Real estate is a huge part of the global capital market, but most portfolios have little exposure. Many investors have an undiversified investment in residential real estate by owning a home, but REITs provide a convenient way of gaining broad exposure to many types of commercial real estate. They also help diversify a portfolio’s stock market risk.
Real Estate as a Share of the Capital Market
Modern portfolio theory urges investors to look to “the market portfolio” as the starting point for their asset allocation, based on the assumption that it is the most attractive return/risk portfolio available. However, ascertaining what the market portfolio contains is harder than you might think, particularly for non-traded assets like real estate. Data from many different sources must be gathered, corroborated, and organized to avoid both double-counting and missing components. Estimates of real estate aggregate value vary widely.
The graph above is based on data from Savills World Research, which uses a very broad definition of global real estate. By far the largest component is residential real estate, which comprises 42% of the total. The sum of all three real estate components (in shades of blue above), 1) commercial (8%), 2) agricultural land and forest (7%), and residential (42%) is a whopping 57% of the world capital market.
The problem with using such a broad definition of real estate is that only commercial real estate is usually considered investable.1 Residential real estate is predominantly owner-occupied private homes. While this constitutes a significant portion of personal savings for many people, it is not at all easy to invest in a diversified portfolio of such properties, except through a few real estate investment trusts (REITs).2 Certain equity REITs provide some exposure to farmland3 and forestland4. However, these are very few and their coverage of the market is extremely sparse.
The best recent work regarding the size of and returns for the global market portfolio is from Doeswijik, Lam, and Swinkels. They published a ground-breaking paper in 2012 entitled The Global Multi-Asset Market Portfolio 1959-2011, and have recently updated it with Historical Returns of the Market Portfolio (2017). The graph below uses their much narrower definition of global real estate that includes only institutional investments in equity real estate. They estimate that real estate is only 6% of the global capital market.
So, depending on how broadly you define the asset class, real estate ranges from a low of 6% of the global market portfolio to a high of 57%. It is a bit dated at this point, but in a 2006 paper, Ibbotson estimated that global real estate (using a fairly narrow definition that excluded corporate-owned real estate) was 8.3% of the global market portfolio.5 Using the Savills data cited above, but excluding residential, agricultural, and timberland from the analysis and including only commercial real estate would result in a total real estate weight of 16%. There is no pinpoint “right answer” for how much to strategically allocate to real estate, but an allocation of at least 10% seems well supported.
Real Estate Investing Through REITs
The vast majority of real estate investing is done directly and privately.6 However, the “securitization” of commercial real estate in the U.S. has grown dramatically since the early 1990s. Now all kinds of real estate investments can be made through real estate investment trusts (REITs). A REIT is a company in the business of owning real estate that is exempt from the payment of corporate income tax as long as it adheres to certain rules, including a requirement to pay out at least 90% of net income to shareholders in dividends. REITs often concentrate on one type of real estate, such as office buildings, apartments, or shopping centers. Typically, they own dozens of different properties, and actively manage those properties to maximize shareholder value, performing such functions as acquisition, disposition, lease-up, development, renovation, and onsite management. Senior executives of the REIT are usually large shareholders. REIT shares trade just like common stocks.
But is investing in REITs the same as investing directly in real estate? As the aggregate market capitalization of REITs has grown and more commercial real estate has become securitized, more analysts are concluding that REITs are a very good proxy for all commercial equity real estate. Ibbotson (2006), perhaps the most recognizable authority on the subject, says “Although all investors may not yet agree that direct commercial real estate investments and indirect commercial real estate investments (REITs) provide the same risk-reward exposure to commercial real estate, a growing body of research indicates that investment returns from the two markets are either the same or nearly so…Over long time horizons, [they] should yield similar results because the underlying investments are largely the same.”
While it is true that most U.S. REITs are included in broad equity indices like the S&P 500, their weights remain quite small—less than 3%.7 In order to achieve anything like a global capital market weighting in real estate, it is necessary to have a specific allocation to real estate. For most investors, that will mean investing in REITs and listed real estate stocks.
