“Why are Real Estate Investment Trusts (REITs) Off to Such a Great Start in 2021?”
With almost half of 2021 now behind us, both domestic and global stock markets are off to a roaring start: The Dow Jones Industrial Average in the US has surged ahead 10.69%, while on the international front (as measured by the MSCI World Index excluding the US), equities have advanced 9.87% (as of May 31). Global economic growth appears to be returning even quicker than expected after the Covid pandemic, with many economists now forecasting that inflation could rise above the critical 4% level. Even with these healthy equity returns to begin the year, there is one area of the financial markets that is off to an even better start: real estate investment trusts (REITs).
Before we dig into the numbers, what exactly is a REIT? Equity REIT’s, are almost like a mutual fund, but invest strictly in companies involved in real estate. A REIT fund manager will assemble a variety of real estate-like stocks across a swath of real estate sectors: Companies that own, operate or finance income-generating real estate. Examples would be ‘old economy’ real estate like offices, apartments, shopping centers, storage facilities, hotels, etc. ‘New economy’ sectors that are now part of the REIT sphere are cell towers, data centers, life science and industrial companies. Some individual company names that many would be familiar with are Simon Property Group (that operates Lenox Mall here in Atlanta), Public Storage (storage facility) and American Tower (cell phone towers).
The main benefit REITs can give investors is an additional level of diversification within the equity component of their investment portfolio. Purchasing rental properties or vacant land can be an expensive endeavor for most individuals in terms of the upfront cost involved, management expertise required and ‘idiosyncratic’ risk (risk in each individual investment). Mutual funds or exchange traded funds that invest in REITs avoid these risks by allowing investors to purchase a small piece of a variety of real estate companies that are managed professionally and do not required the substantial initial investment. The liquidity ease of selling REIT shares vs unloading direct real estate quickly is another benefit.
In terms of returns, investors can benefit from in REITs in two different ways: through healthy dividend payouts and capital appreciation. The underlying properties that REITs own produce either a rent or lease payment that are paid out to investors. In fact, by law, to be classified as a REIT, the investment must pay out 90% of its earnings as dividends. This can benefit investors because as a dividend, only part of this income is taxed. In terms of capital appreciation, REITs give investors the exposure to the actual physical structures they own, which generally increase over time (and can actually be exacerbated during inflationary periods, which we will touch on later).
Similar to investments in common stocks, REITs are exchange-traded investments that are closely tied with the performance of the economy, and as such, do not come without risk. This was evident in 2020 during the onslaught of the global Covid pandemic where both domestic and international REITs produced dismal returns. As 2020 drew to a close, the US REIT market declined 5.86% (vs a gain of 19.96% in the Russell 2000 Total Return Index) while the global REIT market was off 9.16% (vs a gain of 14.33% for the MSCI All-Country World Index).
The opposite cannot be more true of REIT returns as we approach the halfway mark of 2021. REITs have dwarfed equity market returns both domestically and globally. As measured by the National Association of Real Estate Investment Trusts (NAREIT), REITs are up 21.4% in the US and sporting a healthy dividend yield of 3.05%. Internationally, global REITs (which include the US) are up 14.52% (in US dollars) with an even better dividend yield of 3.31%. Both of these returns are easily outperforming their stock market counterparts: The US Russell 1000 Index is up 14% while the MSCI All Country World Index 11% during the same measurement period.
Why are REITs performing so well over the first several months of 2020? The reason for this outperformance is two-fold.
First is the gradual reopening of the economy after the global Covid pandemic ravaged several real estate sectors in 2020. As the vaccination rollout continues and Covid concerns subside, several real estate areas have bounced back significantly. Economic activity has increased substantially and as people return to a more ‘normal’ life, areas such as bricks-and-mortal retailing, hotels and the office sector have all seen recoveries in their fundamentals. Albeit slowly, consumers are returning to the malls and workers back to the office, which both bode well for real estate.
The second has been the slow re-igniting of inflation which poses positive aspects for real estate. During inflationary periods, real estate often experiences two benefits: The underlying property values tend to increase and the rents/lease payments associated with those properties tend to be bumped up on tenants. As such, REIT investors can benefit from these two positives. In fact, the increases in REIT dividends have outpaced inflation (as measured by the Consumer Price Index) in all but two of the past twenty years. Currently REIT dividend yields are double the earnings yield on the S&P 500 as well as 10-year Treasury bond yields. This inflation benefit can allow investors to lump REITs in with commodities (like gold) and Treasury Inflation Protect Securities (TIPS) as good long-term inflation hedges.
Even with the rosy returns REITs have produced so far into 2020, the investment sector does not come without risk. For example, if new vaccine-resistant Covid variants arise, the economic recovery could derail, taking real estate values and their related incomes with it. If the economy heats up too quickly and inflation gets does get out of control, global central banks will be forced to raise interest rates with could negatively impact the sector. Furthermore, behavioral and attitude changes towards working from home and online shopping could possibly have longer term structural changes to real estate and how individuals use real estate in the future.
Where can REITs fit in with your portfolio investment allocation? Although most investment professionals would lump REITs into the equity portion of a long-term portfolio due to their capital appreciation potential, REITs can also be considered a more ‘hybrid’ type of investment. Equity REITs offer unique risk exposure to one sector, physical real estate and, coupled with the large dividend yield they produce, could possibly be included in the ‘alternative’ investment sector with commodities, hedge funds and private equity.
In conclusion, REITs are unique, sector-specific investments that can provide investors stock-like, long-term investment returns. In fact, over the 1972-2019 period, equity REITs have actually outperformed the S&P 500 (in terms of total returns which include both capital gains and dividends) by a 13.3% to 12.1% margin. REITs also produce a low correlation of returns against other portfolio components and exhibit lower volatility in terms of standard deviations. This being said, depending on the stage of the economy and the business cycle, a weighting of 2.5% to as high as 7.5% can be deemed appropriate exposure for an allocation to this area.
Check out the attached video where Bob Pisani of CNBC interviews Michael Arone, Chief Investment Strategist at State Street Global Advisors. Arone discusses how rising interest rates may not have as much effect on the REIT sector as they have in the past given the robust economic growth both domestic and global economies have been experiencing over the start of 2021. Arone also talks about inflation being positive for REITs in 2021 in terms of higher property values and increasing rental payments.