What Asset Allocation Level Should You Use for Real Estate Investment Trusts (REITs)?

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Over the past few weeks, we’ve been discussing several interesting aspects of asset allocation and portfolio design. For example, we’ve explored how gold/precious metals, international equities, short-term bonds, and intermediate-term bonds perform as asset classes and if/how they should be weaved in to your asset allocation.

Continuing this investigation on portfolio construction, I wanted today to look in to the question of “what level, if any, of your portfolio should be allocated to Real Estate Investment Trusts (more commonly referred to as REITs in an effort to reduce the mouthful of words!)?”

Let’s get started!

Why Bother Considering the Addition of REITs at All?

To begin, the first question that I suppose we should address is the question of why it’s even worth considering adding REITs to your portfolio in the first place.
As is the case with many elements of Modern Portfolio Theory and portfolio construction in general, REITs provide a favorable diversification benefit when incorporated with other components of your portfolio.
More specifically, this diversification benefit comes from the fact that the average return statistics of REITs are not perfectly correlated with other commonly-included asset classes of a portfolio. In mathematical terminology, we can say that the diversification benefit is obtained because the correlation coefficients of REITs with the other asset classes are not 1.
The demonstrate this in tabular form, I ran a correlation coefficient analysis of the annual returns of the Total US Stock Market, REITs, and Short-Term Treasuries between the ~40 year period between 1972-2011 (using data from the Bogleheads.org Simba backtesting spreadsheet).
The correlation coefficient results can be seen in the table below. As you can see (green highlighted cells), the correlation coefficients between REITs and the Total US Stock Market / Short-Term Treasuries are quite favorable at 0.62 and 0.01, respectively. What this means in English is that the returns of REITs move in sync with the stock market in general a little over 1/2 the time and with Short-Term Treasuries almost none of the time. 

According to Modern Portfolio Theory principles, adding a poorly correlated asset class in to a portfolio can often decrease volatility while possibly, increasing returns. Thus, this is the motivation for looking at including REITs in a portfolio/asset allocation.

What Do the Experts Say About Adding REITs to Your Portfolio?

Before getting too far in to my own asset allocation analysis, I generally like to quickly review and summarize the thoughts that people much more qualified than I am have on a subject.

As such, listed below is a summary of what has been recommended in the books of several well-respected asset allocation authors regarding the incorporation of REITs in to a portfolio:

  • Larry Swedroe (probably my favorite investing author I have found to date)
  • Burton Malkiel
    • In his famous and amazing book (2003 edition), A Random Walk Down Wall Street, Malkiel provides example asset allocations with between 10-15% of the total portfolio allocated to REITs.
  • William Bernstein (my 2nd favorite investing author I have found to date)
    • In his 2002 book, The Four Pillars of Investing, Bernstein displays sample portfolios/asset allocations with REITs representing 6-10% of the total portfolio.
    • He also mentioned that because REITs are poorly correlated with the total stock market, investors generally will have tracking error if their REIT allocation is greater than 15% of your equity position. In other words, REITs should be kept to less than 15% of the equity allocation.
    • This perspective was approximately echoed in his 2001 book, The Intelligent Asset Allocator, as well.
  • Rick Ferri
    • In his 2006 book, All About Asset Allocation, Rick provides sample portfolios containing 10% allocation to REITs during working years, and 5% allocation during retirement.

Conclusion from Literature – So, after looking through all of the books that have helped me build my portfolio over the years, the consensus seems to be that REITs should make up between 10-15% of an investor’s equity allocation in order to get the diversification benefit but not risking the introduction of tracking error. Of course, this number will change as your life cycle allocation adjusts during different life stages.

How Have REITs Performed in the Past Compared to Other Portfolio Components?

In this case especially, the literature seemed to provide rather definitive guidelines about what is a good amount an investor should allocate to REITs. This is nice, since it takes some of the guesswork out of my analysis.

The first thing that is interesting to examine when seeing how REITs have performed compared to other common asset classes is to see how an investment made a long time ago (~40 years in this case) would have grown.

As such, shown below is the hypothetical growth of a $10k starting investment in REITs (red line), the Total US Stock Market (blue line), and US Short-Term Treasuries (green line) between the years of 1972-2011.

As you can see, the investment in a REIT surprisingly produced a MUCH higher ending portfolio value than the investment in the Total US Stock Market ($400k vs. $850k with the REIT).

If we look at the actual return data that produced the graph above, the superior performance of REITs during this time period is also confirmed. REITs had an average return of 13.4%, compared to only 11.3% for the Total US Stock Market.

