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REITs, Your Home, and the Asset-Allocation Decision

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Diversification across asset classes is an important component of an investment plan. Put very simply, diversification reduces risk by not putting all your eggs in one basket. It is also important to diversify across asset classes that have low correlation. Real estate is an asset class that not only has its own risk and reward characteristics, but also has a relatively low correlation with other U. S. equity asset classes. It is therefore a good diversifier of risk and should be considered when constructing an asset-allocation plan.

For the period 1975-1999 REITs (Real Estate Investment Trusts) provided a rate of return of 16.0%. This compares to a return of 17.2% for the S & P 500 Index. It is worth noting that all of the outperformance by the S & P 500 Index occurred during just the last two years. Looking only at the period 1975-1997, REITs outperformed the S & P 500 by 18.5% to 16.6%. It is also worth noting that in 1977 when the S & P 500 Index was down 7.2%, REITs were up 18.0%. In 1981, the next year of negative performance by the S & P 500 Index (it fell by 4.9%), REITs were up 6.1%. In 1984 and 1992, when the S & P 500 Index rose just 6.3% and 7.7%, REITs returned 21.8% and 28.3%. Of course, there are also periods when the S & P 500 Index outperformed REITs. For example, from 1998-1999 the S & P 500 Index outperformed REITs by 24.7% per annum to -8.9% per annum. The combination of the lack of predictability of returns and the low correlation makes a strong case for including REITs as an asset class in an investment portfolio.

Returns for Composite REIT Index vs. S&P 500 Index

Source: National Association of Real Estate Trusts

September 14th marked the 40th anniversary of the creation of the REIT industry. President Eisenhower signed into law legislation creating REITs on September 14, 1960.

Once a home-owning investor decides to include real estate in a portfolio, he or she must decide how to view their home in the asset-allocation process. In addition, how the home is financed and the nature of the mortgage should be considered in terms of its risk implications for the portfolio.

Let's first address the home itself.

A home is clearly real estate - however, it is very undiversified real estate. First, it is undiversified by type. There are many types of real estate: office, warehouse, industrial, multi-family residential, hotel, etc. Owning a home gives an investor exposure to only the residential component of the larger asset class of real estate. Even then, by excluding multi-family residences, it only provides exposure to the single-family component. Of course, the best way to gain exposure to the broad equity real estate asset class is to own an index or passively-managed REIT fund that invests in all equity REITs.
Another problem is that a home, by its very nature, is undiversified geographically. Home prices might be rising in one part of the country and falling in another.

Source: National Association of Realtors

Yet another problem is that home prices may be more closely related to exposure to a local industry than to the real estate market in general. For example, in the 1980s home prices in Texas, and in oil-producing regions in general, plummetted when oil prices collapsed. Conversely, in the late 1990s home prices in Silicon Valley skyrocketed, riding the technology boom (this trend could reverse as the technology sector continues to gyrate). Homes in other areas of the same states experienced a completely different pricing environment.

The diversity of your portfolio decreases if the value of your home is based on a local industry, and if you happen to work in that industry. This lack of diversification would be further compounded if your investment portfolio is loaded with assets with exposure to the same industry to which your home is exposed. This is often true of executives that own stock in their company and/or have stock options. It is also true of employees that invest in their employer's stock through retirement plans.

A good example of the problem I have set forth above is illustrated with a real-world scenario that involves an investor who lives in Seattle, which used to be considered a one-company (Boeing) town. Accordingly, the following example might have been a very typical one:

A senior executive at Boeing owns an expensive home in Seattle. She has the vast percentage of her financial assets invested in Boeing stock. She contributes to Boeing's retirement plan, purchasing more Boeing stock. She also has stock options. She thought she had some diversification of assets because her home was considered real estate exposure (not Seattle, nor Boeing, nor airline, nor even oil price, exposure). There were several periods when Boeing was impacted by a recession in the airline industry. The company's stock, reflecting those troubles, fell sharply. Strike one for our investor. Boeing reacted by laying off employees. Being one of those laid off, strike two for our investor. With so many unemployed, Seattle home prices collapsed. Strike three for our unlucky investor. The problem was that all of the risks (employment, equity, home) that our investor incurred were highly correlated.

The bottom line is that owning a home, and considering it exposure to real estate might be similar to being a senior executive with lots of stock and options in Microsoft and thinking you have exposure to large growth stocks. The correlation of any one stock to the overall asset class of equities, or large growth stocks, might turn out to be very low. Stocks might be up overall, but your stock might be down. Similarly, real estate might be up, but the price of your home might be down. Therefore, as a general rule, investors should not consider their home as exposure to real estate. About the only real protection a home provides is against inflation in construction costs. And, since in many parts of the country land is by far a more important component of home prices than is the cost of construction, it may not be much protection at all.

Let's now turn to how a home is financed.

If a home is financed with a fixed-rate mortgage, that mortgage effectively is a short (negative) bond position, and should be considered as such when looking at the overall portfolio. The fixed rate on the mortgage does provide inflation protection. A fixed rate mortgage also has a put feature. If interest rates decline, the put (putting the mortgage back to the lender by paying it off) allows the borrower to refinance the mortgage at the current rate. This provides protection against falling interest rates (for those on fixed incomes) and deflation. If a home were financed with an adjustable rate mortgage, the risk picture would be considerably different. Therefore, it is very important that investors consider how a home is financed in developing an asset allocation strategy.