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The basis of asset allocation is to combine asset classes that have low performance correlations, with the goal of optimizing the risk-return profile of the overall portfolio. A traditional strategic asset mix includes allocations to both stocks and bonds — but less often do we see a targeted allocation to US real estate investment trusts (REITs) in that mix for individual investor portfolios.
US REITs diversify bond and equity exposures
Historically US REITs have demonstrated low correlation with both domestic and international stocks, as well as domestic bonds. This implies that REITs (companies that own and typically operate income-producing real estate or real estate-related assets) can serve as potential portfolio diversifiers when combined with a traditional balanced asset mix of stocks and bonds.
While US REITs carry some equity-like characteristics, they also have unique features that lend to their diversification merits:
- Income generation: US REITs are required to distribute at least 90% of their taxable income annually in the form of dividends. As a result, dividend income generally makes up a substantial portion of total return for REITs, with the income portion generally demonstrating lower variation than capital appreciation over time. This in turn aids in their defensive nature when equity markets are in decline.
- Inflation hedge: REITs may offer some inflation hedging by means of the contractual and structural characteristics of the underlying leases. Some examples of this are shorter-term leases and inflation-linked leases. Select real estate sectors such as apartments, hotels and self-storage generally have shorter-term lease structures that enable them to adjust rates more quickly in response to the prevailing market environment and hence increase rental rates in the face of inflationary pressures.
A comparison: Balanced portfolio with and without a core US REIT allocation
The Invesco Real Estate team evaluated the potential benefit of including a targeted allocation to US REITs by starting with a basic balanced strategic asset allocation of 50% US equities, 40% US bonds and 10% international equities. We then adjust the weightings to incorporate targeted REIT allocations of 10, 15, 20, 25 and 30% — which we reallocate from U.S. equity — creating five different balanced strategic asset allocation mixes that include US REITs. The results indicate that incorporating a targeted allocation to US REITs may improve long-term risk-adjusted returns, as measured by the 20-year Sharpe ratio. Moreover, it appears the improvement in long-term risk-adjusted returns holds if we evaluate the 20-year Sharpe ratio on a rolling basis as shown in the chart below. This highlights the consistency of the diversification relationship that US REITs provide to a balanced stock and bond portfolio over time.
Source: StyleADVISOR, as of Dec. 31, 2018. For illustration purposes only. This does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The hypothetical portfolios consist of the following: US Balanced Portfolio represented by 50% US equities, 40% US bonds and 10% international equities. US Balanced Portfolio (10% REITs) represented by 40% US equities, 40% US bonds and 10% international equities (and REIT allocation). US Balanced Portfolio (15% REITs) represented by 35% US equities, 40% US bonds and 10% international equities. US Balanced Portfolio (20% REITs) represented by 30% US equities, 40% US bonds and 10% international equities. US Balanced Portfolio (25% REITs) represented by 25% US equities, 40% US bonds and 10% international equities. US Balanced Portfolio (30% REITs) represented by 20% US equities, 40% US bonds and 10% international equities. US REITs represented by the Wilshire US Real Estate Income Trust Index. US equities are represented by the S&P 500 Index. International equities are represented by the MSCI EAFE Index. US bonds are represented by the Bloomberg Barclays US Aggregate Bond Index. Past performance does not guarantee future results. An investment cannot be made directly into an index.
To further illustrates the impact of adding a target allocation to US REITs, the Invesco Real Estate team looked at the growth of $10,000 invested over time. With the impact of compounding, the five strategic asset allocations that include US REITs show noticeable outperformance over a 20-year period, relative to the allocation without US REITs.
Source: StyleADVISOR, as of Dec. 31, 2018. See previous chart for descriptions of the six portfolios. Past performance does not guarantee future results. An investment cannot be made directly into an index.