Intriguingly, REITs delivered this higher return with almost exactly the same volatility as the Total US Stock Market, meaning that it was highly efficient. Of course, this efficiency was likely what caused the ending portfolio value to be so much higher for REITs compared to the Total Stock Market.

REIT Allocations in a 3-Component Portfolio Design

More important to us as portfolio design “engineers” is how an asset class will behave and/or benefit us when incorporated in a realistic portfolio/asset allocation.

To assess this for the REIT asset class, I re-ran the portfolio analysis during the 1972-2011 period using a portfolio consisting 30% of fixed income Short-Term Treasuries and then varying allocations of REITs (between 0-70% of the total portfolio). The remaining allocation was filled up with the Total US Stock Market asset class.

Shown below is the average annual return vs. risk graph that resulted from the analysis.

And, shown below is the exact data that was used to construct the return / risk curve above.

If we examine this data a little more closely, we see that every increase in REIT allocation results in an increase in average return, as we might expect since this asset class did better than Total Stock Market during the time period analyzed.

However, more importantly, we see that adding up to 70% allocation to REITs results in the same risk level as a non-REIT portfolio. In terms of return/risk efficiency, we see that a portfolio containing 40-50% REITs is the most efficient.

You can view the complete set of numbers/calculations for my analysis by accessing the Google Docs Spreadsheet here.

Conclusions from 3-Component Portfolio Analysis –

Unfortunately, just because this analysis I ran above shows that a 40% REIT asset allocation is most efficient, it doesn’t mean that we want to rush out and buy as many REIT shares as we can.

This is due to two things – historical data and tracking error.

  • During the past 40 years (even though this is a huge chunk of time), REITs have performed phenomenally well compared to historical standards for real estate.
    • For example, in Rick Ferri’s book, All About Asset Allocation, he provides long term returns for real estate and the total stock market between 1930-2004. The data shows that the Total Stock Market (9.7% average annual return) has outperformed real estate (9.3% average annual return) by 0.4% per year.
    • In general, the consensus in almost every other long term study I have read indicates that real estate / REITs should be expected to have long term returns roughly the same as common stocks.
    • Thus, we cannot rely on the stellar REIT results from the past 40 years to continue.
  • Next, we must also consider tracking error.
    • Since REITs have low correlation with the general stock market, myself (and likely other investors) would not have the discipline to stick with a 40-50% REIT allocation over a long term period.

Conclusions about REIT Asset Allocation and My Personal Path Forward

So, after sifting through all this analysis, what’s the overall verdict on what asset allocation should be committed to the REIT asset class?

Listed below are my key takeaways from this investigation:

  • REITs provide a strong diversification benefit due to their low correlation of returns with other asset classes, and thus, are good to include in your portfolio. They also have an attractive return / risk efficiency profile.
  • Even though REITs have nicely outperformed the total stock market in the past 40 years, over the long run, history suggests that we realistically should expect REITs to produce returns more equivalent to common stocks.
  • An appropriate asset allocation to REITs is between 10-15% of an investor’s equity allocation in order to get the diversification benefit of the asset class, but not risk the introduction of tracking error. This is the recommendation from the literature as well.

My Personal Path Forward – I want to lastly share how this analysis affects me personally. I currently use a 70/30 equity-fixed income asset allocation. 10% of my total portfolio (or ~14% of my equity position) is allocated to REITs. Thus, I’m pretty much already in line with my conclusion above. So, no action is needed at this time. I do, however, need to make a note to track this asset class as a % of my equity position going forward.

How about you all? Do you have any exposure to real estate or REITs in your investing portfolio?

If so, what % of your portfolio does it constitute?

Share your experiences by commenting below!

About the Author Jacob A Irwin

Hi folks! My name is Jacob. I am the owner and operator of My Personal Finance Journey. I started this blog in January of 2010 and have enjoyed the journey ever since. Since finishing up graduate school in Virginia in 2014, I have been working in biopharmaceutical development in Colorado. You can read more about me and this site here​. Please contact me if you have any questions!

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Leave a Comment:

rjack says May 1, 2013

I love your asset allocation articles!

I agree with you that REITs help diversify your asset allocation. However, I currently have no REIT because I own my own home and therefore it represents my real estate diversification. In fact, according to the 10-15% guideline, I have too much invested in real estate when I consider the value of my home.

Do you think this makes sense?
My recent post New Feature – Asset Allocation Calculator

    MyPerFinJourney says May 1, 2013

    Thanks rjack! I can always count on you to be a fan of my sometimes long-winded / painfully detailed / numerically-packed asset allocation articles! haha 🙂

    You bring up a GREAT question regarding how your house should be treated in an asset allocation.

