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Real Estate Investment Trusts (REITs) - YouTube
Channel: Ben Felix
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- Real estate has historically been
[1]
one of the best performing
global asset classes.
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Real estate investment trusts,
more commonly known as REITs,
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are a special type of fund
that invests primarily
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in income-producing real estate assets.
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The income that a REIT earns
flows to the unit holders
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and the unit holders also participate
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in the capital appreciation
of the buildings.
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Investing in a REIT gives you access
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to a liquid diversified
portfolio of real estate assets
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without the need to manage
anything directly on your own.
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This makes some of the biggest issues
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with direct real estate investing,
[32]
like illiquidity,
management intensiveness,
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and the inability to properly
diversify, go away completely.
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Just like with stocks,
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it is possible to buy a low
cost index fund of REITs.
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I'm Ben Felix, portfolio
manager at PWL Capital.
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In this episode of Common Sense Investing,
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I'm going to tell you how
real estate investment trusts
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fit into your portfolio.
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(upbeat electronic music)
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The first thing that we need to understand
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in thinking about adding a REIT index fund
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to your existing portfolio of index funds
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is that any total market equity ETF
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will already have an
allocation to real estate.
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Canadian, US, and
international stock markets
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have somewhere between 3
and 5% of their total assets
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in real estate.
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When we are talking about adding REITs
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to an existing portfolio of index funds.
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we are really talking about adding REITs
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in excess of market cap weight.
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A major reason for over-weighting
REITs in a portfolio
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is that REITs are often viewed
as a distinct asset class.
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If REITs are in fact a
distinct asset class,
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then adding them to a
portfolio of stocks and bonds
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should result in a
diversification benefit.
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This idea of a diversifying asset class
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seems to be backed up by the
relatively low correlation
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that REITs have historically
had with stocks and bonds,
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and by the fact that the returns of REITs
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are not well-explained
by market beta alone.
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When considering REITs in a portfolio,
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it also doesn't hurt that their returns
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have been pretty great.
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Going back to July 1989 through June 2019,
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the S&P Global REIT Index gross div
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returned 9.24% per year on average,
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while the MSCI All Country
World Index, also gross div,
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returned 7.77% per year on
average both in Canadian dollars.
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The correlation of these indexes
over that period was 0.513,
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which is low.
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Combining the two indexes
together in a portfolio
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seems like a compelling proposition.
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Let's consider this proposition
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in the context of the academic literature.
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If REITs are truly a distinct asset class,
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we would not expect the known risk factors
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that explain stock and bond returns
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to be able to explain REIT returns.
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In a 2018 paper titled Real Estate Betas
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and the Implications for Asset Allocation,
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Peter Mladina studied how
distinct the returns of REITs are
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from good old stocks and bonds
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from the perspective
of known risk factors.
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Mladina used the modified version
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of the Fama French Five Factor Model
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to examine how well the risk
and return of both REITs
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and private real estate investments
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are explained by known factors.
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The factors in the modified model
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were market beta, size, and value,
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which are equity factors
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that I've talked about many times before,
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plus the term and default factors,
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which are factors that
explain fixed income returns.
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The study covered the period
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from January 1986 to December 2015.
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The findings were surprising.
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The factor exposure of real estate
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roughly resembles that of a portfolio
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consisting of 60% small-value stocks
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and 40% high-yield bonds.
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This tells us that REITs
are not necessarily
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going to give us something
that we could not already get
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from stocks and bonds.
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One of the most important
findings of the study
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is that while stock and bond factors
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explain the returns of real estate,
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the risk of real estate
is primarily driven
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by the idiosyncratic risk
of the real estate sector.
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This point is crucial to understanding
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how REITs might fit into a portfolio.
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Mladina found that the factors
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that explain the returns of
real estate are priced risks,
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risks with a positive expected return.
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They are also risks that we can access
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through stocks and bonds.
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While the returns of REITs are explained
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by these priced risk factors,
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the risk of real estate
is primarily driven
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by the idiosyncratic risk
of the real estate sector,
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which is not a priced risk.
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It is not a risk for what you would expect
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a positive return from taking.
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Let's recap quickly.
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The returns of real
estate, including REITs,
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can be explained by
exposure to risk factors
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that we can already get
from stocks and bonds.
