REITs Are Not Bonds
Real Estate Investment Trusts (‘REIT’s) have become a common alternative to bonds in portfolios. They are frequently sold to investors as stable, income-producing assets that have the additional safety of being backed by real estate. However, history clearly demonstrates that REIT’s are far from stable. Indeed, they are among the riskiest investments, more volatile than both stocks and most direct investments in real estate. Their use as a bond alternative creates a far riskier portfolio and leaves investors, especially those expecting a conservative allocation, surprisingly more exposed to an economic downturn.
A REIT is a company that owns or finances real estate. REITs are like mutual funds in that they allow investors an easy vehicle to purchase a prepackaged group of underlying investments. Mutual funds, of course, are used to purchase a group of underlying stocks or bonds, and REIT’s are used to purchase an underlying group of real estate investments.
Many investors who are attracted to the REITs because they are backed by real estate will be surprised to learn that REIT’s can actually be riskier than real estate itself. During the financial crisis, the prices of REITs were extremely volatile. For example, publicly traded REIT’s fell 60% between September 2008 and 2009, declining farther and faster than the S&P 500 itself. In addition, REITs fell dramatically faster than real estate, which declined by only 15% during that same time period.
One of the primary reasons for the difference is the use of debt, which amplifies any volatility in real estate prices. For example, REIT’s traditionally employ 50% or more in debt to acquire real estate. At 50% debt ratio an investor who places $50,000 with a REIT will get exposure to $100,000 in real estate. Given this structure, a 15% reduction in real estate will result in a 30% reduction in the value of the REIT’s value. More debt will result in more volatility and risk. Moreover, unlike a direct investment in real estate where an investor could simply ‘hold-on’ through the crisis, research has shown that REIT’s with higher debt levels were more likely to sell property, and raise cash through equity issuances at depressed prices during the financial crisis, resulting in lasting damage to REIT investors.
Even more concerning are unlisted or ‘alternative’ REIT’s. These products are sold as a stable, safe alternative to stocks and bonds because they have no daily liquidity and investors cannot see the price volatility in their investment. However, they are extremely risky vehicles and typically use even more debt than their publicly traded cousins.
Although Real estate investment trusts may have a place in an investor’s portfolio, investors should assess the level of risk that is appropriate for their goals and mindset. Given the volatility in REIT’s, using these investments as an alternative to bonds, simply because REIT’s also generate income, is very dangerous. If used in any portfolio, the risk of REIT’s should be considered and conservative investors should be wary.
“REIT and Commercial Real Estate Returns: A Post Mortem of the Financial Crisis”. Sun, Titman & Twite. McCombs School of Business at the University of Texas at Austin. April 2013
“Dangers in Unlisted Real State Trusts”. Laise, Elanor. Kiplinger. June 2011. http://www.kiplinger.com/article/investing/T044-C000-S001-dangers-in-unlisted-real-estate-trusts.html