REITs can offer solid gains, diversity

Real estate investment trusts keep surprising investors with their strong performance.

So far this year, they have continued the solid gains they have shown over the past five years. By Feb. 17 they were ahead 8.8 percent since the start of the year, as measured by the NAREIT Equity Index, compared with a gain of only 3.9 percent for the broad market, as measured by the Russell 3000 Index.

But behind the strong gains lurks a concern among some investors that something has to give. They remain fearful that a crash – or at least a slowdown – in the residential real estate market in the wake of higher interest rates would harm REITs.

Their concern is understandable. After all, both market segments have the words “real estate” in their names. But that is where the comparison stops. Residential real estate and real estate investment trusts are different entities and are not necessarily linked.

Many investors include REITs in their portfolios because historically they have often moved differently than the overall stock market. They have zigged when the others have zagged. That has made them good diversifiers. For example, REITs delivered a return of 12.1 percent in 2005, whereas U.S. equities, as measured by the Russell 3000, achieved a return of 6.1 percent.

But the belief that a downturn in prices in the residential market will necessarily harm REITs is a myth of real estate investing.

Although a crash in residential housing prices could have a broad impact on the economy, it is important to remember that REITs invest primarily in shopping malls, office buildings, industrial and apartment buildings, not in the residential market. These property sectors react to different factors than the residential market. Although interest rates do play a role, many other factors influence the health of these property sectors.

Indeed, in the case of apartments, demand for apartment rentals might rise if mortgage rates rise. The reason: The number of people attracted to buying their own homes might drop in the wake of higher rates. Those people might then turn to renting, boosting that sector.

In addition, although prices have risen considerably in the commercial real estate market, the increases are not as strong as those in the residential market.

Another myth is the belief that the significant oversupply of commercial real estate in the late ‘80s and early ‘90s shows that REITs are riskier investments than stocks.

This isn’t necessarily so — at least not based on the historical record. If the downturn experienced more than a decade ago is a reminder that real estate investment trusts can fall in value, it is a good reminder. But the worst one-year return registered historically by REITs between 1980 and 2004 was a fall of 17.51 percent in 1998. The worst three-year return over the same time was a 1.82 percent drop from 1997-99.

Can it be worse for real estate investment trusts now than it was then? Sure, but many worst-case scenario factors would have to come together to create a real estate market worse than the late 1980s and early 1990s. And, to put matters in perspective, the worst one-year fall in the broad U.S. stock market since 1980 was a 21.54 percent decline for the Russell 3000 Index in 2002. The worst three-year return recorded by the index over that time was a fall of 13.7 percent from 2000 to 2002.

REITs should be a long-term investment that serves as a diversifier to stocks and bonds. Investing long term also enables an investor to take advantage of the dividends that REITs pay and that help to buffer price declines. If historical trends hold, REITs might deliver long-term returns somewhere between those of stocks and bonds – although there is no guarantee that will occur. Sure, we may see negative returns. But a crash in the context of a bubble is unlikely.