Will REIT's Protect You From Inflation?

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rattlenap
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Will REIT's Protect You From Inflation?

Post by rattlenap »

Can REIT's be a hedge against inflation? I am not talking about your regular 2-3% inflation. No, I am referring to unanticipated runaway inflation just like the rampant inflation we had in the 1970's.
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nisiprius
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Re: Will REIT's Protect You From Inflation?

Post by nisiprius »

I used the "large-company stocks" (S&P 500) and inflation data from SBBI, and REIT index data from
NARIET here to construct this chart.

This is total return, including reinvested dividends, adjusted for inflation, showing the growth of $10,000 invested in 1971 in (blue) REITS, and (red) stocks.

Image

I would say that I don't see any obvious reason to have preferred REITS during the era of high inflation. Both of them took a hit and took ten years to get back to even.
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venkman
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Re: Will REIT's Protect You From Inflation?

Post by venkman »

I think stocks in general are supposed to be a hedge against inflation. Most companies make money by selling things. When the price of things goes up, companies make more money. Plus, most companies own a fair amount of real assets, too.

I'm not an expert, but theoretically, periods of high inflation are when the value premium really kicks in.
LeeMKE
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Re: Will REIT's Protect You From Inflation?

Post by LeeMKE »

I don't hold REITs.

So if inflation isn't a reason to hold REITs, why do some folks like to hold these?
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Re: Will REIT's Protect You From Inflation?

Post by venkman »

LeeMKE wrote:I don't hold REITs.

So if inflation isn't a reason to hold REITs, why do some folks like to hold these?
Equity level of risk/returns, with only moderate correlation to the US stock market. They're good for diversification, if you're into Modern Portfolio Theory.
NiceUnparticularMan
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Re: Will REIT's Protect You From Inflation?

Post by NiceUnparticularMan »

Any holdings of real, productive assets should be an inflation hedge--eventually. That includes ordinary company stocks and equity REITs (not mortgage REITs, so when I say REITs I mean equity REITs). The problem is the pricing of things like stocks and REITs doesn't necessarily respond positively to unexpected inflation in the short term, which you can think of as related to how these companies and REITs also have costs, including costs of capital, that can increase before they can pass on those increases to customers/tenants. Or you can just think of it as equity prices hating periods of high uncertainty.

To deal with this, you could focus on the realizable earnings return of stocks and REITs, separate from the price return. This is a little tricky since you have to track retained earnings in addition to dividends, which can be realized through immediate share sales (note the REIT rules mean they have less of these to worry about). But that would be the question--holding aside the price effect, if earnings are tracking upward with inflation, then you are in fact getting a long-term inflation hedge.

Generally, REITs are also a bit more of a "pure" real asset play than ordinary company stocks (this is again because of the REIT rules). So MAYBE they will be a better inflation hedge--at least if you control for the short-term price effect.

If you wanted to test this theory with 1970s data, you don't want to calculate total return including reinvested dividends--that's actually doubling down on the price effect. Rather, you would want to track this sort of realizable earnings return. If REITs did a bit better than ordinary company stocks using this approach, then they would have been a better inflation hedge in this sense.
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Re: Will REIT's Protect You From Inflation?

Post by NiceUnparticularMan »

LeeMKE wrote:So if inflation isn't a reason to hold REITs, why do some folks like to hold these?
For the reason I just gave, for a true buy and hold investor only looking at realizable earnings returns, REITs might in fact be a better inflation hedge.

But generally, another part of the case for equity REITs is that real estate is a very important means of production, and that equity REITs are a fairly efficient way of buying a diversified portfolio of productive real estate. That in turn leads to a potential diversification benefit in an overall portfolio.

Here is a white paper from Vanguard laying out this point:

https://personal.vanguard.com/pdf/icreecr.pdf
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munemaker
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Re: Will REIT's Protect You From Inflation?

Post by munemaker »

LeeMKE wrote:I don't hold REITs.

