REITs v/s Other Financial Instruments

- Vatsal Rai

June 21, 2024

Introduction

Real estate has traditionally been a key element in building wealth, providing a dependable way for individuals to grow and safeguard their assets over time. Property ownership offers a physical asset that not only increases in value but also has the potential to generate consistent rental income. This combination of capital appreciation and income generation makes real estate a desirable investment. However, many potential investors are deterred by the high initial costs, ongoing management challenges, and lack of diversification inherent in directly owning property.

This is where Real Estate Investment Trusts (REITs) come in, presenting an attractive alternative that addresses many of the issues associated with conventional real estate investments. REITs enable individuals to invest in large-scale, income-producing properties without the need to purchase or manage them directly. By buying shares in a REIT, investors can access a diversified portfolio of properties, including commercial buildings, apartment complexes, and shopping centers. This not only reduces the entry barrier but also spreads risk across a wider range of assets.

REITs offer a distinctive opportunity for investors looking to enter the real estate market. But how do they compare to other financial instruments? This article explores a comparative analysis of REITs versus stocks, bonds, derivatives, commodities, art, mutual funds, and fixed deposits (FDs).

General Performance of REITs

A study^[7] analyzed a span of 24 years and found significant variations in performance among different types of investments. The chart below illustrates the average annual net returns and expenses associated with 12 different asset classes over this period.

Among these, listed equity REITs stood out with the third highest average annual net return of 10.9%. Unlisted real estate, on the other hand, yielded slightly lower returns at 8.6% on average, which was approximately 2.3% less than REITs.^[7]

Conversely, hedge funds and tactical asset allocation (TAA) strategies, along with U.S. other bonds, were identified as the poorest performing asset classes over the studied period.

When comparing public and private REITS, on average public REITs offer dividend yields around 5% to 6%, whereas in contrast, private REITs often provide yields in the 7% to 8% range, as reported by the National Real Estate Investor.^[8]

REITs v/s Stocks

Both REITs and stocks represent a form of ownership in a company, are traded on exchanges, and their values can fluctuate based on market sentiment and company performance. Investors can benefit from both capital appreciation and dividend income with these investment options.

However, REITs and stocks have distinct differences. REITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends, and to have no more than 50% of its shares held by 5 or fewer individuals during the last half of the taxable year.^[3] This typically results in a higher and more stable yield compared to the average stock. In contrast, stocks, particularly those of growth companies, often provide greater potential for capital appreciation. REITs are generally considered less volatile than stocks, especially those that are cyclical and heavily influenced by economic conditions. Nonetheless, certain REIT sectors, such as hospitality, can experience increased volatility during different economic cycles.

TIME PERIOD	S&P 500 (TOTAL ANNUAL RETURN)	FTSE NAREIT ALL EQUITY REITS (TOTAL ANNUAL RETURN)
1972-2023	10.2%	12.7%
Past 25 years	7.6%	11.4%
Past 20 years	9.7%	10.4%
Past 10 years	12.0%	9.5%
Past 5 years	15.7%	10.3%
Past year (2023)	26.3%	11.4%

Over the past 20, 25, and 50 years, REITs have outperformed the S&P 500, as evidenced by historical data in the above table.^[1] In more recent times, however, the S&P 500 has delivered higher returns than REITs, particularly over the past one, five, and ten years. Despite these recent trends, long-term performance still favors REITs over stocks.

Dividend payments play a crucial role in the returns of both stocks and REITs. For example, dividend income has accounted for 41% of the S&P 500's total return since 1930.^[1] Research conducted by Ned Davis Research and Hartford Funds supports this, showing that from 1973 to 2022, S&P 500 companies that paid dividends had an average annual total return of 9.2%, significantly higher than the -0.6% return of non-dividend payers. Furthermore, companies that increased their dividends outperformed those with unchanged dividend policies, with returns of 10.2% compared to 6.6%. Conversely, companies that reduced or eliminated dividends saw much lower average returns of 3.95%.^[1]

