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Course 407
Real Estate Investment Trusts

Introduction

For many years, REITs, or real estate investment trusts, were seen as a good way to diversify a portfolio and provide some degree of protection against volatility in the equities market. During the 2000 market downturn, for example, when the S&P 500 lost 9%, real estate stocks gained 34% on average.

However, that was an extreme market environment, and events since then have altered REITs' role as a diversification tool.

This course will cover what REITs are, their diversification value, and how to think about them when constructing a portfolio.

What They Are

REITs are a type of stock made up of portfolios of commercial properties. These properties generate income from rent and capital appreciation in the form of rising property values. REITs typically invest in office buildings, shopping centers, hotels, and other properties. Some focus on specific types of real estate, such as health-care REITs that own hospitals, skilled-nursing facilities, and so forth. There also are mutual funds and exchange-traded funds made up of REITs as well as those that track REIT indexes.

REITs' main purpose is to generate revenue from leases. And because they are required to pay nearly all of that revenue to shareholders, they can offer high yields, making them good choices for investors looking for a steady source of income, though they are far more effective in tax-advantaged accounts such as IRAs or 401(k)s where their nonqualified dividends are shielded from Uncle Sam. Historically, REITs have provided a hedge against inflation, which tends to increase real estate prices and rents.

Diversification Value

One significant change was the addition of REITs to the S&P 500 in late 2001. (Today real estate makes up about 2% of the index.) This change has had a significant impact on the correlation between REITs and the S&P 500, one of the most widely used measures of overall stock market performance. With REITs added to the index, the S&P 500 has become more sensitive to their performance. In addition, as index funds have increased in popularity, more money has flown into REITs, as well, helping to increase this correlation.

The increased correlation between REITs and stocks was borne out in painful fashion during the 2008 market crash, when real estate funds lost 39.6%, compared with a 37% drop in the S&P 500.

It also should be noted that REITs are not the low-volatility asset class some think. Depending on the time period under review, real estate can have a standard deviation (a measure of volatility) greater than that of the S&P 500 index.

Asset Class Still Has Value in a Portfolio

Do these statistics mean REITs shouldn't play a role in your portfolio? Not at all. Although they might not provide the degree of diversification from stocks they once did, REITs do offer the benefit of exposure to an asset class that can deliver consistent income and possibly above-market returns.

It's also worth noting that, like stocks, REITs generally have a low level of correlation with bonds. REITs' role as a diversifier from stocks might be diminished, but they can still add diversification to a bond-heavy portfolio.

Just keep REITs' volatility and correlation to stocks in mind when considering your asset allocation. Also, be aware that many stock funds contain REITs, so you might already have some exposure to them without even knowing it.

Quiz 407
There is only one correct answer to each question.

1 REITs are
a. a type of stock made up of portfolios of commercial properties
b. a type of mutual fund made up of portfolios of commercial properties
c. a type of ETF made up of portfolios of commercial properties
2 Which statement below is false?
a. REITs' main purpose is to generate revenue from leases
b. REITs are not required to pay out revenue to shareholders
c. REITs can offer high yields
3 Why are REITs more highly correlated to the stock market today than they were 15 years ago?
a. They were added to the S&P 500 index in 2001
b. They are more widely held by more people via index funds
c. Both A and B
4 Which statement below is true?
a. REITs can add diversification value to a bond-heavy portfolio
b. REITs are consistently low-volatility investments
c. Mutual funds cannot own REITs
5 Before adding REITs to your portfolio
a. Understand what exposure you may already have to REITs in your portfolio via your mutual funds
b. Make sure the REIT doesn’t invest exclusively in shopping centers
c. Make sure you need the income
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