Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:18]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:37]

Thank you, Mary, and welcome to episode 21 of Risk Parity Radio. This episode will be part two of our analysis of REITs as an investment. Part one was in episode 19. If you'd like to take a listen to that. And the way we are doing this is by going through the 10 questions to ask when considering an investment from David Stein. And those questions will once again be listed in the show notes. Now we answered the first five of those questions in part one of this two-part episode, and so we will proceed to questions six through ten for this episode. Now question six is what is the investment vehicle? Well here we are talking about publicly traded REITs and so these are companies that are listed on stock exchanges and that is the investment vehicle. As we mentioned in our answer to question one in episode 19, REITs are a special type of company that can only invest in real estate or businesses related to real estate and it must pay out 90% of its income annually to its shareholders. So it is designed to pool a large investment in real estate and distribute income to all of its owners. Now publicly traded REITs, as we mentioned, are traded on the stock exchanges and you can buy them and sell them just like any other stock or exchange traded fund. Question 7. What does it take to be successful? Well, it takes a little patience as it does with many of these kinds of investments. REITs are not a terribly exciting investment and their purpose really is to make some income. They do go up and down in capital appreciation when the stock market goes down. Most REITs tend to go down with it, although not as much. When the stock market goes up, most REITs tend to go up with it, although not as much. But they are constantly paying out that income, and that is what is most desired by people who hold REITs. If you are looking for something to grow a lot, REITs are probably not the investment for you. If you are looking for something that pays steady income, REITs are the investment for you. And so what it would take to be successful is to be able to hold on to those REITs even as they go up and down, collecting the income as you go. And then when the REITs do decline, it would be advantageous to buy more of those REITs so that your income increases. This is similar to most any other tradable investment in terms of how you be successful in investing in REITs. And just one mention again that publicly traded REITs are not the only kind of REITs you can invest in. privately owned REITs or held REITs are also possible as an investment. But to be successful in that investment, you would need to have a lot better knowledge both of what that private REIT is investing in and to be able to read all of the legal forms and contracts that govern your investment and when you can get your money out of that investment. What that tells you is you really probably should stay away from private REITs unless you have the desire to become very knowledgeable about real estate investments in particular and feel like you can handle that kind of a challenge. Question eight, who is getting a cut? Well, obviously the managers of the REIT do get paid salaries, and they may also be owners or holders of the REIT. And so that comes out of the income from the REIT. But you can take a look at that if you want to analyze any particular REIT, and those figures are publicly available. Usually you can tell whether a REIT is doing well or not simply by looking at how the income is fluctuating or not fluctuating over time for the best REITs their income would be growing and that would show that the REIT is being well managed. There are no transaction fees for trading in REITs if you use a no fee broker, so there's no cut being taken out there. The government will take a cut of the income if this is in a taxable account. As we mentioned in episode 19, there is now a discount on the taxes applied to REITs under Section 199A of the Qualified Business Investment section of the new 2017 tax code or addition to the tax code. So you should be aware of that. And now we are getting to the most important question of the day, which is question nine. How does it impact your portfolio? How will REITs impact your portfolio? Well, to look at this kind of analysis, we need to consider what else is in your portfolio. We are assuming for the purposes of this that your portfolio has a large allocation of stocks and has some bonds and maybe some gold and some other things, but really the dominant part of your portfolio is in stocks. Now, how do REITs compare to stocks? REITs are part of the total stock market portfolio, so they do perform similarly to stocks over long periods of time. We took a look at an analysis from Portfolio Visualizer that showed that REITs tend to slightly underperform the stock market over the past 26 years. but in any given decade, REITs may outperform stocks or stocks may outperform REITs, and the same is true for any given year. And then that leads us to our most important consideration as to how are these REITs correlated or not correlated with our other assets, and in particular our stock holdings. If you look at the REIT funds, it's interesting, the big REIT funds like VnQ have a correlation coefficient of around 0.65 to 0.70. The international REITs are actually a little bit more correlated to the stock market than the domestic REITs, and that probably has something to do with whether the value of the dollar is going up or down, but I'm kind of speculating there. But then When you break it down and look at the individual REITs, and I should tell you though, first though, that these funds that hold the REITs, like VNQ, are not necessarily as diversified as you might think, and they also are not invested in what you might think or primarily invested in what you might think. And that is because they are held by their market capitalizations. which can be very large for very unusual REITs. And so if we do look inside of what is inside of VNQ, for example, we see that the main holdings, these are 30% of the holdings, are American Tower, Prologis, Equinix, Crown Castle, Digital Realty, SBA Communications, and public storage. and that comprises about 30% of the total holdings of that fund. Now, what is interesting about those is none of those are traditional residential property REITs or even commercial property REITs. They are all in those infrastructure cell towers and specialized sectors. What is interesting about all of those is they are not renting for the purpose of having human beings in the buildings, either as living there or in offices, but in terms of storing data things and places to have cell towers. Now, there's nothing necessarily wrong with that because they have obviously been some of the most successful REITs in recent times, growing with the internet and that is why they have become so large and become such a large proportion of this fund. But if you were thinking about comparing buying a REIT, say, as something like a real estate investment, either a residential investment or an investment in an office building you might be banking on the side, these two things are not really equal. You should be really be thinking of VNQ as investing in all of these large businesses that are structured as REITs and not necessarily some kind of individual property kind