The chart below depicts the average annualized rolling ten-year returns for REITs and the Russell 3000 for each month from January 2000 to October 2020. In recent years, REITs have consistently outperformed the broader stock market, including during the Great Financial Crisis. This outperformance is partially attributed to the inflated non-REIT returns in the early 2000s, driven by the tech bubble, which provides the Russell 3000 with a higher baseline for its ten-year returns. Additionally, the chart illustrates the lower variability of REIT ten-year returns, with a standard deviation of 9.0% compared to 16.0% for U.S. stocks, as indicated in the chart.^[2]

When looking at average annualized returns for REITs since the early 1990s, it becomes clear that REITs generally outperform the broader U.S. stock market over longer periods. In terms of annual returns, REITs exceeded U.S. stocks more than 56% of the time.^[2]

REITs v/s Bonds

Both bonds and REITs generate a consistent income stream, albeit in different ways. Bonds provide fixed-interest payments, while REITs distribute regular dividend payouts. Generally, both investment types are seen as lower-risk options compared to stocks.

However, there are notable differences between the two. Bond yields are usually lower than the dividends from REITs, particularly in the case of high-quality bonds. According to Cohen & Steers, an investment manager that offers a number of REIT funds, REITs achieved a cumulative return of 57.9% during the period from 2004-2006 in a rising economic environment, significantly outperforming stocks, which had a return of 15.5%, and bonds, which returned 5.9%.^[4]

On the flip side, bonds, especially government bonds, tend to offer greater price stability. In contrast, REIT dividends can vary based on the performance of the real estate market and the individual company's success. Consequently, bonds are typically more suitable for investors who prioritize capital preservation and a reliable income. REITs, however, attract those looking for a mix of income and potential capital growth.

REITs v/s Commodities

Commodities such as gold, oil, and agricultural products are standardized, tradable goods. These items are characterized by their high price volatility, which can be significantly affected by disruptions in the supply chain, changing weather conditions, and geopolitical events.

In contrast, Real Estate Investment Trusts (REITs) provide a more stable investment option. The value of REITs is closely linked to the performance of the real estate market. Generally, the real estate market experiences less volatility compared to the commodities market, making REITs a steadier investment choice. But this also means that over time, commodities might offer stronger diversification benefits than REITs. From December 1990 to March 2006, the quarterly returns of the Dow Jones-AIG Commodity Index exhibited a negative correlation with both the S&P 500 and the Lehman Brothers Aggregate Bond Index (LBAG). During the same period, they showed a positive correlation with the Consumer Price Index (CPI) and the quarterly change in inflation. Additionally, from 1992 to 2007, the Deutsche Bank Liquid Commodity Index (DBLCI) achieved positive returns 60% of the time when equity returns were negative.^[5] It also surpassed the cumulative returns of the fixed income markets during this period. Notably, in June and July of the previous year, while the S&P 500 experienced declines, the DBLCI-MR recorded positive returns exceeding 5% each month.^[5] Compare this with the fact that as of April 18, 2008, the relationship between the MSCI REIT Index and several major stock market indices showed strong correlations. Specifically, the correlation coefficient between the MSCI REIT Index and the Dow Jones Industrial Index was 0.745, indicating a notable positive relationship.^[5] Similarly, the correlation with the NASDAQ Composite Index stood at 0.706, highlighting another significant positive correlation. Additionally, the MSCI REIT Index showed a robust correlation of 0.771 with the S&P 500 Index during the same period.^[5] These correlation coefficients suggest that movements in the MSCI REIT Index tended to align closely with movements in these prominent stock market benchmarks in April 2008. This data underscores the potential of commodities as a robust diversification tool, particularly during periods of equity market downturns.

REITs v/s Mutual Funds

Mutual funds are professionally managed investment vehicles that pool money from multiple investors to purchase a diversified portfolio of securities such as stocks, bonds, and real estate investment trusts (REITs). They are designed to offer investors exposure to various asset classes while benefiting from the expertise of professional fund managers.

Both mutual funds and REITs share common benefits such as diversification across multiple holdings, which helps spread risk across different assets and sectors. This diversification is particularly appealing to investors looking to reduce the impact of volatility on their investments and benefit from a broad range of opportunities.

However, there are notable differences between mutual funds and REITs. Mutual funds generally come with management fees that cover the costs of professional management and administration. These fees can vary widely depending on the fund's strategy and management style. On the other hand, REITs, which are specifically focused on real estate investments, may offer more targeted exposure to the real estate market. This allows investors to directly access the real estate sector without the broader diversification of a mutual fund.

