Is Your Allocation to Real Estate Doing Its Job?

Like most successful investment advisors, you likely allocate a portion of your clients' portfolios to real estate. Popularly known as an asset class that can enhance portfolio diversity, reduce volatility and potentially improve risk-adjusted returns, there is a reason why 83% of financial advisors in the U.S. recommend REITs to their clients.¹

And you are well aware choices abound for you when identifying the right real estate strategy for your clients. For example, you have access to domestic and global REITs, real estate mutual funds, and real estate ETFs. And these securities don't even include the private real estate market.

We often get questions from advisors regarding how effective real estate is in delivering on its promises. For example, does it truly act as an uncorrelated asset class to equities? Is it an effective and competitive alternative source of income compared to traditional fixed-income investments? Is a 5% allocation to real estate meaningful enough to have a positive impact on portfolio performance? These are all valid questions and are the reason why we believe you will find this discussion helpful.

Real Estate Can Help Diversify

Commercial real estate is an asset class subject to its own unique set of market influences. And the political, economic, and policy forces that can impact the performance of stocks and bonds often influence commercial real estate in different ways.

A good illustration of how real estate can help diversify a traditional portfolio when market conditions are challenging is to look at how it has performed during inflationary environments:

"The period 1974-1981 was the most inflationary eight years in the history of the Consumer Price Index at 9.3 % per year, but equity REIT returns easily preserved purchasing power, with income and total returns averaging 10.2% and 16.3% per year." - Forbes.com²

But When Public REITs Closely Correlate, Private Real Estate Can Help

On the other hand, there have also been periods where publicly-traded REITs have performed very similarly to equities, causing some industry experts to caution investors against relying too much on real estate's diversification capabilities.

"Over the past three years, REITs have also moved fairly closely in step with large-cap stocks, with a three-year correlation coefficient of 0.75. That makes REITs significantly less attractive from a diversification perspective." - Morningstar³

To help minimize this correlation conundrum, many advisors turn to private real estate for their clients. Private real estate investments are not subject to the same market influences as publicly-traded securities and subsequently are less correlated.

Why Quantity Matters

What is the appropriate real estate allocation for a client's portfolio? Obviously, answers to that question depend on several factors, including the client's investment objectives and time horizon. Yet, because many investment advisors are not as familiar with commercial real estate as they are with equities and fixed income instruments, we often hear that allocations are relatively small, considering how big the asset class is.

According to NAREIT, the U.S. REIT industry's leading trade and research organization, multiple studies have found that the optimal REIT portfolio allocation may be between 5% and 15%. But a 5% or smaller allocation is not likely to provide the desired benefits that real estate can offer, including a hedge against inflation, an alternative source of income, and the potential for reduced portfolio volatility. That's why many investment experts recommend a 15% allocation or larger.

"David F. Swensen, Ph.D., noted CIO of the Yale endowment and author of Unconventional Success: A Fundamental Approach to Personal Investment, recommends a 15% allocation to REITs for most investors." - NAREIT.com⁴

NAREIT explains that "Commercial real estate is the third-largest asset (17 percent) in the U.S. investment market, after U.S. equities (37 percent) and U.S. bonds (43 percent). Modern portfolio theory argues that well-diversified investment portfolios should include meaningful allocations to all assets in the market basket, including real estate."

Growth or Income. Or Both?

Many advisors use real estate in client portfolios for the primary purpose of diversification. But the world of commercial real estate is vast, and the strategies used by investment managers cover the risk spectrum from conservative to aggressive, with objectives ranging from income to capital appreciation.

To ensure your real estate allocation is doing what you want it to do, it's imperative that the investment strategies of the managers you select align with your client’s investment objectives. Knowing whether your real estate allocation is designed for income or growth will also help you understand where it sits on the risk spectrum in a portfolio. That lets you know where you might want to reduce specific allocations (bonds or stocks) as you increase your exposure to this essential asset class.

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Sources & Important Disclosures:

¹https://www.wealthmanagement.com/reits/what-right-reit-allocation
²https://www.forbes.com/sites/bradthomas/2021/04/07/why-reit-investors-dont-need-to-fear-inflation/?sh=1c29de79aba0
³https://www.morningstar.com/articles/1028248/why-im-lukewarm-on-real-estate
⁴https://www.reit.com/nareit/advocacy/investor-outreach/resources-financial-advisors

Past performance is no guarantee of future results. Investing in real estate is intended to be a long-term investment and there are risks associated with real estate investing including changes in economic conditions affecting the demand for real estate and the illiquid nature of investing directly in real estate.