Real estate stocks don't have the shine of high-flying growth stocks or the intrigue of beaten-down value stocks, but they deserve a place in your portfolio nonetheless. While the market is going down, real estate will still be there, consistently churning out income to investors.
Let's go over how real estate stocks bring diversification, inflation protection, and income to your portfolio. We'll use Rayonier (RYN -0.56%), Gladstone Land (LAND -0.39%), and Annaly Capital Management (NLY -0.32%) to illustrate each concept.
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Diversification
True diversification benefits come from not being correlated with your other investments. That means it's better to buy one real estate stock, one retail stock, one bank stock, and one tech stock than to buy four tech stocks. If a market or sector-level calamity happens to tech stocks, it's likely to take down all four of your tech stocks. It isn't as likely to adversely affect the real estate, retail, or bank stocks.
Take a look at Rayonier's performance compared to the S&P 500 over the last year.
Data by YCharts.
Sometimes Rayonier's stock price followed the market, going up and down along with every other stock. Sometimes, most notably during the big drop earlier this year, it went up while the market went down. Real estate stocks aren't always a hedge to the market falling -- when investors get emotional, everything can go down at once -- but real estate prices respond to different factors than the stock market, so they're often not correlated.
In this case, Rayonier is a real estate investment trust (REIT) that owns 2.7 million acres of timberland. When investors were leaving growth stocks en masse, the price of lumber was hovering around three or four times the price it was two years ago.
Rayonier produces around 11 million tons of lumber each year and turns that production into a 2.6% dividend yield for investors. Rayonier's business is insulated from the fears that drove down growth stock prices, and it benefits from increasing commodity prices. This double whammy allowed it to have a positive return earlier this year when the market was falling.
Inflation protection
With the way the Federal Reserve works in the U.S., there will likely always be some level of inflation. The problem is when it gets to levels that start to hurt your portfolio. Right now, the CPI shows inflation of 7.9% over the last 12 months . That's a pretty high hurdle to clear to have good real returns in your portfolio.
Real estate is generally considered a good inflation hedge because real estate companies raise rents (and sale prices if properties are sold) along with inflation. For extra protection, you can buy real estate companies that benefit from inflation, such as Gladstone Land.
Gladstone owns farmland and leases it to farmers. Most of its leases are on a triple net basis, which means that the farmer is responsible for variable costs like insurance, maintenance, and utilities.
The leases also generally have either participation clauses or upward market adjustments. That means when the prices farmers sell their food for go up, Gladstone gets paid more rent. So its rental revenues go up, but its costs don't go up as much because the farmer is responsible for paying the variable costs. And the best part is that those excess profits are returned to shareholders as dividends.
Income
Real estate stocks, REITs specifically, are known for the income they generate for investors. REITs are required to pay out 90% of net income, so they often have very high dividend yields. This income stream is usually a trade-off for growth. REITs can't reinvest capital into the business, so they generally don't grow as quickly as other stocks.
For many investors, that is a good thing. It's nice to have low-volatility stocks in your portfolio that pay income consistently. The dividend, as long as the company keeps paying it, sets a floor on returns. If part of your portfolio is diversified into conservative income stocks, you don't have to panic when your high-flying growth stocks take a tumble.
Annaly is a good example of this. Its stock hasn't been a great performer over the past few years because of interest rate fears, but its total returns are basically flat because its dividend is so high.
Annaly is a mortgage REIT. It invests in mortgage-backed securities that are backed by the government. Government backing means there is very low risk of default for the company, but an increase in interest rates could mean it has to borrow money at a higher rate than it's earning on its investments.
Right now, the dividend yield is 11.8%. Interest rate-related fears could spell more flat returns in the stock, but the company has a hedging program, and investors should make plenty of income from the dividends until the stock price turns.
Location, location, location
Real estate stocks have a place in every investor's portfolio. But remember to choose them using the same principles you use to analyze any other stock. Find good businesses run by smart and ethical management, and buy them when they're trading for less than they're worth.