US REITs are sometimes underrepresented in individual investor portfolios
Despite the appeal of US REITs as a diversifying asset class, individual investors often lack a designated allocation to US REITs within their portfolios. Conversely, institutional investors such as pension plans, foundation and endowments have been utilizing targeted allocation to US REITs (both private and public) for some time, with the purposes of income generation, inflation protection and of course diversification.
Source: 2017 Institutional Real Estate Allocations Monitor and Invesco Real Estate, as of July 2018
The question remains as to why individual investors have not fully embraced US REITs as a core allocation within their portfolios. It may be that many investors believe that they have ample exposure to the real estate market through home ownership, and do not seek additional exposure through listed REITs. However, residential home ownership is very different from the commercial real estate exposure that REITs deliver. First, home ownership lacks the income generation feature that commercial real estate provides by means of rental income, but instead requires payments for insurance, property tax and mortgage interest. Secondly, real estate market exposure for a standalone single-family home is concentrated to a single property and location. Conversely, publicly traded REITs generally provide diversified exposure to different commercial properties which can range in property type and geographical location. Many US REITs have hundreds if not thousands of properties across the US. As such, REITs can deliver more diversified real estate exposure than does standalone residential home ownership. Lastly, over time the US commercial real estate market has significantly outperformed the US residential market.2
The Invesco Real Estate team believes that US REITs play an important role within a multi-asset portfolio and should be considered a core allocation within a strategic asset allocation framework. By virtue of their low correlation with stocks and bonds over the long-term, US REITs should be viewed as a key ingredient for diversifying equity and fixed income exposure within investor portfolios. Accordingly, carving out a dedicated allocation to US REITs within a strategic asset allocation provides an attractive opportunity for diversification and potential for improved risk-adjusted returns over the long-term.
About Invesco Real Estate
Invesco Real Estate has nearly 500 employees in 21 different markets worldwide with assets under management of approximately $65 billion as of Sept. 30, 2018. Our focus areas include US and global real estate, global real estate income, infrastructure and master limited partnerships.
Learn more about Invesco Real Estate Fund.
1 Source: US REITs represented by the Wilshire US Real Estate Income Trust Index. US equities represented by the S&P 500 Index. International equities represented by the MSCI EAFE Index. US bonds represented by the Bloomberg Barclays US Aggregate Bond Index.
2 Source: StyleADVISOR and the Federal Housing Finance Agency (FHFA). US commercial real estate as measured by the Wilshire US REIT Index; residential real estate as measured by the FHFA Monthly House Price Purchase-Only Index, from September 1991 through December 2018.
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A real estate investment trust (REIT) is a closed-end investment company that owns income-producing real estate.
The Sharpe ratio is a measure of risk-adjusted performance calculated by dividing the amount of performance a portfolio earned above the risk-free rate of return by the standard deviation of returns; a higher Sharpe ratio indicates better risk-adjusted performance.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The MSCI EAFE Index is an unmanaged index designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the US and Canada.
The Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.
The Wilshire US Real Estate Income Trust Index is a market-based index of publicly-traded US real estate investment trusts. It is designed to be more reflective of real estate held by pension funds.
There is no guarantee that companies will declare future dividends, or that if declared, they will remain at current levels or increase over time.
Investing in stock involves risks, including the loss of principal. Although bonds generally present less short-term risk and volatility than stocks, investing in bonds involves interest rate risk; as interest rates rise, bond prices usually fall, and vice versa. Bonds also entail credit risk and the risk of default, as well as greater inflation risk than stocks. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
Senior Client Portfolio Manager
David Wertheim is a Senior Client Portfolio Manager focused on real asset securities. In this capacity, he works with Invesco’s real assets investment management team, serving as its representative to clients and prospects.
Mr. Wertheim began his career in 2000 and joined Invesco in 2018. Prior to joining Invesco, he was a senior client portfolio manager for real assets, commodities and equities with Deutsche Asset Management.
Mr. Wertheim earned a BBA from George Washington University with a dual concentration in international business and marketing.