All about investments, personal finance and well-being! But almost always based on academic research.
In this article we will analyze the investment alternative called REITs from an academic perspective, in order to define whether or not it is convenient to invest in these instruments. For those who don't know, REITs is short for Real Estate Investment Trust (REITs) and they are publicly traded financial assets that we can buy and sell the same way we trade stocks. The main characteristic of these assets is that they allow us to invest in real estate assets with very little capital (this solves one of the main problems in the world of real estate, that is, the need to have a large level of capital or debt).
Another relevant point of REITs is that, unlike stocks, they deliver most of their profits in the form of dividends, that is, periodic payments made to investors (commonly payments are made every 3 months).
In order to define whether REITs should have a place in our portfolios or not, we must analyze what level of earnings this asset class has, the importance of geographic diversification, psychological preference and what effects this asset class has on a stock portfolio. and bonuses.
As you already know, trying to choose the best assets or sectors to invest in has historically been a bad investment strategy (I invite you to read my article on Stock Picking if you want to know more about it). For this reason, trying to choose the best real estate sectors or companies will bring you less profit in the long term than if you had bought all the available REITs (in addition to requiring a lot more work). For this reason, if you want to invest in REITs, the best option is to buy an ETF that includes hundreds or thousands of these different assets, that is, an ETF that follows a good REIT index.
There are many alternatives, but for this article I will use Vanguard Real Estate ETF (VNQ), Vanguard Global ex-US Real Est ETF (VNQI) and iShares Global REIT ETF (REET) since those 3 ETFs are most likely available in almost all the countries.
If we look at the data from August 2014 to March 2022, the results of these ETFs are:
- VNQ: 8.26%.
- VNQI: 3.95%.
- REET: 5.99%.
Standard deviation (volatility):
- VNQ: 16.68%.
- VNQI: 14.54%.
- REET: 16.26%.
Remember that these returns are delivered, for the most part, through dividends.
As we can see, the returns of this asset class are somewhat far from the returns of the shares. If you only got this far you might think that they are a decent investment alternative, especially considering that they focus on recurring payments and not so much on capital appreciation. But it is important that we go deeper.
The importance of international diversification
According to the previous numbers, it makes no sense to invest in the real estate markets of countries outside the USA, the profitability of that country has far exceeded that of the rest of the world in the last 8 years. So, what is the use of diversifying internationally? Well let me tell you that it works (and a lot).
The 2019 paper "The Rate of Return on Everything, 1870 - 2015" by the Federal Reserve Bank of San Francisco found that from 1870 to 2015, an internationally diversified real estate investment delivered an annualized return of 7.05 % (this is pretty good). We can see that the current returns of the previous ETFs are relatively close to the historical average, but the question remains: why have less profits if with only the USA I obtain more than the rest of the world? Well, this very paper has the answer.
To get the return above, you should have invested in all 16 countries that were studied. If you had only invested in Australia, France, Japan, Portugal, Spain, Italy, Switzerland, the United Kingdom and the United States, your return would have dropped significantly.
Not because a certain country (regardless of which one) has done well in recent decades, does it mean that it will continue to deliver good returns in the future. It is impossible to predict which sectors and countries will deliver the best performance over the next decade. This is because no one can see the future.
International diversification is essential in any investment (stocks, real estate, bonds, etc).
I'll cover this point in more detail when I write about a dividend-focused investment, but as you can imagine, receiving regular dividend payments feels great. By receiving dividends, investors feel great comfort and security because they receive cash on a regular basis. However, this kind of investment eliminates your most important ally: compound interest.
The psychological preference for dividends is a psychological bias that we must put aside, since it prevents us from obtaining great profits. This has been studied by the paper "Explaining investor preference for cash dividends" (Meir Statman. et al; 1984).
Again, I will discuss this point in much more detail in a separate article on the subject.
REITs in a portfolio of stocks and bonds
The papers "Real Estate Betas and the Implications for Assest Location" (Peter M; 2018) and "REIT Return and Pricing - The Small Cap Value Stock Factor" (Randy A. et al; 2006) analyzed what benefits investors obtain by including REITs in an existing portfolio of stocks and bonds.
The main conclusion reached by both papers is that real estate returns (REITs) can be explained by stock and bond market risks. In other words, the possible excess returns that REITs give are already in the stock and bond market. Specifically, owning some exposure to Small Cap Value stocks was found to deliver the same benefits as adding REITs. In other words, if you already own Small Cap Value shares, then there is nothing REITs can give you.
REITs are a good alternative for investors looking to generate cash flow. They can be recommended as long as the investor understands the disadvantages that this type of investment carries:
- False sense of security and comfort.
- Increase in the payment of taxes.
- Substantially lower returns in the long term due to the loss of compound interest.
In addition, we know that if we already have a portfolio that has Small Cap Value type stocks, adding REITs will not give us any benefit.
I hope you liked my article. Stay tuned as little by little I will be analyzing the whole world of investments.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2022 Nicolas Hidalgo