Own more real estate? I know, it sounds preposterous. The nightly news is filled with stories of record foreclosures, climbing default rates, and families trapped in underwater mortgages. Though many homeowners have learned the hard way that their personal residence isn't always a good investment, many investors might be surprised to find that real estate as an asset class has long been considered a great way to diversify your portfolio.

Traditionally, real estate has served as a safe haven during market turmoil because of its low historical correlation with the stock market, its consistent cash flow production, and its inflation hedging properties. Also, real estate investing trusts (REITs) pay higher dividend yields than most stocks due to a special tax structure that requires them to pay 90% of their earnings to shareholders. These fattened dividends have caused a feeding frenzy for yield-starved investors in a low-interest-rate environment.  

As you might expect, this high demand from income-oriented investors has resulted in higher stock prices and lower yields for many REITs. This trend would usually be a red flag for value-oriented investors because popularity is associated with high prices and low future returns on investment. However, with increasing economic uncertainty and high market volatility, I believe that a carefully selected portfolio of real estate equities still has an excellent chance of beating stocks over the next decade while reducing the overall volatility of your portfolio.

The proverbial free lunch
The most important reason to add real estate to your portfolio is simple -- diversification. Over the last several decades, real estate has tended to zig when both stocks and bonds zag, making it an excellent diversifier. In fact, adding a 10% to 20% allocation to real estate to a portfolio of stocks, bonds, and T-bills from 1972 to 2006 was shown in a study by Ibbotson Associates to both increase returns and lower the volatility of a portfolio.

Portfolio 1
Portfolio 2
Portfolio 3
Real Estate 0% Real Estate 10% Real Estate 20%
Stocks 50% Stocks 45% Stocks 40%
Bonds 40% Bonds 35% Bonds 30%
T-Bills 10% T-Bills 10% T-Bills 10%
Return 10.7% Return 11.1% Return 11.5%
Volatility 10.9% Volatility 10.6% Volatility 10.5%

Source: Ibbotson Associates via NAREIT (1972-2006).

Arguably, past isn't prologue, and the last three years have seen the relationship between real estate and stocks tighten as most asset class returns were closely correlated during the credit crisis. Though I think that this relationship might persist for the next few years, I also believe that this was an anomaly that is not representative of the normal U.S. business cycle. According to data by Morningstar, the pre-crisis average correlation between U.S. REITs and U.S stocks came in at .61 and the correlation between U.S. REITs and U.S. Bonds was -.10. In contrast, since 2008, real estate's correlation with U.S. stocks has been unusually high, often exceeding .80. This relationship makes sense because REITs are dependent on debt to purchase new properties or refinance maturing loans, so they're especially vulnerable during periods of credit tightening. In response to these credit scares, many REITs have deleveraged their balance sheet, so I think it's likely that we'll see a reversion to the mean as the credit markets continue to stabilize.

Ratchet up that allocation
Investing directly in real estate is both capital- and labor-intensive and usually doesn't offer the diversification benefits that are mentioned above unless you have a sizable bankroll. Interestingly, I've also found that the real estate weighting in most equity indexes is grossly inadequate to provide the level of diversification that I desire. For example, real estate only represents 3.2% of the Wilshire 5000 Total Market Index ETF. The obvious alternative is to supplement this with additional investment in REITs and other real-estate-related stocks.

As a result, I'm launching a real-money portfolio called the Total Realty Portfolio through The Motley Fool's Rising Stars platform. This portfolio will focus on helping Fools find reasonably priced real estate investments to fill out their desired real estate allocation. My strategy will be more ambitious than simply buying a basket of REIT indexes or ETFs. I'll be working to identify the best operators in each real estate subsector and related industries in hopes of delivering excess returns while maintaining a similar risk profile as an REIT index. The four main classes of investments that I will invest in include:

  • Equity REITs, such as Boston Properties, Simon Property Group, Weyerhaeuser
  • Mortgage REITs like Annaly (NYSE: NLY), Chimera (NYSE: CIM), American Capital Agency (Nasdaq: AGNC)
  • Real Estate Equities -- CB Richard Ellis, Home Depot (NYSE: HD), Brookfield Asset Management (NYSE: BAM)
  • Infrastructure -- Brookfield Infrastructure Partnership, American Tower (NYSE: AMT), National Grid (NYSE: NGG)

The ultimate goal of the portfolio will be to provide a mixture of capital appreciation, income generation, and inflation protection while generating returns that don't track the stock market. Watch for my first Rising Star buy recommendation within the next week.

Follow me on twitter at @TMFTotalRealty and join me on the Total Realty Portfolio homepage and discussion board to see my latest investments and talk everything real estate.