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Choosing to get exposure
to those risk factors
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through real estate adds
the idiosyncratic risk
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of the real estate sector,
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which is a risk without a
positive expected return.
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Mladina also compared his factor benchmark
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to real estate indexes
that he used in the study
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along the efficient frontier,
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which is the set of optimal portfolios
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that offer the highest expected return
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for a given level of risk.
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He found that none of
the real estate indexes
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earned a spot in the optimal
risk adjusted portfolio,
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which was dominated
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by the five factor real estate benchmark.
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This tells us that the most efficient way
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to get exposure to the
factor returns of REITs
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is through a portfolio
of stocks and bonds.
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The findings in Mladina's
paper were consistent
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with the findings of Jared
Kizer and Sean Grover
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in their 2017 paper Are
REITs a Distinct Asset Class?
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They used a slightly
different factor model
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consisting of market beta, size, value,
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and momentum equity factors,
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and the term and credit
fixed income factors.
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They similarly found that REIT
returns could be explained
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by stock and bond factors.
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Based on this information,
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Kizer and Grover constructed a
portfolio of stocks and bonds
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designed to match the
factor exposure of REITs.
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They accomplished this
using 67% small-value stocks
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and 33% corporate bonds.
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They found that the
portfolio of stocks and bonds
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produced better returns
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and risk adjusted returns than REITs.
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This finding is consistent with the idea
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that REITs are not adding
any expected return
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in excess of what could be achieved
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through stocks and bonds,
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but they are adding
additional uncompensated risk.
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It is also consistent
with Mladina's finding
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that REITs would not earn any
allocation in the portfolio
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that falls on the efficient frontier.
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The findings from Mladina
and Kizer and Grover
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suggest that while REITs do offer exposure
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to common risk factors with
positive expected returns,
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a more efficient approach to
accessing those risk factors
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is through stock and bond ETFs,
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which do not result in exposure
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to the uncompensated
real estate sector risk.
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Kizer and Grover recommend maintaining
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something close to a
market cap weight in REITs.
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Beyond the fact that
overweight REIT exposure
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introduces idiosyncratic
real estate sector risk,
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REITs are also relatively tax inefficient.
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They distribute fairly high-income yields
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and most of that income is
fully taxable as income,
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even for Canadian REITs,
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when it is received in a taxable account.
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Even in a tax-free account,
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any income yield from US or foreign REITs
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is subject to a foreign withholding tax.
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Finally, in Canada, there
really aren't that many
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good REIT products to choose from.
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Vanguard's FTSE Canadian
Capped REIT Index ETF
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has only 18 holdings and
an MER of 39 basis points.
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BMO's Equal Weight REITs
Index has 22 holdings
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and an MER of 61 basis points.
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And the iShares S&P/TSX
Capped REIT Index ETF
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has 19 holdings and an
MER of 61 basis points.
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If you really want to
access the excess exposure
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to the factors that drives REIT returns,
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you may consider adding additional weight
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in small cap value stocks
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and lower credit bonds to your portfolio.
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Adding small cap value
stocks to a portfolio
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can be accomplished easily for US equities
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with US-listed ETFs like IJS and VBR.
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Unfortunately, it is not so
easy to add this exposure
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for Canadian and international stocks.
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For more exposure to lower credit bonds
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as opposed to using a
Canadian corporate bond ETF,
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it might make more sense to
seek more global bond exposure.
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The Canadian fixed income market
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has a high concentration in government
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and high credit quality bonds
relative to the global market.
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Adding more global bond exposure
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offers more exposure to the credit premium
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without adding the specific risk
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of the Canadian corporate bond market.
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In Canada, we do have
some options to do this
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with Vanguard's VBG and VBU,
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which together offer exposure
to the global bond market
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hedged to Canadian dollars.
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Do you have REITs in excess
of market cap weights
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in your portfolio?
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Tell me about your thought
process in the comments.
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Thanks for watching.
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My name is Ben Felix of PWL Capital
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and this is Common Sense Investing.
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If you enjoyed this video,
please share it with someone
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who you think could benefit
from the information.
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And don't forget,
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if you've run out of Common
Sense Investing videos to watch,
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you can tune in to weekly episodes
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of the Rational Reminder podcast
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wherever you get your podcast.
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