So if inflation isn't a reason to hold REITs, why do some folks like to hold these?
There is a school of thought that owning different types of assets provides diversification and removes systematic risk from a portfolio.
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Re: Will REIT's Protect You From Inflation?

Post by nisiprius »

venkman wrote:
LeeMKE wrote:...So if inflation isn't a reason to hold REITs, why do some folks like to hold these?...
Equity level of risk/returns, with only moderate correlation to the US stock market. They're good for diversification, if you're into Modern Portfolio Theory.
A few points. Both of these are claims; when you examine history, the claims turn out to be mixed with periods of time when they weren't always true. The typical thing is rather like my chart. Both stocks and real estate did in fact broadly keep pace with inflation over the period shown, 1972-2015, but neither was consistently reliable in the short term. In both cases, you would either have to say that they didn't really keep up with inflation at times or you would have to say that their natural fluctuations were so huge that the natural fluctuations mattered much more than their relationship to inflation.

First, the value of most assets more or less has kept pace with, and in many cases earned a real return (above inflation), "historically," if you look at "the long term." The only exceptions are physical currency itself, and investments, such as nominal bonds, that are directly tied to specific numbers of dollars. Some things that have, in the past, more or less kept inflation over longer periods of time include: salaries, stocks, real estate, commodities, gold, most bank accounts, and the rarer kinds of bonds (TIPS and series I savings bonds in the U.S.) that are directly tied to the CPI instead of to specific numbers of dollars.

Thus, almost any investment can and is touted as an "inflation hedge." (And it is usually touted by comparing it to "cash" in the strict sense, rather than to "money in the bank" in a decent interest-bearing account).

Second, don't forget that REITs are tied to commercial real estate, about which all I know is that it is a fairly different beast from residential real estate.

Third, never forget that REITs are in fact stocks. Just as stocks in gold mining companies are stocks, not gold, REITs are investments in stocks, not in real estate. They are literally a stock sector, and in fact were just recently broken out into a top "headline sector" instead of being part of "financials." Because there are specific regulations that affect REITs differently from other stocks, there's a case to be made that there is some fundamental difference between REITs and other stocks that should predict differences in future behavior--for example, higher dividends than other kinds of stocks.

The claim is indeed made that REITs have "equity level of risk/returns" (reasonable since they are equities) with "only moderate" correlation to the U.S. stock market. The claim of low correlation was borne out in 2000-2002, when REITs, represented here by the Vanguard REIT Index Fund, VGSIX, blue, earned just $4,000 on a $10,000 investment during a time when a stock market investment, VTSMX, orange, lost just about $4,000.
Source
Image
Unfortunately, during 2008-2009, when I owned a very small amount of VGSIX, and was frantic over the losses of the stock market as a whole, VGSIX lost more.
Image
The difference between losing $5,200 (Total Stock) and losing $6,300 (REIT index) was noticeable and meaningful--an extra little punch to the gut at a time when I didn't need that. (My habit is to use 12/31/2007 to measure "drop during 2008-2009." Notice that if I'd picked a later date the relative loss would have looked even worse).

What this means, of course, is that "low correlation" is not the same thing as "negative correlation," and that even when it is all working according to theory, "low correlation" assets sometimes help and sometimes hurt, and it is only over very long periods of time that the claimed favorable balance can be shown.

Bill Schultheis' 1998 "Coffeehouse Portfolio" is a simple, round-number version of the kind of portfolio generally recommended at the time by people using "slice-and-dice," "tilted," factor-aware strategies. It call for a 10% REIT allocation. If we look overall, at the behavior of the Coffeehouse Portfolio (Portfolio 1, blue), and then the same allocation with the REIT allocation removed and everything else adjusted proportionately upward (Portfolio 2), we do see that the Coffeehouse Portfolio was better with the REITs in it.

