2

C H A P T E R

Why Invest in REITs?

M any investors buy REITs solely for the attractive dividend

yields they offer relative to government bonds and other invest-
ments. However, there are many more, equally compelling reasons
to include REITs as part of a well-balanced portfolio. Two such
reasons are that REITs typically have delivered total returns that
exceed those of the S&P 500 Index and that their dividends gener-
ally increase faster than inflation (as measured by increases in the
Consumer Price Index [CPI]), making REITs an effective hedge
against inflation. A third and equally important reason is that
REITs are a diversification tool; a wealth of research has proven
that investing in REITs helps lower risk and increase returns on a
portfolio of stocks and bonds.

Double-Digit Total Returns

Investor total returns on any stock investment are calculated as
the sum of dividends received plus any appreciation (or less any
declined) in stock price during the time the stock is owned. Due in
part to their attractive current yields, REITs have tended to deliver
annualized total returns to investors of 10 to 12 percent over time.
As shown in Table 2.1, equity REITs delivered average total annual
returns of 12.0 percent from 1972 to 2015—or 170 basis points more
than the 10.3 percent total return achieved by stocks in the S&P 500
Index over the same period. (A basis point [bps] is equal to 1/100
of a percentage point; for example, 1 percent equals 100 bps.)

19
The Intelligent REIT Investor: How to Build Wealth with Real Estate Investment Trusts,
Stephanie Krewson-Kelly and R. Brad Thomas
© 2016 by Stephanie Krewson-Kelly. All rights reserved. Published by John Wiley & Sons, Inc.
20 The Intelligent REIT Investor

Table 2.1 Comparative Compounded Total Annual Returns

Timeframe* All REITs All Equity REITs S&P 500 NASDAQ† DJIA

2015 2.3% 2.8% 1.4% 7.0% 0.2%

3-Year 10.3% 10.6% 15.1% 19.8% 12.7%
5-Year 11.6% 11.9% 12.6% 14.9% 11.3%
10-Year 6.9% 7.4% 7.3% 9.7% 7.8%
15-Year 10.8% 11.1% 5.0% 4.8% 5.8%
20-Year 10.3% 10.9% 8.2% 8.1% 8.8%
30-Year 9.4% 10.7% 10.4% 9.6% 8.4%
40-Year 12.0% 13.7% 11.4% 11.0% 7.8%
1972 – 2015 9.8% 12.0% 10.3% 8.9% 7.0%

∗ Compounded annual total returns for the number of years ended December 31, 2015. Shaded areas
represent time periods when equity REITs outperformed the S&P 500 Index.
† Price appreciation only. Compounded annual returns from 1972 to 2015 are calculated from the NASDAQ

Composite’s inception date of December 31, 1973.

Source: Reproduced by permission of the National Association of Real Estate Investment Trusts® and is
used subject to the Terms and Conditions of Use set forth on the NAREIT website, including, but not
limited to, Section 9 thereof.

Dividends
Dividend income is one of the primary reasons to invest in REITs,
in large part because their yields represent an attractive premium to
yields offered by other investments. As of December 31, 2015, the
average dividend yield from REITs in the FTSE NAREIT All REITs
Index was 4.3 percent, or approximately 200 basis points higher than
the 2.3 percent yield on 10-year U.S. Treasuries and the 2.2 percent
yield from the S&P 500 Index.
REITs are an attractive investment for people seeking current
income, provided that the REIT has a conservatively leveraged bal-
ance sheet and well-located assets that are competitively managed.
When a REIT possesses these qualities, it generally can sustain—and
preferably grow—the dividend it pays to shareholders. Chapter 3 dis-
cusses the characteristics of REIT dividends and dividend yield, as
well as quick calculations investors can perform to assess the sustain-
ability of a REIT’s dividend.

Liquidity
Publicly traded REITs offer investors the ability to add real estate
returns to their portfolios without incurring the liquidity risk that
accompanies direct real estate investment. This is because REITs that
are publicly traded on stock exchanges can be bought or sold in
 Why Invest in REITs? 21

an instant, like other stocks, through a financial advisor or online

trading services. (Nontraded and private REITs do not offer similar
liquidity; these structures are discussed in Chapter 6.) In contrast,
direct investments in real estate can take several months or even years
to sell. Publicly traded REITs, therefore, enable investors to partici-
pate in real estate–based investments in a liquid manner.

