Friday Finance: the trouble with REITs

https://static.seekingalpha.com/uploads/2019/7/13/saupload_REIT-Real-Estate-Investment-Trusts-2.png

This is an extract from The Poor Man’s Guide to Financial Freedom: A Realistic, 10-Step Manual for Building Liberating Wealth on a Low to Medium Income.

REITs

There is a way to invest only a small portion of your capital in property instead of buying a whole house.  This is through a fund that pools investor money and uses it to invest in many properties.  Such a fund is usually called a real estate investment trust (REIT, pronounced ‘reet’).  Through this vehicle, you can put exactly as much or as little of your wealth into property as you want, with plenty left over for investing in shares and bonds in order to better diversify your holdings. 

In addition, these REITs can invest in a variety of types of properties, i.e. mortgages, commercial office space, or retail, and they can invest across many locations, thus significantly reducing the risk should any one investment go bad.  For some investors, this can be a good way of getting into property without having all the hassle of owning an actual house.

Most REITs are for commercial properties but some REITs are in the form of mortgage-backed securities (MSBs).  This is basically a product made by banks selling on the mortgages they have issued.  Check the glossary if you’d like more information [book exclusive content].

These were exactly what triggered the Great Recession: they were marketed as fairly safe investments, but actually they were built on a house of cards, the cards being people who’d been granted home loans despite not having the income and credit rating to merit such lending.  These are called ‘subprime mortgages’, and when too many people could not pay up, the global economy crashed.

So far as I know, these funds have now been reformed.  However, I do not know everything about every REIT on the planet.  Check it out and always seek independent advice, as we’ll discuss in Step 9.

While a Round 2 of the subprime crisis seems unlikely, and would not directly affect most REITs anyway, a more serious concern is how well REITs actually diversify your portfolio.  If REITs were good for diversifying away from shares they would get completely different returns to them, but research indicates that the correlation between a big Vanguard REIT and the S&P 500 (i.e. shares) is 0.64.[i]

For those who’d like a recap of their schoolboy math, a correlation of 1.00 means the returns are exactly the same, 0.00 means there is no correlation, and a correlation of -1.00 means that the returns are exactly opposite to each other.  There’s a short refresher on these coefficients at the link in this endnote.[ii]  If two investments were inversely (negatively) correlated, that would be perfect.  It would mean that while one asset struggled, the other would be doing well, thus evening out risk while not sacrificing too much on returns so long as both are growth assets.

https://static.twentytwowords.com/wp-content/uploads/Screen-Shot-2014-05-09-at-9.47.38-AM.jpg

Unfortunately, that correlation between shares and REITs of 0.64 is getting kind of close to 1.00, which shows that REITs are actually giving you pretty similar returns to shares, at similar times.  They tend to move in tandem with one another.  For this reason, I’m not sure that REITs really offer that much diversification. 

In addition, I had a look at an Australian Vanguard REIT fund and found that the main companies they invest in are listed on the stock exchange.  This means that if you have an ordinary index fund of shares you will have some exposure to property anyway, and if you separately invest in a REIT you’ll be investing in them twice and paying extra fees for the privilege.  I’m not sure why you’d want to do that.

Finally, some people claim that property is a good hedge against inflation because land, unlike money, is limited in supply.  This might be another reason for diversifying into a REIT.  However, I’ve since read convincing arguments that REITs hedge against inflation not a lot more than shares do.[iii]

If you really like the idea of investing in real estate but don’t want to buy a whole house, a REIT may be suitable.  Try to find one that doesn’t just invest in shares that you already have exposure to.


[i] https://www.macroaxis.com/invest/market/VNQ–compareProfile–%5EGSPC

[ii] https://www.dummies.com/education/math/statistics/how-to-interpret-a-correlation-coefficient-r/

[iii] https://jlcollinsnh.com/2014/05/27/stocks-part-xxii-stepping-away-from-reits/

Also available on many other platforms.

2 comments

  1. ruralcounsel · June 1

    Many REITs are invested in commercial properties. How well do you think shopping malls and office buildings are doing in this time of COVID, Amazon, and “work from home?” Financial outfits are even considering abandoning Wall Street and NYC as being too expensive, too unnecessary, and too unsafe to live in anymore.

    Liked by 1 person

  2. Stacy · June 23

    Thanks for sharing your insight on the matter!

    Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s