I recently visited Machu Picchu, and a fellow hiker asked me what I do for work. I explained that I run a real estate investment club and that we pool small amounts of money to collectively buy fractional shares in large apartment complexes. She furrowed her brow and replied, “But why would I need to bother with all that private equity stuff? I’m already diversified into real estate with REITs in my brokerage account.”
I cringed at her use of the word “diversified.” Because for all the benefits of real estate investment trusts—and there are many—they don’t do the one thing that most investors think they do.
They don’t provide much diversification from your stock portfolio.
But I’m getting ahead of myself.
The Case for REITs
Don’t get me wrong, I’m no anti-REIT crusader. They offer plenty of advantages for investors, starting with being completely passive. You click a button in your brokerage account and congratulations! You’re done and can go back to your demanding full-time job, family life, and hobbies.
They don’t cost you an arm and a leg, either. The minimum investment is simply the price of a single share, which could be as little as $10. Compare that to the minimum investment in a rental property or real estate syndication. Either will set you back tens of thousands between the down payment, closing costs, cash reserves, and initial repairs. For first-time investors, it often takes years to save that much investment capital.
Then comes the liquidity. You can sell shares at a moment’s notice with no transaction cost whatsoever.
Investing in REITs doesn’t require the same knowledge and skill as rental properties. I lost my shirt when I first started investing in rental properties because I didn’t know what I was doing. For REITs, it’s as easy as investing in a REIT index fund and calling it a day.
Real estate investment trusts have actually performed pretty well over the last half-century, too. Over the 51 years from the start of 1972 through the end of 2022, U.S. REITs have delivered an average annual return of 11.26%, including both dividends and price growth. Some REITs pay yields over 5%, although high yields often coincide with low growth.
For a more detailed argument, read Jussi Askola’s case for REITs here.
So Why Don’t I Invest in REITs?
Those arguments have their merits, which investors can debate. But my objection is simpler, and harder to refute: REITs not only share stocks’ volatility but also a close correlation with their performance.
That correlation means that you don’t actually get much diversification benefit. This is the main reason I invest in real estate in the first place: to counterbalance my stock investments.
Don’t take my word for it. Take a look at how U.S. REITs have performed each year since 1972, compared to the S&P 500:
As an astute investor, you probably asked, “Okay, so what’s the actual correlation between REITs and the stock market at large?” Glad you asked: it’s 0.59, according to a multidecade study by Morningstar. That correlation is in line with other sectors of the stock market, such as telecommunications (0.62), consumer staples (0.57), and energy (0.64).
In other words, you can think of public REITs as one more sector of the stock market.
And one that’s just as volatile as the larger market, at that. Consider that last year, the average U.S. REIT delivered a total return of -25.10%, and that includes dividends. Yet the average residential property price rose 10.49%. That doesn’t include the income yield from rents, which in some markets exceeded cap rates of 8-10% in 2022.
Meanwhile, the S&P 500 fell 18.11% last year. Did REITs provide any protection for your portfolio against a crashing stock market? Absolutely not—quite the opposite, in fact.
How to Invest in Real Estate for Real Diversification
If you want true diversification to balance out your stock investments, you need to step out of the comfort zone of your brokerage account.
That could mean, well, just about any other type of real estate investment beyond REITs. But consider the following three, in order of ease and convenience.
First, you could invest through real estate crowdfunding platforms. I’ve invested through most of the mainstream platforms if only to gain firsthand experience for reviewing them as a writer. Some have my trust and respect (and a lot of my money), others my skepticism. All provide true diversification from the stock market. You can invest small amounts in some of them, and a few even offer liquidity and short-term investments. Crowdfunding platforms are easy to evaluate through the wealth of third-party reviews online and are entirely passive.
At the second level of complexity lie real estate syndications. Most of my real estate investment capital sits here. Don’t be intimidated by terms like “syndication” or “private equity”—these are simply group investments. You buy fractional ownership in an apartment complex or other large property, such as a self-storage facility, retail center, or mobile home park. And as a fractional owner, you get all the benefits of owning any other property: ongoing passive income, appreciation, leverage, and tax advantages such as depreciation.
Syndications come with a few challenges, such as finding syndicators and meeting the high minimum investment (often $50-100k). This is precisely the point of our investment club: each member can come up with small amounts of money to collectively reach that high minimum.
At the highest level of complexity and labor lie direct investment: buying properties yourself. These include long-term rental properties, short-term vacation rentals, flips, and every other direct investing strategy. It takes a ton of skill to consistently earn high returns and a massive amount of labor. But it also comes with enormous rewards, from ongoing passive income to tax benefits and, of course, true diversification from the stock market.
The Role of REITs in Your Portfolio
So, how should you invest in real estate? Should you invest in REITs?
I have no idea. It depends on your goals and the rest of your portfolio.
In my portfolio, I invest in real estate as a higher-return alternative to bonds. That means I need true diversification from the stock market.
I invest in stocks as long-term growth investments, largely in my retirement accounts. Because I don’t plan to sell any stocks for decades, I don’t care about their volatility. I just invest automatically every week through a robo-advisor, spreading my money among index funds.
Real estate, with its inherent tax benefits and passive income, balances against those stock holdings. The ongoing income helps on my journey to financial freedom. Combined with the low correlation with my stock investments, that means my real estate investments serve a similar role as bonds but with much higher returns.
Most of my real estate investments lie in syndications, as our investment club aims for 15-30% annual returns on them. But I also keep some money in shorter-term real estate crowdfunding investments for easy access in a pinch.
The average investor doesn’t approach their portfolio the same way I do. Most investors just lump stocks and REITs together as “equities” and invest in bonds to diversify against them. If you don’t care about the correlation between your stocks and real estate investments, then by all means, invest in REITs. It’s far easier than investing in rental properties or other real estate investments.
But if you invest in real estate as a counterweight to your stock portfolio rather than a part of it, you need more separation. Look to crowdfunding, syndications, or direct ownership for true diversification—along with all the other fun perks from tax benefits to ongoing income to appreciation and leverage.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.