The Intelligent REIT Investor Guide. Brad Thomas
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href="#ulink_294fd648-8b44-5fbe-92cf-889feab7c0de">Figure 1.1
Source: Nareit website.
Admittedly, that makes them sound indistinguishable. So here's the difference: REITs enjoy largely unique benefits that include merely modest correlation with other asset classes, less market price volatility, more limited investment risk, and higher current returns – each of which we'll look at next.
Lower Correlations
Correlations measure how much predictive power the price behavior of one asset class has compared to another. So if we want to predict what effect a 1% rise (or fall) in the S&P 500 will have on an investment category – REITs, stocks, small caps, bonds, and so on – for any particular time period, we look at their relative correlations.
For example, if the correlation of an S&P 500 index mutual fund with the S&P 500 index is perfect (written out as 1.0), then a 2% move in the S&P 500 would predict a 2% move in the index fund as well. On the opposite end of the range, correlations can trend down to −1.0, in which case their movements are completely opposite. And in between is 0.0, which suggests no correlation at all.
This concept is important in the investment world, since it allows financial planners, investment advisers, and individual or institutional investors alike to structure broadly diversified investment portfolios with the objective of having the ups and downs of each asset class offset each other as much as possible. This ideally results in a smooth increase in portfolio values over time, with much less volatility from year to year or even quarter to quarter.
Cohen & Steers Senior Vice President and Global/U.S. Portfolio Manager Laurel Durkay – along with Senior Vice President and U.S. Senior Portfolio Manager Jason Yablon – gave some interesting insights on the subject in their September 2020 publication, “How REITs Benefit Asset Allocation.”
They noted, “REITs have historically served as effective diversifiers, as they tend to react to market conditions differently than other asset classes and businesses, potentially helping to smooth portfolio returns.”
They also wrote that “share aspects of both stocks and bonds – responding to economic growth like equities, but with yields and lease‐based cash flows that give them certain bond‐like qualities.” In addition, they're “subject to real estate cycles based on supply and demand, with the added stability of commercial leases. And they tend to be more sensitive to credit conditions due to the capital‐intensive nature of real estate.”
The co‐authors add that “these distinct performance drivers” have actually resulted in “low long‐term correlations with stocks and bonds. Since 1991, U.S. REITs have had a 0.57 correlation with the S&P 500 and a 0.21 correlation with U.S. bonds (see Figure 1.2). Global REITs have also exhibited diversifying correlations, albeit to a more modest degree, due largely to higher correlations of Asia's real estate market with both [Asian] and U.S. equities.” (See Figure 1.3.)
Accordingly, in markets where stocks are rising sharply, REITs may lag relative to the broad stock market indexes. This happened in 1995, when REIT stocks underperformed comparatively speaking while still providing investors with 15.3% total returns. And it happened again in 1998 and 1999, when their returns were actually negative. Conversely, during many equity bear markets – such as 2000–2001 – lower correlating stocks such as REITs tend to be more stable and may suffer less.
Source: Cohen & Steers.
Source: Cohen & Steers.
Durkay and Yablon add that “sudden changes in bond yields can have a meaningful influence on short‐term REIT performance. However, such periods tend to be temporary. In the long run, REIT returns are driven primarily by the distinct cash flows and growth profiles of the underlying property markets and the added stability of leases [that provide] the potential diversification benefits of an allocation to real estate.”
Bottom line: Correlations will vary over time, particularly during short time frames. However, because commercial real estate is a distinct asset class with distinct attributes, it's reasonable to expect REITs to maintain fairly low relativity to other asset classes over reasonably long time periods.
Lower Volatility
A stock's volatility refers to how much its price tends to bounce around from day to day or even hour to hour. Over the past four decades or so, REITs have proved to be less volatile than other equities on a daily basis. This has even been despite their increasing size and popularity, which has brought in new investors with different agendas and shorter time horizons.
Another factor that usually helps tamp down on such issues is REITs’ higher dividend yields. When a stock yields next to nothing, its entire value is comprised of all future earnings, discounted to the present date. If the perceived prospects for those earnings decline even just slightly, the stock can plummet. However, much of a REIT's value is in its current dividend yield. So a modest decline in future growth expectations will have a more muted effect on its trading price.
It's true that their volatility spiked from 2007 through 2009 due to concerns about their balance sheets and the American economy. And in 2020, the Covid‐19 pandemic also caused significant REIT volatility, though shares still didn't fall as hard as they did in 2008. This is because most of them were already reducing leverage and building up access to capital to strengthen their liquidity, which helped them immensely.
On the larger issue of volatility, Cohen & Steers adds, “At its Core, real estate exists to support basic needs of individuals and businesses, providing shelter and facilitating commerce.” And there will always be demand in that regard. It's only a matter of whether those needs are “housed in a different form or location,” or reflect “current preferences, such as residents moving from multifamily apartments in dense cities to suburban single‐family homes.”
Investment trends can change quickly and unexpectedly. In some years, REIT stocks will be very popular; in others, they'll be all but ignored. Admittedly, some “trends may be more permanent: accelerated e‐commerce adoption driving demand for industrial/logistics at the expense of retail.” Some examples include “greater reliance on digital infrastructure benefiting data centers and cell towers” and “increasing acceptance of work from home affecting office utilization.”
The rise of hedge funds – including those with very short time horizons – has added another wild card to the deck. REITs can sometimes become the sandbox in which these funds like to play, bringing more volatility with them than there otherwise would, or should, be.
The reason I bring this up is because it's important to know what can cause volatility in the stocks we purchase, REITs or otherwise. When our stocks go up, it's too easy to ignore risk in our pursuit of ever‐greater profits. And when our stocks drop, we too often tend to panic, dumping otherwise sound investments because we're afraid of ever greater losses.
Consider missed market expectations, which can play havoc on otherwise stable stocks. Let's say you own shares in a “regular” company that reports a 15% year‐over‐year increase in earnings. Yet because analysts expected a 20% increase, the stock drops. That scenario has played out