Valuable Property

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REITs are Valuable Property

We use six different asset classes. The one most commonly misunderstood is Resource based stocks (or ‘hard asset’ stocks). These resource based investments include companies that own and produce an underlying natural resource. Examples of these natural resources include oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel, and other resources such as diamonds, coal, lumber, and even water. But perhaps one of the most important components of this category is Real Estate Investment Trusts (REITs).

It was with interest, therefore, that I read Craig L. Israelsen’s Financial Planning article entitled, “Valuable Property” in which he wrote:

A real estate investment should only be a portion of a portfolio, so a head-to-head comparison of real estate funds somewhat misses the point. More to the point is a comparison of what each REIT fund adds to a portfolio, rather than its performance as a stand-alone asset.

Consider a simple two-asset portfolio consisting of 60% large-cap U.S. stocks and 40% U.S. bonds – the old balanced model. Using the SPDR S&P 500 (SPY) as the stock measure and the SPDR Barclays Capital Aggregate Bond (LAG) as the bond standard, the 10-year average annualized return of a 60/40 portfolio (with annual rebalancing) from January 2002 to December 2011 was 4.61%.

Next, replace part of the stock position with REITs. The new asset allocation is 40% SPY, 20% REIT fund and 40% LAG. This 40/20/40 asset allocation was tested using all of the REIT funds in The Big 25 chart with 10-year performance histories. The average 10-year annualized return for the 40/20/40 portfolio was 6.27%, with a high of 6.63% (using FARCX as the REIT fund) and a low of 5.93% (using CSEIX as the REIT fund).

Two observations: after adapting a traditional 60/40 portfolio to include a REIT component, the results over the past 10 years were uniformly improved. The smallest performance enhancement from adding REITs was 132 basis points (which would have produced an ending balance more than $2,100 higher than a 60/40 portfolio, assuming a starting lump-sum investment of $10,000), and the largest performance enhancement was 202 basis points (an ending balance more than $3,300 higher than a 60/40 portfolio). This added performance came with no additional risk. The standard deviation of the 10 annual returns in the 60/40 portfolios was 11.4%, while the average 10-year standard deviation of the 40/20/40 portfolios was 11.8% – a trivial increase in volatility.

Some advisors refer to real estate as an “alternative” asset class. They shouldn’t. Research shows that REITs should play a fundamental role in any investment portfolio.

An allocation to REITs is important for both the rebalancing bonus and the diversification even if you don’t allocate 20% of your portfolio. REITs are only 2% to 3% of the total equity market, so even a small additional allocation will double or triple weight REITs as a sector of the economy. We also recommend adding an allocation for foreign REITs.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818…)