Is There Any Diversification Benefit At All?

For decades, when investment advisors talked about “diversifying your portfolio to include real estate,” they typically meant adding REITs to your stock portfolio.

Don’t get me wrong, real estate investment trusts (REITs) have their advantages. They’re extremely liquid and easy to buy or sell with the click of a button in your existing brokerage account. And you can invest for the cost of a single share, which could mean investing $15 instead of $50,000.

But do publicly-traded REITs offer true diversification from the stock market at large? Perhaps not as much as you’d like to think.

What are REITs?

Real estate investment trusts are companies that either own real estate investments or loans secured by real estate. In fact, to qualify as a REIT under IRS code, the company must earn at least 75% of its gross income from real estate in some way, and at least 75% of its assets must be real estate-related, among other more technical requirements.

As the names suggest, equity REITs own properties directly, and mortgage REITs own debts secured by real property. Hybrid REITs own both.

REITs typically specialize in one real estate niche. For example, a REIT might focus exclusively on self-storage facilities, or on multifamily properties in gateway cities, or a hundred other niches.

Some real estate crowdfunding companies offer private REITs sold directly to investors. But most REITs trade on public stock exchanges.

That subjects them to the same volatility and violent mood swings as the stock market at large. Prices can crash in a single day, even if the underlying real estate assets haven’t budged in value. But we’re getting ahead of ourselves.

REIT Rules

As outlined above, companies must earn the overwhelming majority of their income from real estate to qualify as a REIT.

REITs must also pay out at least 90% of their taxable income in the form of dividends. In practical terms, that means they usually pay high dividend yields but sometimes see limited share price growth since they can’t reinvest profits into growing their portfolio.

There are other rules that apply to REITs, such as being governed by a board of directors and having at least 100 shareholders after the first year, but I can feel the yawn starting now, so we don’t need to dwell on them.

So why would a company jump through all these hoops to qualify as a REIT? Because they get special tax treatment: they pay no corporate taxes on money distributed to investors as dividends. As a result, many REITs payout 100% of their earnings to shareholders and pay no corporate taxes at all.

REIT Returns

Real estate investment trusts have actually performed pretty well over the past half-century.

From 1972-2022, U.S. REITs delivered an average annual return of 11.26%. That’s comparable to the S&P 500, with its average annual return of 11.98%. Both figures include dividends and price growth, and both are just a mathematical average of annual returns, not the more accurate compound annual growth rate (CAGR).

So where’s my beef with publicly-traded REITs, if not their returns?

The Correlation Between REITs and Stocks

The trouble with REITs is that they offer little diversification from the stock market. They’re too closely correlated.

A Morningstar study over nearly two decades found a correlation of 0.59 between U.S. REITs and the broader U.S. stock market. If your middle-school math needs a little dusting off, a correlation of 1 is lockstep, while a correlation of 0 means no connection whatsoever.

A correlation of 0.59 between real estate stocks and the larger stock market is similar to other sectors of the economy. For example, telecommunications stocks share a 0.62 correlation to the broader market. The correlation for consumer staples is 0.57, and energy stocks are 0.64. You could even think of REITs as one more sector within your broader stock portfolio.

Just take one look at this chart and tell me the correlation isn’t clear:

Why does the correlation matter? Because it means a stock market crash also sends your REITs tumbling. Eggs and baskets and all that.

Consider that in 2022, the average return on U.S. REITs was -25.10%. Yes, you read the minus symbol correctly—they lost over a quarter of their value. Meanwhile, the average U.S. home price rose 10.49% in 2022.

That’s quite a disconnect. This is precisely the point of diversifying into different asset classes: when one collapses, you can hopefully still collect strong returns on another. That particularly matters to retirees, who depend on their investment returns to pay their bills.

In fact, that figure for residential property prices doesn’t include the income side of real estate returns. Good rental properties often earn a cash-on-cash return of 8% or higher, and short-term rental yields can be even higher in the right markets. When I’ve compared long-term and short-term rental returns on Mashvisor, I sometimes see yields as high as 12% on Airbnb rentals.

Alternatives to Public REITs

If you want a lower correlation between your stock and real estate investments, you need to go further afield than publicly-traded REITs.

Consider the following alternatives to get the benefits of real estate along with true diversification.

Private REITs: You can invest in non-traded REITs through crowdfunding platforms like Fundrise and Streitwise. Do your own due diligence, but at least they share little correlation with stock markets.
Non-REIT Funds: Not all real estate funds meet the legal definition of a REIT. For example, Groundfloor offers a fund of property-secured short-term loans with full liquidity and no discernible correlation to the stock market, called Stairs.
Fractional Ownership in Rentals: Platforms like Arrived and Ark7 let you buy fractional shares in single-family rental properties for $20-100 apiece. You collect rental income in the form of distributions, and get your share of the profits when the property sells.
Real Estate Syndications: Syndications offer fractional ownership in commercial properties, such as apartment complexes, mobile home parks, self-storage facilities, and more. As a downside, they typically require high minimum investments, usually $50-100K. But some real estate investment clubs like mine help investors pool their money to invest with less.
Direct Ownership: There’s always the old-fashioned way: buying properties yourself. But again, that often requires $50-100K in a down payment, closing costs, repair costs, cash reserves, and the like. It makes it hard to diversify your real estate portfolio.

Should You Invest in REITs?

Far be it from me to tell you how to invest. If you prize liquidity above all else and want to get started with a few real estate-related investments for $100, buy a few REIT shares.

I personally want my real estate investments to counterbalance my stock investments. I don’t need liquidity from my real estate holdings—I already have liquidity in my stocks.

In fact, I invest in real estate as an alternative to bonds in my portfolio. It serves most of the same functions: diversification from stocks, passive income, and low risk of default. Real estate also provides better protection against inflation, and while it might dip 5-10% in value, it can’t drop 100% (like bond values can if the borrower defaults or declares bankruptcy).

You invest the way that’s best for you. I’ve found my own happy place, a balance between passive real estate syndications and diversified stock funds from across the world.

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