Mindfully Investing focuses on the three mainstream investments of stocks, bonds, and cash.  I thought it would be worthwhile to add some information on so-called “alternative investments”.  Two of the most popular alternative investments are gold, which I covered in a recent post, and real estate, which I’ll discuss in this post and my next post.

It’s funny that people think of real estate as an “alternative investment” when 64% of U.S. families own a home, but only 54% of the U.S. population owns stocks.  For philosophical reasons, many people don’t like to think of their current or future home as an investment.  Even if we ignore home ownership, real estate is still one of the most common investments.  For example, 10 of the 18 portfolios suggested by finance big-wigs and analyzed at Portfolio Charts have substantial allocations to real estate.

Real Estate as Investment

Home ownership philosophies aside, an investment is almost anything you purchase that you expect to generate income or appreciate in value.  That definition fits the money down and monthly loan payments on a home (the purchase) and the potential for capital gains when a home is later sold (appreciation).

Further, ignoring the large amount of capital tied up in your home could distort your investment plan.  I’ve described my family’s investing portfolio as 80% stocks and 20% cash, with the cash allocation shrinking as my retirement progresses.  But in reality, it’s more accurate to say our portfolio is 65% stocks, 15% cash, and 20% real estate, because we own our main home, a rental property, and a vacation condo.  These last two properties are clearly investments, because the rental pays regular income and both could produce a capital gains when we sell them.

Although many of us have no plan to move out of our main homes, failing health will eventually force many of us into assisted living or the like.  Selling a main home is certainly an option for meeting those future expenses.  Further, many people’s retirement plans explicitly include using home equity through a reverse mortgage, downsizing, or moving to a region with cheaper real estate prices.  So, I think it’s mindful for most investors to include all of their investments in their long-term retirement plans including their main home and any other real estate.

Real Estate Investing Options

Beyond a main home, you can invest in real estate dozens of different ways, which I’ll lump into two broad categories.

Real Estate Investment Trusts (REITs) – REITs are companies that own, operate, or finance income-producing real estate in a range of property sectors.  Most REITs issue publicly-traded stock that you can easily buy and sell like any other stock, including in mutual funds or Exchange Traded Funds (ETFs) that contain the stocks of many REIT companies.  And just like any other stock, you can make money on REITs through both dividend payments and price appreciation.  There are many kinds of REITs that I won’t go into here, some of which are not publicly traded.

Traditional Real Estate – Traditionally, buying real estate means buying a property with a physical address, or part of such a property, or a part of many such properties.  The property could be houses, rental properties, vacant land, farms, part of buildings like a condo, whole buildings, or drive-in theaters for that matter.  I’ll get into more details on traditional real estate and rental properties in my next post.

For the rest of this post, I’ll focus on REITs.

Should You Invest in REITs?

Because REITs are a particular type of stock, it makes sense to evaluate REIT stocks like any other stock.  The main reason to hold different types of stocks is for diversification.  The most mindful way to invest in stocks is to avoid the idiosyncratic risks associated with individual stocks and instead buy baskets of stocks in the form of funds.  Although diversifying your stock fund types is no silver bullet, it may sometimes reduce portfolio volatility or slightly increase returns as compared to less-diversified approaches.  Diversification offers greater potential benefits when the stock types involved are relatively uncorrelated or negatively correlated.

Correlation – What are the recent correlations between REIT stocks and the rest of the stock market?  This graph from Ben Carlson shows the rolling 3-year correlation between REITs and U.S. stocks since 1980.

In this time, the correlation between REIT stocks and all U.S. stocks was mostly between about 0.2 and 0.9, with a brief excursion into barely negative territory around 2001.*  And as I like to point out, correlations often increase exactly when you hope diversification will come to your rescue.  Thus, the REIT correlation with other stocks was highest during the 2008 financial melt down, when almost all asset prices were plunging in unison.  While these correlations show that REITs have provided some sporadic and moderate diversification to a stock portfolio, they also suggest we should be skeptical of claims that REITs are “heavily non-correlated” with stocks.

