommend maintaining something close to a
market cap weight in REITs. Beyond the fact that
overweight REIT exposure introduces idiosyncratic
real estate sector risk, REITs are also relatively tax inefficient. They distribute fairly high-income yields and most of that income is
fully taxable as income, even for Canadian REITs, when it is received in a taxable account. Even in a tax-free account, any income yield from US or foreign REITs is subject to a foreign withholding tax. Finally, in Canada, there
really aren't that many good REIT products to choose from. Vanguard's FTSE Canadian
Capped REIT Index ETF has only 18 holdings and
an MER of 39 basis points. BMO's Equal Weight REITs
Index has 22 holdings and an MER of 61 basis points. And the iShares S&P/TSX
Capped REIT Index ETF has 19 holdings and an
MER of 61 basis points. If you really want to
access the excess exposure to the factors that drives REIT returns, you may consider adding additional weight in small cap value stocks and lower credit bonds to your portfolio. Adding small cap value
stocks to a portfolio can be accomplished easily for US equities with US-listed ETFs like IJS and VBR. Unfortunately, it is not so
easy to add this exposure for Canadian and international stocks. For more exposure to lower credit bonds as opposed to using a
Canadian corporate bond ETF, it might make more sense to
seek more global bond exposure. The Canadian fixed income market has a high concentration in government and high credit quality bonds
relative to the global market. Adding more global bond exposure offers more exposure to the credit premium without adding the specific risk of the Canadian corporate bond market. In Canada, we do have
some options to do this with Vanguard's VBG and VBU, which together offer exposure
to the global bond market hedged to Canadian dollars. Do you have REITs in excess
of market cap weights in your portfolio? Tell me about your thought
process in the comments. Thanks for watching. My name is Ben Felix of PWL Capital and this is Common Sense Investing. If you enjoyed this video,
please share it with someone who you think could benefit
from the information. And don't forget, if you've run out of Common
Sense Investing videos to watch, you can tune in to weekly episodes of the Rational Reminder podcast wherever you get your podcast. (upbeat electronic music)
