Opposites Attract: The Diversification Benefits of REITs.

Real estate has historically proven to be an attractive addition to stock and bond portfolios due to low correlations and competitive risk-adjusted returns. But in recent years, the benefits of owning real estate would have been diminished by the spectacular performance of high-tech stocks, which have driven stock indices to unprecedented levels. With equity valuations at or above historical highs, investors looking for proven approaches to mitigating risk without foregoing return should revisit real estate.

Real estate, more specifically real estate securities, look particularly interesting given their current levels of valuation and their low to negative correlations with the industry sectors which have driven stock indices upwards in recent years.

REITs as Portfolio Diversifier

In the financial world, an investor is at risk every time an investment is chosen. Although one may not be able to eliminate financial risk completely, one can mitigate that risk through the use of a tried and true concept called diversification. At its root, simple diversification can be defined as "not putting all your eggs in one basket," or "spreading the risks." To give a more elaborate definition, diversification may be defined as combining assets which are less than perfectly correlated in order to reduce portfolio risk without sacrificing portfolio returns. The lower the correlation between assets, the more diversification will be able to reduce the portfolio's overall risk.

But what of diversification in today's market, where a narrow band of stocks is propelling the broader market to new and dizzying heights? Is there room for such a concept in a market where the selection of just a few large-cap growth stocks could make the difference in any portfolio? Modern portfolio theory would suggest that the answer is a resounding "yes."

Over the past five years, technology stocks, with an average annual return of 40.3 percent, have been the strongest performing sector within the broader equity market, with health care (35.8 percent), financials (28.9 percent) and communication stocks (26.5 percent) also posting impressive gains. It is therefore tempting for a fund manager to overweight these sectors, particularly technology, in a portfolio. If a portfolio is overweighted with tech stocks, for example, then diversification theory would suggest that combining assets which are less than perfectly correlated will enhance risk-adjusted returns.

Technology stocks and real estate investment trusts (REITs) have been negatively correlated for the past five years. In fact, REITs have had a lower correlation with technology than any other sector over this time period. Thus, by adding REITs to a mixed-asset portfolio consisting of an overweight in technology stocks, the portfolio's overall risk is reduced should something go awry in the technology sector.

Most investors would probably be surprised to know that despite the superior returns of tech stocks over the past five years, REITs, with their negative correlation, would have enhanced a portfolio's risk-adjusted return. For example, a portfolio consisting of 50 percent tech stocks and 50 percent REITs would have had a higher risk-adjusted return (Sharpe ratio of 2) than a portfolio consisting of 100 percent tech stocks (Sharpe ratio of 1.6).

REITs Earn a Place in a Diversified Portfolio

Looking at REITs in the broader context of all industry sectors included in the S&P 500, REITs play a meaningful role in the composition of an optimal portfolio (i.e., the portfolio with the best risk-adjusted returns), even over the last five years, when their returns have lagged other industry sectors. Using historical return data over the past five years, an optimal mixed-asset portfolio would have included REITs at nearly every point along the risk-return spectrum. At intermediate risk levels, REITs comprise close to 30 percent of an optimal portfolio and reduce portfolio risk by 365 basis points.

REITs Offer Compelling Valuations

In addition to its strength as a portfolio diversifier, REITs are attractive from a valuation perspective. With the collapse in REIT prices in 1998, REIT valuation levels have reached a new cyclical low. From a real estate perspective, REITs are trading at price to Net Asset Value (NAV) discounts of 10 percent to 15 percent. Discounts to NAV have led to increasing public-to-private arbitrage, as well as share repurchase programs. These activities should help to preclude further valuation declines.

From a capital markets perspective, REITs have never traded at lower FFO multiples. REIT forward FFO multiples have declined from approximately 14 times to its current average of 8.9 times. Meanwhile, the S&P 500 continues to hit historically high valuation levels. Additionally, REIT dividend yields are at a all-time-high level (7.7 percent as of February 26, 1999), with payout ratios at a historical low (68 percent of cash available for distribution). Finally, with corporate bonds yielding 5.8 percent as of March 24, 1999, REITs appear to offer a great bargain for yield sensitive investors.

Conclusion

Traditionally, the rationale for including real estate, specifically REITs, in a mixed-asset portfolio has centered on their low correlation with other assets, such as technology stocks. In recent years, these benefits have been muted by the outsized returns in a few industry sectors. Assuming more modest returns from tech stocks and, in turn, more faborable relative returns from real estate securities, the prospective impact from diversification in the future should be dramatically enhanced.