Investors seeking control over their real estate exposure may prefer individual REITs, as they can select specific properties or types of real estate that align with their investment goals. In contrast, those looking for diversified exposure across various real estate assets within a single investment might find a real estate mutual fund more suitable. Real estate mutual funds typically invest in a range of properties and REITs, offering investors the benefit of professional management and broader diversification across the real estate sector.

The below highlights the difference b/w REITs and Mutual Funds, and their approximate returns.^[6]

Parameter	REITs	MF
Investment Type	Directly invest in real estate.	A diversified portfolio of securities.
Stock Exchange	Stock Exchange	ETFs trade on stock exchanges. Other funds can be bought and sold at their NAV.
Investment Structure	Direct investment in real estate	Indirect investment in various assets
Potential Returns	Rental income and property value appreciation	Capital gains and dividends
Expected Yield	~10%	~10%-12%

Final Word

Real Estate Investment Trusts (REITs) have emerged as a compelling investment vehicle, offering a unique blend of real estate exposure, income potential, and liquidity. Throughout this comparative analysis, REITs have demonstrated their ability to compete with and often outperform other financial instruments over extended periods. They provide investors with the benefits of real estate ownership without the burdens of direct property management, making them an attractive option for those seeking to diversify their portfolios.

The comparison with stocks highlights REITs' potential for steady income and capital appreciation, albeit with different risk-return profiles. When contrasted with bonds, REITs offer higher yield potential but with increased volatility. The analysis against commodities underscores REITs' stability, while the comparison with mutual funds illustrates their focused real estate exposure. These distinctions emphasize the unique role REITs can play in an investment strategy.

As the real estate market continues to evolve, REITs remain adaptable, spanning various property types and geographic regions. This flexibility, combined with their historical performance and income-generating potential, positions REITs as a valuable component of a well-rounded investment portfolio. However, like all investments, REITs are subject to market fluctuations and economic conditions, underscoring the importance of thorough research and consideration of individual financial goals.

When selecting an investment, consider your financial goals, risk tolerance, and time horizon. REITs may suit those seeking stable income and long-term capital appreciation, while stocks might be preferable for higher growth potential. Assess current market conditions, as REITs can underperform in rising interest rate environments. Consider diversification benefits, understanding that REITs' correlation with stocks has increased over time. Evaluate tax implications, especially REITs' high dividend payout requirements. Lastly, consider your desired level of involvement - REITs offer passive real estate exposure compared to active management in direct property ownership. By weighing these factors against your personal financial situation, you can determine the most appropriate investment for your portfolio.

References

[1] DiLallo, Matthew. 2020. "REITs vs. Stocks: What Does the Data Say?" The Motley Fool. August 5, 2020. https://www.fool.com/research/reits-vs-stocks/.

[2] "REIT Average & Historical Returns vs. U.S. Stocks." n.d. Www.reit.com. https://www.reit.com/news/blog/market-commentary/reit-average-historical-returns-vs-us-stocks.

[3] "Investor Bulletin: Real Estate Investment Trusts (REITs)." n.d. https://www.sec.gov/files/reits.pdf.

[4] "REITs: Still a Viable Investment?" n.d. Investopedia. Accessed June 20, 2024. https://www.investopedia.com/articles/financial-advisors/030116/reits-still-viable-investment.asp#:~:text=REIT%20Past%20Performances%20in%20Rising%20Rate%20Environments&text=4%20The%20cumulative%20return%20for.

[5] "Commodities vs. REITS" n.d. https://seekingalpha.com/article/76023-commodities-vs-reits

[6] "Real Estate vs Mutual Fund - Which Has Better Returns?" n.d. Scripbox. Accessed June 20, 2024. https://scripbox.com/mf/real-estate-vs-mutual-funds/.

[7] "Nareit." 2019. Nareit. 2019. https://www.reit.com/data-research/research/updated-cem-benchmarking-study-highlights-reit-performance.

[8] CFP, Matthew Frankel. n.d. "A Beginner's Guide to Private REITs." The Motley Fool. https://www.fool.com/investing/stock-market/market-sectors/real-estate-investing/reit/private-reits/.

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