Real Estate Investment Trusts (“REITs”)

reit-promo-type-1What do soaring rental markets, high yields and diversity have in common?  Answer: they are all part of the reason that Real Estate Investment Trusts (“REITs”) are booming.  In fact, they just became a new sector in the S&P 500 index.

For the first time since 1999, the S&P 500 index is being reconfigured; breaking out REITs from the financial sector. It makes sense, due to the unique characteristics of REITs. They own or finance property and pay no taxes, but have to distribute 90% of earnings to shareholders.  Their current yield is 3.6% more than double the 1.7% yield offered by a ten-year Treasury bond.

The growth of REITs have been accelerated by increases in renting as more people have decided to rent, not own, their houses.  Rents have increased 3%-6% per year in cities such as New York and San Francisco.  REITs have become very involved with residential real estate.  Some REITs, for example, own and rent groups of suburban single-family houses with gardens and make a substantial return doing it.

REITs have become more and more diverse. The early RE ITs of the 1960s were primarily used to own office buildings and produce a steady stream of rental income.  They were viewed similarly to bonds; drawing little interest in the 80s and 90s when stocks were providing double-digit annual returns.  Today REITs own cell towers and data centers.  Casinos and hotels have sold their properties to REITs and lease them back for their operating business.  Macy’s and McDonald’s have been receiving pressure from activist groups to do the same.

REITs have been one of the hottest investments of the last decade.  They’ve attracted $68 billion in Exchange Traded Funds (“ETFs”) since 2010; the most by any major industry classification, outpacing energy, technology and all the others. They are trading at 23 times earnings, compared with 17 for the S&P5 500 index on average.  With the influx of new cash, they have reduced their debt-to-asset ratio from 70% in 2008 to 31% today.

At DWM, we consider REITs as an alternative; neither a stock nor a bond. REITs have been part of our Liquid Alternatives model for many years.  As such, they currently represent about 7% of our clients’ alternative asset class. There is a small overlap due to the fact that REITs represent about 3% of the S&P 500 Index which clients gain exposure to via our DWM Core Equity model.  Overall, a typical DWM investor would have a roughly 1.5-3% overall allocation to REITs in their diversified portfolio.

With REITs being hot, it comes as no surprise that we’ve received questions recently wondering if now is the time to increase our overall REIT allocation.  We think not.

It’s curious.  Seventeen years ago, the S&P 500 Index added a new sector, technology, by splitting it from industrials.   This was right before the bust in March of 2000.  It took 13 years for the tech sector to return to its 1999 levels.  Similar results occurred with the Dow Jones industrial Average added Microsoft, Intel and Apple.  At the time of admission, all companies were at all-time highs, but once admitted, their values fell and it took considerable time for them to recover to those levels.

No one knows if the REIT breakout will help or hurt this sector. We do know REITs have performed well for our clients, for us and for others. We also know they have relatively high current valuations.  This is a good reason to keep the allocation where it is now and keep monitoring the situation.