Last November, our US ETF team soured on US REITs and even went so far as to sell them from our asset-allocation model portfolio (published as part of our Morningstar ETFInvestor Newsletter). We decided to sell US REITs for the time being because of the then-imminent real estate crash and debt crisis. With the real estate correction well under way, credit spreads stabilising, and the worst offenders of the debt boom already in bankruptcy, we decided it was time to revisit the asset class and reassess its worth as a diversifier to stabilise our portfolio. Since the adoption of the REIT structure has picked up steam globally during this decade, looking worldwide makes sense as well. Unfortunately, our investigation into the past 40 years of returns from investable US real estate equity did not reveal the promising alternative used in so many “Yale Model”-inspired portfolios. Though 17 years makes for a much less reliable study, we also see little promise from international real estate as a portfolio diversifier.
Although we call it the original alternative, in many ways real estate was simply the original institutional investment. Land was the main store of wealth and the measure of power for centuries before the industrial revolution and its contemporaneous creation of debt and equity markets. As the Dutch were developing the modern corporation in the 1700s, universities and religious foundations managed countless acres of countryside and some of the choicest urban real estate for the rental yields. Equity or debt stakes in wealth-generating companies came to dominate the investable universe through the 20th century, but real estate rents remained an important contributor to the portfolios of institutions large enough to own and manage entire properties. The stability of rents and their fairly low correlations with other investments made land a valuable anchor for those who could afford it.
The great democratisation of real estate investments started in 1960 when the US Congress created the REIT structure, allowing individuals to buy shares of real estate portfolios traded on public exchanges. The concept was followed by Australia a little over 10 years later with the creation of Listed Partnership Trusts (LPTs).
In the first couple of decades, US REITs mostly owned mortgage debt, providing steadier returns at the cost of potential price appreciation. The Tax Reform Act of 1986 allowed REITs to manage their own properties, encouraging a new boom in real estate equity investments to come on the market. Australia mirrored the secular wave of real estate securitisation in the US during the 1990s. Australia's wave was fuelled by the impact of the collapse of the unlisted property trust sector in the early 1990s and the introduction of the Superannuation Guarantee in 1992, which required employers to start paying a proportion of employees' salaries and wages into a superannuation fund.
In theory, these moves should have made real estate returns open to all investors, as they could now buy a portfolio directly invested in buildings and land managed for the rental yields. Instead, we found that the very act of listing real estate on an exchange just made REITs behave like stocks.
The chart below shows trailing three-year correlations between the S&P 500 and the Dow Jones US Real Estate Index, which is tracked by one of the largest real estate ETFs: iShares Dow Jones US Real Estate IYR. This graph uses as much data as possible, going back to the 1992 inception of the REIT index, which means that the first trailing correlation calculations start in 1995. Correlations were positive but fairly low during much of the 1990s and early 2000s. However, as the liquidity boom of the mid-to-late-2000s lifted all boats, correlations between US REITs and US large caps steadily rose until the collapse of the past several months brought them to record highs over 0.80.
The real strike against the diversification benefits of US REITs comes from their high correlation with small-cap value stocks. While the performance of exchange-traded real estate and the S&P 500 diverged massively in the early 2000s, REIT returns maintained a fairly high correlation with the Russell 2000 Value Index. This shows the early-decade diversification benefits of REITs came almost entirely from avoiding the tech boom and bust. Going back to the early 1990s, correlations of 0.80 with small-cap value have hardly been unusual, and today we have seen trailing correlations over 0.90 in the past three years.
If we use the older FTSE NAREIT All REITs Index, we can extend our analysis as far back as 1972. When we do so, we find that the recent high correlations are not a one-time event. REITs also provided little diversification during the bear market and spiking interest rates of the late 1970s and early 1980s, with correlations against the S&P 500 averaging close to 0.80. As interest rates fell in the late 1980s and early 1990s, real estate equities once again closely tracked the US market as a whole. During those two periods, correlations between REITs and the Russell 2000 Value Index stayed between 0.80 and 0.90 for years on end.
The second chart displays trailing three-year correlations between the MSCI EAFE and S&P Developed Ex US Property Index, which is tracked by the largest foreign real estate ETF, the SPDR Dow Jones International Real Estate ETF RWX. We use the same time period as in the first chart. Here, not only do we also see a rising correlation similar to the US analysis but we do not find any period in which the correlation significantly drops. In other words, we have yet to see a period where diversifying an international portfolio into international real estate offers a tangible benefit.
Thus, while real estate might diversify an institution’s portfolio, we can’t say the same for REITs in an individual investor’s portfolio. With higher cost of debt likely weighing down real estate equity returns in the coming years, we are no longer convinced that REITs provide enough diversification benefits or return prospects to make up for the risk of holding them.
Disclosure: Morningstar licenses its indices to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indices.
