- 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)