Historical Diversification with REITs
REITs have been around in the U.S. for a long time. The initial enabling legislation was passed in 1960. However, it wasn’t until the early 1990s that REITs really took off and began to grow dramatically. Since 1990, the FTSE EPRA NAREIT Equity Index (of all U.S. listed equity REITs), has outperformed the S&P 500 and provided a meaningful level of diversification. REITs returned 13.2%, compared to 8.0% for stocks. Over this time period, substituting S&P 500 exposure with up to 30% U.S. REITs would have boosted return (by as much as 1.5%) and lowered risk.
Few analysts would forecast such a significant level of long-term outperformance for REITs compared to the S&P 500 going forward. REITs have smaller capitalizations, lower liquidity, and strong value characteristics, such as high dividend yield, compared to the S&P 500. How those characteristics perform in the market will have a large influence on REIT performance, as well as the distinctive real estate risks that pertain to REITs. A modest level of outperformance for REITs is probably a reasonable expectation, however.
Since most of the risk in U.S. portfolios comes from exposure to U.S. stocks, one objective for strategic asset allocation is to diversify that risk, and thereby lower overall portfolio volatility. The graph above indicates that there was a noticeable diversification benefit on average since 1990. However, the level of correlation between the S&P 500 and the FTSE NAREIT Equity Index has varied considerably, as shown in the graph below. Because the Great Recession of 2008 was a real estate-related event, REITs were particularly hard hit along with stocks—both went down together, sending the correlation through the roof. The opposite occurred during the bursting of the dot-com bubble in the early 2000s. Brick and mortar companies were despised while the bubble was inflating, and they performed particularly well after it burst. Lately, the correlation has settled at around .50, which is considerably lower than the S&P 500 correlation with either small cap stocks (.83) or international stocks (.79). Thus, REITs are providing a much better diversification benefit than either of those two asset classes.
- Real estate is a major asset class, comprising a very large component of the global capital market.
- To have a market weight in real estate requires a special allocation—broad stock indexes do not have enough.
- Many individual investors already have a lot invested in their homes, but very little in commercial real estate.
- Real estate investment trusts (REITs) provide an attractive way to gain exposure to commercial real estate.
- REITs have outperformed the S&P 500 in the past and are likely to modestly outperform in the future.
- REITs provide an excellent diversification benefit of equity market risk—better than either small cap stocks or international stocks.
1 The $32.3 trillion in commercial real estate cited by Savills is mostly private real estate investment, and probably much of it is owner-occupied by companies and government entities. Only a portion of real estate is owned by third-party investors. MSCI estimates that the “professionally managed global real estate investment market” was $8.5 trillion at the end of 2017. Since mortgages are excluded, this would be equity investment in real estate. Only a small fraction of that is “listed” or publicly traded. Cohen & Steers reports a figure of $1.7 trillion for the global REIT market as of 2017.
2 “Single family rental (SFR)” REITs include American Homes 4 Rent (AMH) and Invitation Homes (INVH). There are many apartment REITs, but multi-family residential is generally considered part of commercial real estate.
3 Farmland REITs include Gladstone Land (LAND), Farmland Partners (FPI), and American Farmland (AFCO).
4 Large timber REITs include Weyerhaeuser (WY) and Rayonier (RYN).
5 Commercial Real Estate: The Role of Global Listed Real Estate Equities in a Strategic Asset Allocation, Idzorek, Barad, and Meier, 2006.
6 The tax code historically favored taxable ownership of real estate. Before the 1986 Tax Reform Act, depreciation on real estate could be used to offset ordinary income, providing a strong incentive for taxable investors to own real estate either directly or through limited partnerships. The recent tax law contains provisions favorable to commercial real estate ownership.
7 Seeking Alpha, “New S&P 500 Sector Weightings - What You Need to Know,” Bespoke Investment Group, September 25, 2018.