Returns and Volatility – The other stock measures we typically examine are returns performance and volatility, with returns being by far the more important of the two.  This graph compares the performance since 1994 of U.S. REITs (blue line Portfolio 1), the entire U.S. stock market (red line Portfolio 2), and a 50/50 mix of REITs and U.S. stocks (gold line Portfolio 3) as provided by Portfolio Visualizer.

And here are the return and volatility metrics over this time.

Stock Type	Annualized Return (CAGR)	Volatility (St.Dev.)	Best Year	Worst Year	Maximum Drawdown
REITs	9.3%	19.3%	35.7%	-37.1%	-68.3%
US Stocks	9.3%	14.9%	35.8%	-37.0%	-50.9%
50/50 REITs and Stocks	9.3%	15.5%	33.4%	-37.0%	-59.5%

Although they took different paths along the way, both the REIT and U.S. stock portfolios ended up with the same annualized return of 9.3%.  But REITs were more volatile, including an absolutely stomach-churning maximum drawdown of more than two-thirds of the portfolio value.  And this happened right when many folks were hoping that property values would rescue them from the quick sand of the 2008 financial crisis.  The combined 50/50 portfolio had lower volatility than the REIT portfolio, but the all-stock portfolio still had the best combined metrics for this period.

I’ve always cautioned against putting too much weight in any single comparison of assets over a set time frame.  Ben Carlson likes to say you can win any argument about markets by simply changing the time frame of the analysis.  The above graph shows that REITs underperformed stocks from 1994 to 2003, outperformed from 2003 to 2007, outperformed again from 2009 to 2016, and then underperformed in the last couple of years.  But over the total time that REITs have figured prominently in the stock market, having REITs in your portfolio produced negligible long-term benefit.  Of course, the next 25 years could turn out completely different, and it’s entirely possible that adding some REITs today might help your stock portfolio weather some unexpected storms tomorrow.

Other Factors – Depending on your income bracket, one disadvantage of REITs is that their dividends are usually taxed as ordinary income, while other stock dividends are most often taxed at the relatively low rate of 15%.  However, the 2017 tax reform reduced taxation of REIT dividends in at least a couple of other important ways.  Further, the dividend yield from REIT index funds is often higher than the yield from comparable broad-market stock index funds, which means you won’t necessarily net a lower “take home” dividend from your REIT index fund.  And of course you can invest in REITs through a tax-advantaged account, where these tax differences are mostly irrelevant.

If you intend to add REITs to your stock portfolio, make sure you account for your current amount of REIT exposure first.  For example, a U.S. all-market stock fund like VTI from Vanguard already holds about 4% in REITs.  So, if your portfolio contained only VTI, and your goal was 10% REIT exposure, you would only have to add 6% in REIT funds to reach that goal.

Conclusion

REITs offer convenient exposure to real estate using low-cost index funds.  In recent history REITs haven’t acted that independently or performed that differently from the overall stock market.  To the extent you see value in diversifying across different stock sectors, REIT stocks may be a solid part of your investing plan.  But adding some REITs to your portfolio is certainly no guarantee that you’ll get consistently better performance or protection from the next market downturn.

Before you add REIT funds, be sure to correctly assess your overall exposure to real estate by including in your calculations any REIT exposure from your existing stock funds, your main home, and any other traditional real estate holdings you may have.  For many folks, their main home represents a huge investment that, by itself, often provides enough allocation to real estate.

My overall portfolio includes about 20% in traditional real estate holdings, not counting the small REIT exposure from the broad-market index funds I own.  So, I don’t feel that I need any more exposure to real estate from REIT-specific funds.

I’ll discuss the pros and cons of, and reasonable portfolio allocations to, traditional real estate in my next post.

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* Positive correlation of +1 means that two stocks (or funds) move together in lock step; they are “highly correlated”.  A correlation of 0 indicates that one stock moves randomly with regard to the other; they are “uncorrelated”.  A negative correlation of -1 means that the two stocks move exactly the opposite of each other in equal amounts; they are “negatively correlated”.