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Real estate as a wealth generator is hardly a new idea. People owned property long
before the advent of stock exchanges and other capital markets. In more recent <mes,
large corpora<ons and ins<tu<ons have held commercial real estate in their por?olios.
But individual investors have not tradi<onally had ready access to a professionally
managed, diversified real estate por?olio. This has changed in the last few decades with
the development and growth of real estate investment trusts, or REITs. Now individuals
can add a real estate component to their por?olio to improve overall diversifica<on.
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A REIT is a company that owns, operates, and/or finances real estate property.
1
Most of
this discussion will address equity REITs, which manage different types of income-
producing proper<es, such as hotels, office buildings, industrial facili<es, apartments,
and shopping centers. As commercial landlords, equity REITs typically generate dividend
income from the rent paid by tenants. Many REITs in the US are traded on the public
stock exchanges.
Publicly traded REITs offer investors several poten<al benefits:
Real estate exposure. While publicly traded REITs account for only a small por<on of
the real estate investment universe and the equity market, academic evidence
suggests that REITs have similar returns to the overall real estate market .
2
Low correla1ons with financial assets. Over longer periods of <me, historical
correla<ons of REITs and stocks have been generally low. (Correla<on refers to the
co-movement of asset returns. When two assets are posi<vely correlated, their
returns tend to move together; when nega<vely correlated, their returns are
dissimilar.)
Diversifica1on. A REIT holds a por?olio of proper<es, which may specialize by
property type and industry, or be broadly diversified according to industry and
region. With the more recent advent of real estate securi<es overseas, investors can
further diversify their exposure among foreign developed markets.
Higher yield, regular income, capital apprecia1on. Since REITs have to pay out a large
frac<on of earnings as dividends, they tend to offer higher-dividend income than
equi<es, and this may benefit certain income-oriented investors. Total return of the
shares is <ed to income and change in market value.
Dis1nct asset class. While REITs are considered equity vehicles and can have
significant exposure to the size and value risk factors, they are generally considered
to be a separate asset class, due to their low long-term correla<ons with stocks.
Liquidity and transparency. Publicly traded REITs can be bought or sold whenever the
stock market is open for business. The availability of market-determined share prices
can reveal informa<on about the markets assessment of the companys prospects,
including the ability of the firm’s management team.
Tax treatment. REITs operate as “pass-through” corpora<ons in which most income
goes directly to shareholders. They typically pay li[le or no taxes on corporate
income.
3
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A REIT mutual fund that manages a por?olio of REITs typically offers more diversifica<on
than owning a single REIT. Most REIT funds are either ac<vely managed or indexed. An
ac<ve fund manager seeks to pick securi<es that appear undervalued—an approach that
o^en results in over-concentra<on in a single category, which may raise risks and
poten<al costs, including transac<on costs and management fees. On the other hand, an
index fund tries to replicate a benchmark, such as the FTSE NAREIT Equity REIT Index or
the Dow Jones US Select REIT Index. Although index funds may have lower fees,
securi<es held in the por?olios may experience buying and selling pressure when
indexes are recons<tuted.
Our preferred approach is a structured strategy. Rather than trying to replicate an index,
a manager may choose securi<es based on risk-return characteris<cs, diversifica<on
benefit, and favorable price nego<a<on. By keeping costs low and trading efficiently, a
structured REIT strategy seeks to generate improved returns over <me. Advantages of
this approach include broader, more systema<c exposure to the REIT universe at a lower
cost.
Adding a real estate component to a por?olio may be a good diversifica<on move. But
strategy and implementa<on are crucial, and before inves<ng, you should consider how
a real estate strategy and the REIT you select may affect your por?olio. Some factors that
may come into play:
Asset coverage. Most ac<vely managed stock funds and indexes include REITs in their
equity holdings. This creates the poten<al for overlapping asset class exposure for
investors who add a REIT component in their por?olio. Trea<ng REITs as a separate
and dis<nct strategy helps you achieve more precise risk exposure in the asset class
weights. For example, investors with significant direct ownership in real estate may
want to exclude REITs from the equity component in their por?olio to be[er control
their overall exposure.
REIT category. Equity REITs may operate property in a specific area of exper<se, such
as retail, office and industrial, hotels, or health care facili<es. Residen<al REITs own
and operate apartment buildings and mul<-family commercial dwellings, rather than
single-family homes. Mortgage REITs, which lend money directly to real estate
owners or invest in exis<ng mortgages or mortgage-backed securi<es, are generally
excluded from the equity REIT universe because they perform more like fixed income
instruments, with income based on interest payments. Hybrid REITs combine the
strategies of equity and mortgage REITs.
