Dear Mr. Market:

Well look at you! You’ve done it again…. haven’t you, Mr. Market? On countless past occasions you’ve managed to fool not only the average emotionally driven investor but also the seasoned professional. Now you’re doing it again with an area of the market that has fooled everyone; not just this year but for decades!

Investing in real estate may not seem like something you need to do within your standard “stock and bond” portfolio. Some may argue that your house is enough exposure to real estate and for most individuals it’s their largest investment so it should suffice. Your home is actually considered a “consumption good” instead of a pure investment. Although it’s likely to appreciate over time you will not receive income from it, it most likely has a mortgage attached to it, and if you need to sell 10% of it tomorrow you’re out of luck. Additionally there are many areas within real estate aside from what’s happening on your residential street. Commercial real estate, for example, makes up about 13% of the U.S. economy.

In 2013 almost every expert pounded the table and made intelligent sounding comments calling for investors to reduce exposure to REITs. These words of caution came after it was first announced the Fed would slow down its bond-buying program (Quantitative Easing). Conventional wisdom tells us that when interest rates rise REITs (and other asset classes like Bonds) won’t perform well. Unfortunately most of these comments came after the fact and REIT investors were hit hard in May of 2013. Those who listened to the stale news proceeded to sell their REITs as that “wasn’t the place to be”.

Even die-hard passive investment pros like Larry Swedroe, who is the director of research at Buckingham Asset Management, sold REITs in 2013. Why did this action grab our attention? Mr. Swedroe makes some of the most convincing arguments for passive investing and the use of indexes. If you’re a proponent of Modern Portfolio Theory and aim to stay true to asset allocation, you ideally trim the asset classes that have risen the most and reallocate towards the ones that have been hit. Is that what all the experts like Swedroe did? Nope…not this time! He (they) panicked and got fooled just like the rest of the investment herd.

The challenge, but ironically perhaps the true appeal, to owning REITs in a portfolio is that they give stock market-like returns but don’t always do so in perfect correlation. In other words, REITs provide you with some unique characteristics that earn them the right to be considered as a different asset class thereby enhancing your diversification. People often inherently confuse REITs as being highly correlated to the residential real estate market in their immediate area. Not only can you get attractive returns in a variety of different geographies but you’re also gaining exposure to areas of real estate that normally have barriers to entry for the average investor. Here’s an excellent resource to get you familiar with REITs. Click here and watch the video and then bounce back here to finish this article.

Buying REITs is not just about diversifying your portfolio. We advocate using them due to how well they perform! Most investors don’t realize this but over 30 years they have beat the stock market and they’re doing it again this year. The core investment we use to track REITs is the Vanguard REIT ETF (VNQ) and it’s not only giving us 3.64% in dividend yields but as of this writing it’s up +20.18% YTD compared to the S&P 500 which is currently up +7.04%.

Speaking of performance, how might that look like over time? We’re not asking you to entirely abandon the traditional mix of stocks and bonds but here’s something you need to know:

If on December 31, 1983 you invested $10,000 in a typical portfolio composed of 60% stocks and 40% bonds it would now be worth about $191k. What if you trimmed 5% from both stocks and bonds and allocated them towards REITs over that same time period? Your mix (55% stocks, 35% bonds, and 10% REITs) would be worth about $206k. Want to move the needle a bit more with what we recommend most investors should allocate towards “alternative investments” like REITs? Taking 10% off from both stocks and bonds (50% stocks, 30% bonds, and 20% REITs) and allocating that excess 20% towards REITs would have this same portfolio worth about $221k!

Lastly, what again were those experts worried about with the threat of rates rising? First and foremost, are rates any higher than a year ago? Do you believe the economy is humming along at such a hot pace that the Fed is going to run interest rates up quickly so we don’t get too ahead of ourselves? Folks…rates will eventually rise but don’t buy into the hyperinflation story too early. One final thing to consider is that during 2004 and 2006, when the Fed actually did raise rates, the stock market (S&P 500) rose 21%. How did REITs do since they are supposed to suffer in such an environment?….REITs went up 65% during that same stretch!

Here’s the bottom line: Get some exposure to REITs in your portfolio. Start at 5% and if
upon your next opportunity to rebalance the percentage is at 6% due to appreciation, sell 1% of them to get back to your initial allocation. If the opposite happens and they decline, buy more at a lower cost using proceeds from something else that you sold at a higher price. “Rinse, wash, repeat”…and you’ll beat most Nervous Nellies along with even the most astute and published investors year in and year out.