As real estate investment trusts (REITs) have grown as an asset class, they've expanded into new property types, meaning investors can gain exposure to most industries via real estate. That begs the question of whether REITs alone can provide the diversification investors seek to balance both risk and reward. Here's a look at the pros and cons of investing solely in REITs.
The case for an all-REIT portfolio
Some of the world's wealthiest investors owe the bulk of their fortunes to real estate. The sector has minted several billionaires and quite a few multimillionaires over the years. As their success shows, concentrating on the industry can be extremely rewarding.
While the richest real estate investors made most of their money owning and developing commercial real estate, REITs have also done an excellent job enriching investors over the long term. Since Nareit began tracking REIT performance data in 1972, they've routinely outperformed the S&P 500. Overall, the FTSE Nareit All Equity REIT Index has produced a 13.3% total return versus 12.1% for the S&P 500 from 1972 to 2019. Meanwhile, REITs have beaten the market average 15 of the last 25 years. The implication here is that REITs can be a superior investment over the very long term.
Meanwhile, thanks to the expansion of REITs, investors can gain exposure to several industries. There are currently 13 different subgroups covering various sectors. These include:
This means investors can build a diversified portfolio via REITs. Further, they can use REITs to invest in emerging tech trends like 5G, streaming, the cloud, and other fast-growing sectors like e-commerce and cannabis.
The case against an all-REIT portfolio
Investment managers have performed many studies on REITs to determine how much exposure investors should have to the sector. On average, they've concluded the optimal REIT allocation should be between 5% to 15% of an investor's overall portfolio. On one hand, having some REIT exposure can increase a portfolio's risk-adjusted returns. However, having too much allocation to REITs yields higher volatility.
Two major factors play an outsized role in REIT returns and volatility: interest rates and cyclicality. Usually, when interest rates rise, it causes real estate values to decline. That's because rising rates make it more expensive to finance real estate debt, and yield-seeking investors shift to lower-risk income assets like bonds. Conversely, falling interest rates can have an outsized positive impact on REITs, since they can refinance higher-cost debt, which should boost their NOI and property values.
Meanwhile, the other factor that can impact REITs is real estate cyclicality. Real estate has four phases of its cycle: recovery, expansion, hyper-supply, and recession. Values rise rapidly during the first two phases before tumbling as supply outpaces demand, weighing on occupancy levels and rental rates.
This cyclicality can cause REITs to be very volatile, which has been the case over the past few years. For example, the sector went from expansion in 2019 to hyper-supply and recession in 2020 because of the COVID-19 outbreak. That caused wild swings in REIT performance -- they went from delivering strong total returns of 28.7% in 2019 to an abysmal negative 18% total return so far in 2020. Those wild swings can be challenging for many investors to stomach.
Too much of a good thing can be too much for most investors
While an all-REIT portfolio could generate superior returns, it would also likely be much more volatile, making it not the best option for most investors. However, investors should have meaningful exposure to REITs because they do tend to boost a portfolio's overall returns.