Question: What role, if any, do you see for Real Estate Investment Trusts in a retirement portfolio? Why? Are there any REIT funds you prefer?
Answer: As anyone who has been reading me for a while knows, I believe that ownership of businesses providing useful goods and services is the foundation of wealth creation. Equity REITs certainly fall into that category. Mortgage REITs do not, since they represent creditor claims and fall into the category of debt investments, so the remainder of this post is limited to Equity REITs.
Equity REITs are ALREADY included in many stock index funds. For example, around 2% of the Vanguard Total Stock Market Index Fund is invested in REITs and around 10% of the Vanguard Small Cap Value Index Fund is in REITs. The latter is quite revealing: most REITs are, in fact, small cap value companies, and the annual correlation of returns between REITs and small cap value stocks in general since 1972 has been nearly 90%.
So the question isn’t whether REITs have a role in a diversified investor’s portfolio, since they are probably already in it, but whether it is a good idea to overweight them by purchasing funds specifically limited to real estate investment companies. How to decide?
The first issue was perceptively addressed in the question: since REIT income distributions are significant and taxed as ordinary income (they aren’t “qualified” dividends so they don’t get the lower rate applicable to these), the inclusion of REIT funds should, at most, be limited to retirement accounts that are sheltered from current taxation. Avoid them in taxable accounts.
The second issue is related to the high correlation between small cap value funds and REITs. As I’ve discussed in earlier posts, I’m not a fan of market-weighted index funds, and prefer alternative indexes that avoid the “lottery” premium on high volatility and small cap growth stocks. Many people, however, invest virtually all of their retirement money through employer-based plans which have limited choices. Years ago, small cap value funds were almost unheard-of in 401(k) plans, but REIT funds were prevalent, and they were the best option available to diversify a market-weighted portfolio. That still applies to many investors today, so my advice would be to use the REIT fund offered by your employer if no other small cap value option exists in the plan. But I would use the more diversified small cap value fund instead of the REIT fund when available. If a foreign real-estate fund is included, split the exposure between domestic and international.
The third issue is mainly psychological: some people like the high distributions of REIT funds and are more likely to stick with an equity-heavy portfolio if they include them, seeing them (incorrectly, except for mortgage REITs) as bond substitutes. If I can persuade a person to hold more equity and less debt, I’ll do it.
So I guess my answer, depending on the circumstances, is either “yes” or “meh.” If you are otherwise limited to market-weighted stock index funds, I think REIT funds offer considerable diversification benefits. If you are using alternative indexing or small cap value funds, I don’t see any meaningful value in adding REIT funds, nor any meaningful harm.