    Although there are differing opinions in the PF world about it, I think (and also practice this with my condo equity) that your house should not be counted as part of your normal asset allocation / investing portfolio.

    You can read all of the details in a post I wrote several years ago on this subject at the link below, but it basically comes down to the fact that you cannot really rebalance with your home and your home is a highly un-diversified form of real estate.

    My recent post What Asset Allocation Level Should You Use for Real Estate Investment Trusts (REITs)?

      rjack says May 1, 2013

      I read your post and did some additional research and most people agree with you.

      However, my counter-argument is that my home value is highly correlated to REITs and obviously impacts my net worth. When the housing market crashed, I definitely took a hit to my net worth due to the declining value of my home.

      It is less liquid, but so are other asset classes (like collectibles) that people occasionally use as part of their asset allocation. I don't try to rebalance my home real estate, but I don't want to add to the size of my real estate holdings (and risk) by buying more real estate in the form of REITs.

      I will think about it some more.
      My recent post New Feature – Asset Allocation Calculator

        MyPerFinJourney says May 1, 2013

        Thanks for looking in to that rjack! It is definitely a little bit of a confusing area.

        I agree that you don't want to have enormous amounts of your total net worth in only one asset class. However for me, since REITs are only a pretty small amount of my portfolio (10%), I feel comfortable holding them along with my condo equity, given all of the other considerations involved.
        My recent post What Asset Allocation Level Should You Use for Real Estate Investment Trusts (REITs)?

Jenny@FrugalGuru says May 1, 2013

REITs aren't very attractive to value investors right now because they're trading at near-record levels compared to their value.
My recent post You Are Already Rich!

    MyPerFinJourney says May 1, 2013

    Thanks for reading Jenny! Do you have any REITs in your portfolio?

    For me, since I'm a passive investor, I don't worry about timing the market as being up or down, just focus on maintaining my set allocation targets.

    REITs have had quite a nice run over the past 40 years, so it wouldn't surprise me if they were overvalued!
    My recent post What Asset Allocation Level Should You Use for Real Estate Investment Trusts (REITs)?

MoneySmartGuides says May 2, 2013

I keep my REIT investments to around 5-10% of my total equity portfolio. One key point is that if possible, REIT investing should be done in a retirement account because the income they throw off is considered ordinary income, meaning it gets taxes at your normal rate, not a reduced rate like capital gains.

    MyPerFinJourney says May 2, 2013

    Very good point MS Guides. I have read the exact same thing in several of the PF books mentioned above. REITs are up there alongside fixed income funds with being very tax-inefficient.
    My recent post When Disaster Strikes: The Importance of an Emergency Fund

RIT says May 2, 2013

The property investment portion of my portfolio is 10%. I'm a UK based investor and so split that 5% to UK and 5% to Europe ex UK.
My recent post The Cheapest Loan

    MyPerFinJourney says May 2, 2013

    Thanks so much for reading RIT! I'm curious – do you have access to the big mutual fund houses based in the US (Vanguard and Fidelity) being located in the UK?
    My recent post When Disaster Strikes: The Importance of an Emergency Fund

SiliconValleyGuy says June 10, 2013

Another great post!
I've got 6% in vanguard's REIT fund. However, it seems that over the last 10-15 years the correlation to the stock market has gone way way up. Most of the respected allocation authors seem to have been making their recommendations based on the older period when the correlation is low, as well your data with the other-wise appropriate long term data view may be missing this shift too. It isn't known if it is due to the increasing impact of index funds that include the public reits, or just more equity investors having easy access thru etfs, or some other known force. But i was wondering if you agree they are indeed more correlated now?

    MyPerFinJourney says June 11, 2013

    Glad you liked the post SVG!

    From the looks of the graph, it does seem that there is some higher correlation in recent years between the REIT and the stock market.

    I ran some numbers and found out that the correlation between REITS and the TSM between 1995-2011 was 0.49, so only slightly higher than the entire correlation for the whole 40 year period of 0.40.

    It's tough to predict the future, so all we can do is go with what the data is showing us to make the best “guess” at how to construct our asset allocations.
    My recent post The Size of Your Emergency Fund Should Be In Inverse Proportion to the Stability of Your Income

Rick Upton says May 17, 2015

Hi Jacob,

Great article, thank you! For my Roth IRA account, I’m looking into investing in the following mutual funds:
1) Vanguard REIT Index Fund Admiral Shares (VGSLX)
2) Vanguard Global ex-U.S. Real Estate Index Fund Admiral Shares (VGRLX)
Do you have any advice as to how to allocate my REIT investment between the two?

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