Portfolio Diversification
REITs are a proven diversification tool for portfolio management,
a fact that has been demonstrated in multiple studies by various
prominent investment advisory firms using different techniques,
data sources, and time periods. In simplistic terms, diversification
means that adding a particular investment to a portfolio increases
the overall expected returns of that pool of investments while also
reducing risk. Note that risk is also referred to as volatility.
The reason for this diversification benefit is because real estate
and, by extension, REITs represent one of the three fundamental
investment asset classes, the other two being stocks (also called
equities) and bonds. As Figure 2.1 shows, U.S. investment real estate
(which excludes single-family homes) is estimated to represent
$17 trillion, or 21 percent of the $79 trillion investable assets in the
United States. Because real estate has its own unique drivers and
cycle that are separate from that of other equities and bonds, real
estate investments promote portfolio diversification. (Chapter 7,
REIT Performance, discusses the real estate cycle in detail.)
In the past decade, six major studies have been performed to
determine what allocation to REITs will maximize their diversifica-
tion benefits. (Allocation speaks to what percent of the total portfolio
amount is invested in an asset class. For example, an individual may
invest 20 percent of his or her portfolio in REITs, 40 percent in equi-
ties, and 40 percent in bonds.) Figure 2.2 summarizes their findings.

Fact
A $1,000 portfolio invested in a combination of equities, bonds, and
equity REIT shares will produce greater returns and exhibit less risk
than a $1,000 portfolio that does not include an allocation to equity
REITs.
22 The Intelligent REIT Investor

Investment
U.S. Bonds Real Estate
$35 Trillion $17 Trillion
45% 21%

U.S. Equities
$27 Trillion
34%

Figure 2.1 Investment Real Estate Is the Third Largest Asset Class in the
United States.
Source: Reproduced from NAREIT materials by permission of the National Association of Real
Estate Investment Trusts® and is used subject to the Terms and Conditions of Use set forth
on the NAREIT website, including, but not limited to, Section 9 thereof.

Although many investors believe investing (or allocating)

between 5 and 10 percent of their portfolio in REITs is “about right,”
these six studies have shown that the optimal allocation to REITs is
as high as 20 percent—which is proportionate with the size of the
investment real estate market shown in Figure 2.1.
For example, the 2016 Wilshire Associates study commissioned
by NAREIT, The Role of REITs and Listed Real Estate Equities in Target
Date Fund Asset Allocations (the “2016 Wilshire Report,” reference in
Figure 2.2), found that the optimal portfolio allocates up to 17 per-
cent of assets to REITs. The study showed that a diversified portfolio
that included REITs had nine less basis points of risk (and generated
33 basis points of additional return) than a similar portfolio that did
not include REITs. Although 0.33 percent may not seem meaningful
on the surface, over time the additional return adds up.
A portion of this outperformance can be attributed to the robust
dividend yields and above-average returns REITs offer, but an equally
important factor is the low correlation with which REITs trade rel-
ative to bonds and other stocks. A correlation of +1 between two
investments means that they trade in complete lockstep with one
another; conversely, a correlation of –1 means they trade proportion-
ally in opposite directions. The 2016 Wilshire Report showed that
from 1975 through 2015, REIT share prices moved with a 0.58 corre-
lation with the Wilshire U.S. Large Cap Index and a 0.65 correlation
with the Wilshire U.S. Small Cap Index.
 Why Invest in REITs? 23

Morningstar Analysis Morningstar Analysis Morningstar Analysis

Mean Variance Optimization Mean Variance Optimization Fat Tail Optimization
1990–2007 1990–2010 1990–2009

21% 20% 20%

Morningstar Analysis Wilshire Analysis Wilshire Analysis

Liability Relative Investing Surplus Optimization Surplus Optimization
1990–2009 1990–2012 1990–2015

20% 18% 17%

Note: Allocations to any asset class will depend on the optimization methodology employed, the time period
covered by the analysis, the assets included in the opportunity set, and the expected return assumptions.

Figure 2.2 Portfolio Allocations to Global Real Estate (different researchers,

methodologies, and time periods)
Source: Reproduced from NAREIT materials by permission of the National Association of Real
Estate Investment Trusts® and is used subject to the Terms and Conditions of Use set forth
on the NAREIT website, including, but not limited to, Section 9 thereof.

As a final note, a groundbreaking study completed recently by

CEM highlighted the advantages of owning publicly traded REITs
rather than private real estate. According to a summary of the CEM
study provided by NAREIT, the study tracked returns from over 200
public and private pension plans with combined assets of over $2.5
trillion. The results, which are summarized in Figure 2.3, clearly
demonstrated that publicly traded REITs had the highest return
(net of expenses), with an annualized total return of 11.31 percent.
Private real estate returned just 7.61 percent.

Hedge Against Inflation

Equity REITs rent their properties to tenants according to leases,
the terms of which tend to protect the REITs’ margins from the
effects of inflation. As discussed in Chapter 4, most leases provide
24 The Intelligent REIT Investor

CEM Study Shows Actual Returns and Fees

For Major Asset Classes, 1998–2011

Private Other
REITs Equity Real
Assets Private
Real
Estate

Net Return Hedge

Annualized total
return % net of fees
Funds

11.31%

11.10%

9.85%

7.61%

4.77%
Fees 51
103 113 125
Investment costs BPS
in basis points 238 BPS BPS BPS
BPS

Figure 2.3 CEM Benchmarking Study: U.S. Defined Benefit Pension Plan
Performance
Source: Reproduced from NAREIT materials by permission of the National Association of Real
Estate Investment Trusts® and is used subject to the Terms and Conditions of Use set forth
on the NAREIT website, including, but not limited to, Section 9 thereof.

