Real estate investment trusts provide convenient access to the real estate market through indirect ownership. They were popular when the real estate market was booming, with market capitalization peaking in early 2007, but they later also gained the attention of those wishing to get in close to the bottom. Those seeking to diversify portfolio risk, however, will be disappointed to learn that REITs -- particularly equity REITs -- often behave very similarly to stocks.
Advantages of REITs and Stocks
REITs are like stocks in the sense that they are publicly traded and they allow for divisible investment opportunities at the indirect ownership level. This is in contrast to the indivisible nature of most direct real estate investments, which necessitate large minimum investments. Similarly, the indirect ownership nature of stocks and REITs combined with the fact that they trade in secondary markets on exchanges means that they are both far more liquid than direct real estate investments. Liquidity is a term that refers to the ease and swiftness with which an asset can be sold at its fair value.
Types of REITs
Three major classes of REITs are equity REITs, mortgage REITs and hybrid REITs. Generally, equity REITs are funds that own and operate income-producing real estate and are the most common type of REIT. Mortgage REITs are focused on lending money to real estate owners and operators or acquiring mortgage-backed securities. Hybrid REITs do both.
Equity REIT and Stock Performance
NAREIT index performance data back to 1971 is available at the national association’s website (REIT.com). From the beginning of 2000 to the end of 2008, the average monthly total return for the equity REIT index was 0.9 percent, while the average S&P 500 monthly total return was negative 0.3 percent. During this period, the equity REIT index rose from 2,376 to a peak of 10,527 before falling precipitously back to 4,380 at the end of 2008. In contrast, stocks fell 78 percent from the beginning of 2000 to September 2002 before rising with equity REITs until the financial crisis set in. From January 2009 to November 2012, the equity REIT index fully recovered its value (with an average monthly return of 1.8 percent) and the S&P 500 nearly recovered, with an average monthly return of 1.1 percent.
Mortgage REIT Performance and Relative Volatilities
The NAREIT mortgage index has been nearly flat throughout the entire period of analysis. The average monthly return was 0.8 percent in the first period (January 2000 to December 2008) and 1.3 percent in the second period (January 2009 to November 2012). The relatively high second period average return reflects its low volatility. The mortgage REIT index did not fall nearly as much as the equity REIT index and S&P 500 during the financial crisis. The monthly standard deviations for stocks, equity REITs and mortgage REITs from 2008 to 2013 were 5.0 percent, 8.2 percent, and 3.9 percent, respectively. Over the entire period of analysis, however, stock returns had the lowest monthly standard deviation (4.6 percent -- versus 6.7 percent and 6.1 percent for equity and mortgage REITs, respectively).
Diversification Benefits of REITs
Over the period of January 2000 to December 2008, the correlation coefficient between stock returns and returns to equity and mortgage REIT indexes were 0.51 and 0.33, respectively. The higher the correlation coefficient, the more closely the REIT and stock returns move together over time. Relative to the 2000 to 2008 period, the correlation between stocks and both types of REITS from January 2009 to November 2012 were higher (0.83 for equity REITS), and (0.58 for mortgage REITs). Due to their high correlation with stock returns, equity REITs do not provide as many diversification benefits as traditional direct real estate investment. REITs offer several benefits, but cannot be considered a substitute for traditional real estate alternative investments.
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