Uncover REITs' Diversification Benefits

Many investors are quickly realizing that real estate investment trusts (REITs) are 1 of many effective methods to diversify a modern investment portfolio. REITs were created by Congress in 1960 to give the small investor an easier method to invest in real estate, by combining the capital of many investors and letting the REIT company invest this money in real estate ownership and finance. The REIT company owns and, in most cases, operates income-producing real estate, such as apartments, shopping centers, offices, hotels, and warehouses. Some REITs also engage in financing real estate.

Advantages to Consider

REITs are traded in the same manner as stocks on the open market, and there are also REIT mutual funds that operate and trade in the same manner as other mutual funds.

REITs offer the following 3 important qualities to today's investor:

• Marketability—Over the years, the REIT marketplace has grown to a size that allows a variety of choices for most investors. There are 3 main REIT sectors: equity REITs (ie, those that own and manage property), mortgage REITs (ie, those that engage in real estate finance), and a smaller number of hybrids that do both. With over 200 real estate companies operating in the 3 main sectors, there are plenty of options available.

• Security—The very nature of real estate dictates that it is a physical asset that provides some degree of security and income-generating potential. REITs help minimize the investment risk associated with investing in this industry by allowing the average investor to pool their money and spread the risk between many investors and different properties.

Another form of security is the information disclosure. The SEC regulates the public REIT marketplace with mandated disclosures regarding general information on the company, including how the REIT company is run, the management philosophy, the properties the company invests in, and the investment results. As with any investment, a little research is required to thoroughly analyze a potential investment, and the SEC makes sure that this information is available.

• Performance—REITs have been 1 of the best-performing asset classes over the past several years. According to Morningstar, the Morgan Stanley REIT Index gained 14.3% on an annualized basis in the 3 years ending in May 2003. The S&P 500 is suffering from a 10.9% loss over the same period. According to the Morningstar Mutual Fund Database, the real estate market in general had 2 great performance years in 2000 and 2001, with the Wilshire REIT Index returning 31.04% and 12.36%, respectively. Since 2001, the performance of the real estate market has cooled off somewhat, but the return numbers are still moderately positive.

Low Correlation History The popularity and growth of REITs over the past decade has moved the industry into unfamiliar territory, but many experts believe that the increasing ownership position will continue to reshape real estate investments, finance, and operations into the next century. REITs as an investment in the overall picture of your portfolio can help provide diversification and mitigate volatility because of the structure and low correlation with other portfolio assets.

Correlation is the statistical measure used to describe the degree of dependence between 2 variables. REITs are not closely correlated to the S&P 500, the Nasdaq, international stocks, or bonds. This means that REITs tend to act differently than other asset classes. Most of the time, this means that when REITs go up, the other asset classes will stagnate or go down. The inverse relationship usually applies when REITs move in a downward motion. Correlation is not a definite predictor. It illustrates what has happened over a stated time period and is not a guarantee of any future movements between these asset classes.

Assets' Yield and Return

Another important consideration for REITs is their yield and return. According to research by Cohen & Steers Capital Management, Inc (800-330-7348; www.cohenandsteers.com), as of March 31, 2003, equity REITs have offered dividend yields of 7.2%, compared to the S&P 500's dividend yields of 1.9%. Over the 10-year period ending March 31, 2003, REITs have performed very well in comparison to other asset classes. According to Cohen & Steers, equity REITs had a total return of 8.5%, which is equivalent to the return of the S&P 500 and higher than the return of bonds (7.4%) and the Nasdaq (7.2%).

Using data from Morningstar through May 30, 2003, to further justify REITs as a part of a well-diversified portfolio, 2 diversified portfolios were created to illustrate a hypothetical situation. The following asset classes were used to construct the 2 portfolios along with their corresponding allocations:

Notes:

In each multiyear period examined, Portfolio A has a lower standard deviation and a higher mean return when compared to Portfolio B. The real estate allocation in Portfolio A is directly responsible for the improved risk-return statistics. This asset reduces both the volatility of the total portfolio and the allocation of the other asset classes. These results are based on specific allocations of a hypothetical portfolio. Past performance is no guarantee of future results. This example is for illustrative purposes only.

If you currently do not have any allocation in the real estate asset class, you should seriously consider the benefits and risks of the class in your portfolio. Also, seek the advice of a financial professional who is familiar with your individual situation before making any dramatic changes to your portfolio.

For further in-depth analyses on REITs and reasons to use them in your portfolio, refer to Cohen & Steers Capital Management, Inc, and the National Association of Real Estate Investment Trusts (www.nareit.com/home.cfm). They are 2 of the leading authorities on REIT investing.

William B. Howard, Jr, ChFC, CFP®, is president of William Howard & Co Financial Advisors, Inc, a fee-only investment and financial planning firm in Memphis, Tenn. He has 23 years of experience working with physicians and was named 1 of the top 150 advisors. He welcomes questions or comments at 901-761-5068 or whoward@whcfa.com.