that landlords will bill tenants for various costs (utilities, taxes,
insurance, landscaping, etc.) after they have been incurred. In the
case of triple-net leases, the landlord does not pay any of these
operational costs; instead, tenants pay the costs directly. Apartment
landlords typically have one-year leases, and generally can increase
their rents (also called marking-to-market) to keep pace with inflating
costs. The ability to pass along increases in operating costs enables
REIT revenues to keep pace—albeit with some lag—with rising
prices in times of inflation. The result is that REITs generate
inflation-adjusted earnings, which makes their stocks attractive
investments during times of inflation.
Table 2.2 is excerpted from the 2016 Wilshire Report ref-
erenced earlier in this chapter, and shows how often different
investments—namely REITs, commodities (as represented by the
S&P GSCI Total Index), the S&P 500 Index, and Treasury Inflation
Protected Securities (TIPS)—generated total returns that exceeded
inflation. The higher the percentage shown, the more effective the
investment was at protecting (or hedging) against inflation. From
1975 through 2015, REIT total returns exceeded inflation 74 percent
of the time on a rolling 6-month basis, and 75 percent of the time on
 Why Invest in REITs? 25

Table 2.2 Percent of Rolling Periods in Which Total Return Met or Exceeded
Inflation: 1975–2015

FTSE All Equity S&P GSCI S&P 500 Barclays Capital

REITs Index Total Index Index U.S. TIPS Index∗

6-month rolling returns 74% 56% 69% 69%

12-month rolling returns 75% 57% 72% 74%
∗ BarclaysCapital U.S. TIPS Index inception was October 1, 1997.
Sources: Wilshire Compass; U.S. Department of Labor, Bureau of Labor Statistics. Reproduced from the
2016 Wilshire Report and by permission of the National Association of Real Estate Investment Trusts®
(“NAREIT”) and is used subject to the Terms and Conditions of Use set forth on the NAREIT website,
including but not limited to, Section 9 thereof.

a rolling 12-month basis. REITs’ ability to produce total returns that

were greater than inflation was comparable to owning TIPS, which
exceeded inflation 69 percent of the time over a 6-month period
and 74 percent of the time over a 12-month period. Although it
is not surprising that REITs’ inflation protection exceeded that of
stocks in the S&P 500 Index (69 percent and 72 percent on 6- and
12-month rolling returns, respectively), it may surprise investors to
learn that REITs also were a much more effective hedge against
inflation than commodities, where returns exceeded inflation only
56 percent of the time on a rolling 6-month basis and 57 percent of
the time on a 12-month basis.

Transparent Corporate Structures

The REIT industry is highly transparent in part because, as publicly
traded firms, each company faces a high degree of scrutiny every
quarter. There are over 30 firms in the United States. that provide
equity research on REITs. Additionally, based on data provided by
S&P Global Market Intelligence, 80 of the 223 REITs in the FTSE
NAREIT All REITs Index at the end of 2015 were investment-grade
rated and another 24 were rated but below investment grade, for a
total of 104 rated REITs. (Please see Appendix D, REITs with Credit
Ratings.) These 104 companies represent approximately 80 percent
of the industry’s equity market capitalization and have at least one
fixed-income analyst also scrutinizing their quarterly results. If a man-
agement team pursues a questionable business practice, such as using
short-term variable rate debt to finance growth, one of these ana-
lysts is bound to report on it, alerting investors and likely causing
that REIT’s valuation to suffer. Against the backdrop of accounting
26 The Intelligent REIT Investor

scandals like the Enron Corporation (former NYSE: ENE) in 2001

and Ponzi schemes like that of Bernie Madoff, which was revealed
in 2008, investors increasingly take comfort in REITs because of the
daily scrutiny they endure from the analyst communities.
Secondly, REITs are compelled to pay out at least 90 percent of
their otherwise taxable income, and many pay out 100 percent or
more. REITs also pay their dividends in cash (though the IRS has,
in the past, allowed REITs to issue new stock to pay their dividends)
and, therefore, operate with limited retained earnings. As a result,
they generally issue new public equity every other year in order to
finance growth. Whichever Wall Street firm a management team
selects to underwrite a stock issuance will subject the REIT to
yet another level of scrutiny as part of the investment bank’s due
diligence. As the accounting irregularities discovered at American
Realty Capital Properties’ (formerly NYSE: ARCP) in 2014 proved,
the REIT industry is not immune to scandal. However, incidents
of fraud are few and far between in the REIT world. The difficulty
REIT management teams would have in hiding accounting irreg-
ularities for any extended period of time, without disrupting their
ability to pay dividends or without being found out by the analyst
community or underwriters, minimizes the risk of fraud. The heavy
scrutiny under which REITs operate, as well as the discipline the
dividend payout requirement imposes on management, combine
to make REITs a highly transparent investment class that investors
increasingly turn to for steady appreciation and attractive yield.