However, do look at everything.
  • The CAGR, 7.07% rather than 6.59% is really in a grey area. Some would say this is a big deal, others would not.
  • But notice risk or volatility as measured by the standard deviation was also slightly higher. You can see this in more than one measure of risk, notably the "worst year" and "maximum drawdown," which were worse with REITs in the mix.
  • The Sharpe ratio, a measure of risk-adjusted return, was essentially the same, 0.59 versus 0.58 without REITs, probably not a significant difference but yes, in the direction of "improvement with REITs."
Overall, my personal judgement is that over that time period, in this portfolio, REITs did what experts said they should do, but it wasn't very important--certainly not any kind of powerful magic.

Source
Image
Last edited by nisiprius on Wed May 03, 2017 6:34 am, edited 1 time in total.
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nisiprius
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Re: Will REIT's Protect You From Inflation?

Post by nisiprius »

"Argumentum ad Vanguard" is fairly weak, but it's nevertheless interesting that the company with the world's largest REIT mutual fund chooses not to have an (extra, above-weight) allocation to REITS in its all-in-one funds. I've sometimes wondered whether Vanguard clings to the total market because at the sizes their funds are, there just wouldn't be enough small-cap value to go around, but this isn't really true for REITs. I don't want to bother getting an accurate grand total for their target retirement funds, but it must be on the rough order of ten funds times $30 billion per fund = $300 billion, and the Vanguard REIT index fund has $60 billion in assets, so there would be more than enough to give everybody a 10% REIT allocation (like the Coffeehouse Portfolio) if Vanguard wanted to.

I was, however, struck by this some years ago in my investing life because Burton Malkiel was affiliated with Vanguard for over thirty years, and A Random Walk Down Wall Street recommends REITS very enthusiastically... so I was surprised to see that Vanguard does not use them in its target-date funds. It's also notable that Malkiel and Ellis' The Elements of Investing, intended for novices, does not try to complicate their story by suggesting that it is important to have a REIT allocation (again, beyond what is in Total Stock, in which it is something on the rough order of 2% of the portfolio).
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sweeden22
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Re: Will REIT's Protect You From Inflation?

Post by sweeden22 »

Long term, the graphs do not show too much benefit to REITs. However, I do have a small amount.

If you follow a REIT ticker each day, you will see they do behave a bit differently. Not something you will probably gain too much from on the long term, but sometimes on an individual day, they keep my losses down. That does not mean anything for the long term, but it makes me feel better for the single day!
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Re: Will REIT's Protect You From Inflation?

Post by NiceUnparticularMan »

nisiprius wrote:Third, never forget that REITs are in fact stocks. Just as stocks in gold mining companies are stocks, not gold, REITs are investments in stocks, not in real estate. They are literally a stock sector, and in fact were just recently broken out into a top "headline sector" instead of being part of "financials." Because there are specific regulations that affect REITs differently from other stocks, there's a case to be made that there is some fundamental difference between REITs and other stocks that should predict differences in future behavior--for example, higher dividends than other kinds of stocks.
Since equity REITs do in fact necessarily have a different legal structure from ordinary company stocks, even real-estate related stocks, and these differences explain why REITs perform differently from ordinary stocks, why insist they "are in fact stocks"? Really, they are what they say they are--shares in trusts which invest in real estate.

They are certainly both "equities," but it seems more misleading than helpful to erase the distinction between ordinary company stocks and REITs.
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Re: Will REIT's Protect You From Inflation?

Post by NiceUnparticularMan »

nisiprius wrote:"Argumentum ad Vanguard" is fairly weak
I wasn't saying you have to take their word for it. Rather, the substance of their paper is what is interesting. You would expect REITs to be at least a decent partial proxy for direct holdings of commercial real estate, and Vanguard has confirmed that history is consistent with this view, and they have also done some work in showing the ways they are only a partial proxy. All that is pretty helpful, regardless of the source.
LeeMKE
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Re: Will REIT's Protect You From Inflation?

