Real estate investment trusts (REITs) have had two sizzling years. In a low-yield world, the high yields REITs offer have made investors take notice.
So how can a retail investor get easy exposure to REITs? And what's the proper allocation for a diversified portfolio? I put these questions to REIT expert Ralph Block at the end of January.
A former lawyer, Ralph is a leading expert on REITs, having literally written the book on investing in them: The fourth edition of his Investing in REITs is in the works right now. He is a former co-manager of the Undiscovered Managers REIT fund, and has been personally investing in REITs for more than 40 years.
Our interview covered a variety of REIT-related topics (including Ralph's thoughts on Weyerhaeuser). What follows is an edited portion of our conversation.
Brian Richards: What would be your advice for a retail investor who wanted to get exposure to the REIT space? Is it to index or to look for an actively managed fund, or is it just to get educated?
Ralph Block: I think the basic question for somebody who wants to invest in REIT stocks is, Do they want to do it on an active basis or a passive basis? ... And so if you're going to be a passive investor then the way to do it is just to be passive and say, "OK, I'm going to buy either a REIT mutual fund or I'm going to buy a REIT ETF," whether actively managed by somebody else looking for a four- or five-star Morningstar rating, or just to go index. Vanguard has an index mutual fund [Vanguard REIT Index Fund (FUND: VGSIX)] and they also have an exchange-traded fund [Vanguard REIT Index ETF (NYSE: VNQ)] with very low expense ratios, so ...
Richards: That was one of my later questions -- Vanguard obviously has low expenses and a good reputation.
Block: Sure, a very solid organization.
Richards: And as ETFs have sort of grown in popularity, I know there are now niche ETFs, while Vanguard's products obviously cover the whole spectrum. Do you still prefer those overall -- broad REIT index ETFs?
Block: Yeah, I do. I think an active investor, whether picking individual stocks or picking specific niche ETFs, can do better than a broad-based industry index if they get the sector right. And so the temptation is to say "I think retail's going to do better than industrial," or "I think apartment's going to do better than office, and I'm going to go there."
The problem is, with all the REIT funds out nowadays and the number of institutional investors that are investing in REIT stocks, it's pretty hard to consistently make good sector calls because a lot of people, even in the institutional world, make this mistake. They say "OK, look, our economic studies, space market studies, yada yada, say that the apartments are going to do better than offices."
The problem is, usually by the time they make that call the apartment stocks are going to be trading at much richer prices than the office stocks. So not only do you have to make the sector call right; you have to make the judgment correctly that the stocks don't already reflect what your space market conclusions are. And so I think unless somebody decides, "Well, I just love retail and I don't want to invest in any other REITs" -- fine if you want to go that way, go ahead and buy a retail ETF. But I think for most people it's better just to buy the REIT industry.
This is one area I would say that at least historically, actively managed funds have done better than the benchmarks. And I think that the reason for that is that it's been a fairly small asset class. It's like there have been some actively managed mutual funds that have done pretty well in the small-cap space, but in large caps it's almost impossible to beat benchmarks because there's just so much money in it and there's so many players.
And I think the REIT industry has been like that in the past. When we were managing the Undiscovered Managers REIT fund we'd meet with a lot of financial planners and they'd say "How come you guys keep beating the benchmark? You're not supposed to. It's supposed to be an efficient market." Well, it wasn't very efficient back then but I suspect it's probably more efficient now. Now, whether or not you can beat the benchmark by buying an actively managed fund in 2011 and '12 and '13 -- I just don't know.
Richards: A lot of financial planning model portfolios suggest a 5% allocation to REITs. I happened upon one of your message boards posts about how that's sort of a random kind of allocation in that it doesn't really juice anything and it doesn't give you all that much diversification. And I believe you advocate more along the 15% to 20% line for an average investor portfolio. Is that accurate?
Block: Yes, yes.
Richards: Can you just elaborate on some of the reasons for why 5% is too low?
Ralph: Well, I think that's right. I think 5% is too low. I don't think it'll really accomplish a whole lot for a diversified portfolio. It's not like earning 5% in something like gold or silver, which can go up 200% or down 90%. REITs are going to perform pretty much in line with most stocks simply because in the final analysis, real estate owners do well in expanding economies where there's more demand for space.
But I do think that there are enough differences between REITs and other stocks that justify a 15% or 20% weighting, and what I base that on is several things. First of all -- performance. ... Over the past 10 years REITs have done 11% total returns versus 1% for the S&P 500; 20 years, 12% for REITs, 9% for the S&P; 30 years, 11.6% for REITs, 10.4% for the S&P.
So you have long track records of really good performance, you have during most periods -- not during when everything was going down together, up until fairly recently when everything was correlated -- during most periods REITs' correlations with other asset classes are pretty low. They even have low correlations with bonds, which surprises a lot of people. So you've got that benefit.
You've got stability of cash flows. In most cases, most sectors are protected by long-term leases. They're stable, they're predictable, which can essentially make REITs boring -- these days, that's not a bad thing. And the other unique thing is REITs' requirement to pay out 90% or more of their net income -- what I call opportunity triage.
I think one of the biggest problems in corporate America is that the executives of most companies have decided that a company's cash flow is theirs -- it's not the shareholders', it's theirs. And so what they do is they take that money, they keep the dividend payments really low and they make investments with them, and a lot of times they're not real careful about what they do with that capital.
And so Peter Lynch used to call that "diworsification." And REITs don't have that privilege. They have to pay out most of their cash flows and so that requires that they pursue what I call opportunity triage, where if they've got 10 great ideas they might only have money for two or three of them. And so it imposes a discipline on them to make their best choices, and I think that's a really good thing and it's something you just don't see discussed very often. ...
And I guess the last point in favor of a 15% to 20% allocation is a study done by Ibbotson Associates some years ago. They said, "What happens to a portfolio if you put in 5% REITs, 10% REITs, 20% REITs?" And what they showed was that as you get closer to 20% your risk-adjusted returns continue to increase. You have less volatility and your returns are actually better.