Diversifica1on. As with financial assets, owning a broad mix of REITs can help reduce
specific risk in a por?olio. This diversifica<on eliminates exposure to a single REIT
category, manager style, or geographic region. Also, adding interna<onal real estate
can further enhance the poten<al diversifica<on benefit.
4
Correla<ons among
interna<onal REITs are low across countries, regions, and equity markets, making
them a useful complement to equi<es in developed and emerging markets.
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REITs carry stock market risk, as well as risks specific to individual real estate proper<es,
sectors, regional markets, and the opera<ng firm. The securi<es are also subject to
market pressures that may push share prices above or below the value of the underlying
real estate. However, iden<fying a market premium or discount in a REIT is difficult since
the underlying asset value reported by a REIT is based on an appraisal, which may be
several months old. REIT returns also depend on the buying, selling, and opera<ng
decisions of management.
A manager may adopt risky strategies, such as heavy leveraging or lack of diversifica<on.
They may pay too much for proper<es, acquire poorly performing proper<es, change
strategies regarding property mix, or make other business decisions that compromise
performance. Investors holding foreign REITs or REIT funds are also exposed to risks
specific to the country, such as legal structure, investment restric<ons, ownership rules,
tax treatment, and currency risk.
All of this underscores the importance of knowing your risk tolerance, carefully analyzing
REIT fund managers, and diversifying to eliminate exposure to a single REIT manager or
category.
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1. Equity REITs make up about 91% of the REIT market. Mortgage REITs, which compose about 7% of the
market, loan money to real estate owners or invest in exis<ng mortgage-backed securi<es. Hybrid REITs
combine the strategies of equity and mortgage REITs and make up about 1% of the market. Source:
Na<onal Associa<on of Real Estate Investment Trusts, Inc. (NAREIT).
2. Joseph Gyourko and Donald B. Keim, “Risk and Return in Real Estate: Evidence from a Real Estate Stock
Index,Financial Analysts Journal 49, no. 5 (September-October 1993): 39-46.
3. A US REIT must invest at least 75% of its assets in real estate and derive at least 75% of its income from
real estate property or interest on real estate financing. It must also distribute at least 90% of its income to
shareholders to maintain tax-advantaged status. This pass-through provision allows REIT investors to have
access to the same cash flows as investors in private real estate equity. REIT shareholders, however,
generally must pay taxes on income they receive from a REIT.
4. Over the 20-year period from 1990 to 2009, the annual return correla<on between US REITs and the US
stock market was 0.498 (1.0 denotes exact posi<ve correla<on in returns).
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The informa<on presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.
Diversifica<on neither assures a profit nor guarantees against loss in a declining market.
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Annual Returns: 2000-2009
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2000
31.04%
-11.41%
2001
12.35%
-11.15%
2002
3.58%
-21.15%
2003
36.18%
31.61%
2004
33.16%
11.97%
2005
13.82%
6.16%
2006
35.97%
15.47%
2007
-17.55%
5.83%
US Equity REITs are represented by the Dow Jones US Select REIT Index.
The US equity market is represented by the CRSP 1-10 Index.
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Returns in USD. Incep<on dates for Dow Jones US Select REIT Index is January 1978; CRSP Deciles 1-10
Index incep<on date is January 1926.
Indices are not available for direct investment, and performance does not reflect the expenses associated
with the management of an actual por?olio. Past performance is no guarantee of future results.
The Center for Research in Security Prices (CRSP), at the University of Chicago Booth School of Business
(Chicago GSB), is a nonprofit center that also func<ons as a vendor of historical data. CRSP end-of-day
historical data covers roughly 26,500 stocks—ac<ve and inac<ve—listed on the NYSE, Alternext, Amex
(formerly AMEX), NASDAQ, and ARCA exchanges. OTC bulle<n board stocks are not included.
Past performance is no guarantee of future results. This informa<on is provided for educa<onal purposes
only and should not be considered investment advice or a solicita<on to buy or sell securi<es. OpenCircle
Wealth Partners is an investment advisor registered with the State of Connec<cut.
2008
-39.20%
-36.70%
2009
28.46%
28.82%
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F+C%
Q+C%
PH+C%
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IPH+C%K
Dow Jones US Select REIT
Index
28.46%
-13.65%
8.69%
20.41%
CRSP Deciles 1-10 Index
(US Market)
28.82%
-4.79%
8.46%
15.38%