Post by LeeMKE »

Here's a parting gift to ponder on REITs:

The properties purchased by REITs are those that are not built/owned by the user. For example, Apple owns their own commercial property.When times are good, successful firms build and hold their own real estate.

When times get bad, companies may sell/lease back their real estate to REITs. (Like an Automobile Plant in the 1990s, or an office building for a less than flush firm) And some developers of specialized properties, sell to REITs (post office buildings with a long term lease -- this building will be demolished at the end of the lease)

And the premier properties in most markets are snapped up at premium prices by investors to whom having the best and newest matters most: for example, international buyers investing to have a hold in a specific economy. This seems like folly until you understand that the last property to lose value in a downturn are the premium properties, and they are the first to enjoy a rise as prices begin to recover.

With all this, I've never understood how REIT investors expected to do well. These properties are more subject to the market than most, except for the specialized buildings that seem more like a bond to me.

I figured the REIT popularity was dependent on better performance during high inflationary times, but maybe even that isn't true. And during low inflationary times, like now, I don't see the attraction at all.
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Re: Will REIT's Protect You From Inflation?

Post by rkhusky »

nisiprius wrote: (again, beyond what is in Total Stock, in which it is something on the rough order of 2% of the portfolio).
Morningstar lists the real estate allocation for Total Stock at 3.8%.
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Re: Will REIT's Protect You From Inflation?

Post by asif408 »

nisiprius wrote:A few points. Both of these are claims; when you examine history, the claims turn out to be mixed with periods of time when they weren't always true.
I think this line from nisiprius is the most important. History shows that in general the so-called "inflation hedges" (i.e., REITs, commodities, precious metals) were primarily a hedge or benefit when they had performed poorly in the previous period compared to the overall stock market.

So for example, if you look at a precious metals fund in the 70s, it did dramatically outperform the overall market in the late 1970s, when inflation was rampant. Here is an example using the oldest precious metals fund I know of, FKRCX, compared to the S&P 500 total return index:
http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D. As you can see the precious metals fund fell 70%+ from 1972 to 1976, dramatically underperforming the S&P. And inflation wasn't exactly low during that time frame, though it was much worse in the late 70s. That was followed by an almost 600% return from the fund from 1976 to 1980, which dramatically outperformed the S&P. So you could say it was an inflation hedge, primarily when inflation was very high. But if you look at the entire 1970 decade the performance difference is minimal: http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D

The "inflation hedges" all did well in the 2000-2002 bear market, but IMO that was primarily, again, due to their poor performance in the years leading up to 2000. See this chart that illustrates: http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D. I used the Vanguard 500 fund (VFINX), Energy fund (VGENX), Precious Metals Fund (VGPMX), and REIT fund (VGSIX) as proxies. All of the "inflation hedges" fell 30%, 40%, or in the case of the precious metals fund, 60% at various times in the years leading up to 2000.

From 2003-2007 those hedges went up and actually performed much better than the overall stock market. Not surprisingly, they fell even farther than the good ole' S&P during the 2007-2009 crisis. Of course 2007-2009 was a deflationary crisis, so it is not surprising they performed poorly. But it surely didn't help that they had 7 year of outperformance prior to that.

So I think valuation explains most of the story of these so-called hedges, though there are some legitimate points structurally that might give them some merit as inflation hedges. We haven't really seen high inflation since the 70s, so it's hard to say how actual funds now will perform, since I'm not aware of any REIT or commodity funds available in the 1970s to the general public to backtest against. IMO, they might work if they've underperformed in the previous period, but of course no guarantees. Since the bottom in 2009, REIT returns have exceeded the overall stock market, while commodities and precious metals have lagged considerably. So if I was looking for an inflation hedge, I wouldn't look at REITs right now. Unfortunately, I think a lot of the old folks that think there is something special about dividends have bid up the prices of REITs in a search for yield.
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Re: Will REIT's Protect You From Inflation?