of REIT. And this leads me to another observation, which is that a lot of individual REITs are much less correlated to the overall stock market. than these REIT funds. So for example, and I will link to this table in the show notes, a popular REIT like Realty Income Corporation, which invests in buildings that house 7-Eleven's and pharmacies and has over 6,500 leases across the country, has a correlation coefficient with the total stock market of only 0.36. and a public storage REIT has one of the lowest correlations, that's PSA, that rents those storage units, and its correlation with the overall stock market is only 0.10 these days. Other REITs that are more tied to general economic conditions like Warehousing, which is a timber REIT, that's WY, has a correlation of 0.83 with the stock market, a higher correlation. as does the specialty REIT Lamar Advertising Company. That's LAMR, which is the company that rents billboard space, and that correlation is 0.76. You will find that the sort of core traditional type of REITs tend to have correlations around 0.5 to 0.6, so AvalonBay Communities, Residential Developer, AVB has a correlation of 0.57, Ventus which rents hospital and nursing home has a correlation of 0.50, Welltower also a healthcare 0.47 with the stock market. But what this tells you as far as your risk parity style portfolio is concerned is that you may be better off with a few of these individual REITs with lower correlations with the stock market by themselves than you would with a REIT fund. Now, ordinarily you would be thinking, well, maybe you'd be taking on too much risk by holding individual stocks or REITs in these sectors. But if you look at the very largest ones, you'll see that they do hold up to thousands of different leases or properties so they are well diversified across the United States as far as the individual cash generators in their portfolios. So in a sense, instead of, for instance, going out and investing in one building in your community, you can have access to a thousand buildings across the country by buying one of these REITs. So how will this ultimately affect your overall portfolio? Well, if you put something in your portfolio that has similar returns to the stock market but is diversified and maybe diversified down to a nearly uncorrelated status, say PSA with that 0. 1 status, that should give you approximately the same returns with less volatility in your portfolio overall. That being said, it does not appear that REITs are some kind of panacea for your risk parity style portfolio. They are not negatively correlated with the stock market. They may be positively correlated with some kinds of bonds, and you'd have to compare those individually, but they would make a nice addition if done in a reasonable quantity. You wouldn't want to be overloaded with REITs in your portfolio because it would not grow very much over time. But that does now lead us directly to question 10：Should you invest in REITs as part of your risk parity style portfolio? And I think the answer is maybe because they can be a useful addition but they do not appear to be necessary in that they will not reduce the overall volatility of your portfolio by a lot. So really it comes down to, well, how much of my portfolio should I put into REITs if I want to use REITs? and the answer seems to be somewhere between 0 and 15%. Most people hold 5 to 10% of REITs if they're going to hold them. I should say that you should be thinking or balancing this with other holdings you may have outside of your financial portfolios. For instance, if you already own some rental properties, It probably doesn't make sense to buy more REITs that are also invested in similar kinds of properties. It may make sense to hold some REITs that are holding something different from what you are holding outside in your rental property portfolio. And as we have seen, there are many different kinds of businesses operating under the REIT umbrella. and so many choices that you could make. But if you are going to invest, that leads to another question, which is should you do it through a REIT fund or individual REITs? And the answer there is more one of personal preference. If you do not wish to go into looking into these REITs very closely, then you are probably going to be better off with the funds and the easiest funds to invest in are Vanguard's VNQ, which is domestic REITs, VNQI, which is international REITs, or the iShares fund, R E E T, which is both international and domestic REITs. And that's the one we've used in our sample portfolios simply for simplicity's sake. If you are a little more interested in the composition of your REIT investment, then individual REITs are probably going to be for you. But I would stick with the very largest REITs, such as O, the Realty Income Corporation, because you want to invest in something that actually holds many, many leases or properties. So that they are internally diversified across those properties. As if you were going out and buying a bunch of properties, you would want to have them be as diversified as possible. And some of those REITs, a lot of these REITs are internally diversified, but you're not going to know whether that's the case unless you get on the internet and look them up and see what they actually hold. But you can gain some confidence in most of these very large REITs are likely to be very well diversified internally. But then that leads you to a question, well, how much would you devote to an individual REIT in terms of your overall portfolio? I would not think you would want to allocate very much, maybe 1% to 2% per REIT if you wanted to hold four or five or six different reits individually, that would give you a nice kind of reit portfolio to hold. Of course, you need to manage that if you hold it, but it's probably not going to require a whole lot of management. Usually these things are just something you leave alone and collect the income from, which in your drawdown phase you will probably be living off and taking off as income anyway. which is another advantage to holding REITs. Now if you look in our sample portfolios on the portfolios page at www.riskparadioradio.com, you will see that two of the sample portfolios do have REITs in them and the other four do not. Those two portfolios are the Golden Ratio Portfolio and the Risk Parity Ultimate Portfolio and they each hold 10% in REITs in the form of that REIT fund, R-E-E-T. But you can see there how those assets have performed and it is similar to stock market performance with generating some income that has then been able to be used for drawdowns. But now I see our signal is beginning to fade and it is time to conclude our part to episode on REITs as an investment. If you have any feedback, comments, or questions you can send them to me at frank@riskparityradio.com that's frank@riskparityradio.com or you can go to the website and fill out the contact form there. On our next episode this weekend we will be going back to our Portfolio Reviews and featuring the aggressive 50/50 of our sample portfolios as the Portfolio of the Week, comparing it to a couple Dave Ramsey style portfolios. Thank you for listening in. This is Frank Vasquez with Risk Parity Radio, signing off.

Mostly Mary [20:38]

The Risk Parity Radio Show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here, making sure to take into account your own personal circumstances.