Post by Kevin M »

Using our Simba backtest spreadsheet, I see the following returns for 1977-1982 (inclusive):

19.39% - REIT
11.63% - US total stock market
9.00% - inflation

I chose 1977 - 1982 because this was a period when inflation was above 3%. It rose from about 1.5% to 5.7% in 1973-1974, but fell back to 2.7% by the end of 1976.

Image

So from this data is looks like REITs did a better job of hedging inflation.

However, the biggest relative advantage for REITs was in the first year--1977, with a return of +22.1% for REIT and -4.41% for US stocks. REIT did better in all subsequent years except one, but the relative advantage never increased beyond the lead it got in 1977 (the telltale chart in the spreadsheet tells this story).

REITs achieved the higher return with lower standard deviation, at 10.63% compared to 15.17% for US stocks.

If I expand the timeframe to 1973-1983, REITs still were ahead at 16.17% compared to 10.59% for US stocks and 8.22% for inflation. During this time period REITs had slightly lower standard deviation than US stocks.

The spreadsheet indicates the data source for this period as: FTSE NAREIT All Equity REITs 1972-1996

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NiceUnparticularMan
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Re: Will REIT's Protect You From Inflation?

Post by NiceUnparticularMan »

LeeMKE wrote:With all this, I've never understood how REIT investors expected to do well. These properties are more subject to the market than most, except for the specialized buildings that seem more like a bond to me.
Vanguard's white paper makes a pretty compelling case for REITs pretty successfully tracking the returns on commercial properties in general over the long run (they can depart ways over the short run).
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Re: Will REIT's Protect You From Inflation?

Post by NiceUnparticularMan »

rkhusky wrote:
nisiprius wrote: (again, beyond what is in Total Stock, in which it is something on the rough order of 2% of the portfolio).
Morningstar lists the real estate allocation for Total Stock at 3.8%.
Is that just equity REITs, or all real-estate-related stocks?
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Re: Will REIT's Protect You From Inflation?

Post by rkhusky »

NiceUnparticularMan wrote:
rkhusky wrote:
nisiprius wrote: (again, beyond what is in Total Stock, in which it is something on the rough order of 2% of the portfolio).
Morningstar lists the real estate allocation for Total Stock at 3.8%.
Is that just equity REITs, or all real-estate-related stocks?
Includes mortgage companies, property management companies and REITs. So, 2% +- 0.5% is probably close for just the REIT's.
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Re: Will REIT's Protect You From Inflation?

Post by Pajamas »

rattlenap wrote:Can REIT's be a hedge against inflation? I am not talking about your regular 2-3% inflation. No, I am referring to unanticipated runaway inflation just like the rampant inflation we had in the 1970's.
A gold coin is a gold coin and an acre of land is an acre of land and a case of toilet paper is a case of toilet paper no matter how rapidly fiat currency loses value in periods of high inflation. REITs are an indirect form of ownership of real estate and don't perform in the same way.
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Re: Will REIT's Protect You From Inflation?

Post by venkman »

nisiprius wrote: What this means, of course, is that "low correlation" is not the same thing as "negative correlation," and that even when it is all working according to theory, "low correlation" assets sometimes help and sometimes hurt, and it is only over very long periods of time that the claimed favorable balance can be shown.
Couldn't the same thing be said about international stocks? Many people here consider them a necessary part of their portfolio, but that diversification didn't help in 2008.

If you're looking at asset classes to construct a portfolio, isn't long-term performance/correlation the appropriate metric to use?
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Re: Will REIT's Protect You From Inflation?

Post by Valuethinker »

rattlenap wrote:Can REIT's be a hedge against inflation? I am not talking about your regular 2-3% inflation. No, I am referring to unanticipated runaway inflation just like the rampant inflation we had in the 1970's.
The theoretical inflation protection from REITs arises from the correlation between commercial property leases and inflation.

Property leases tend to be inflation linked. Residential ones renew annually, commercial office and retail ones 10+ years usually (shorter these days).

Although buildings depreciate, cost of construction tends to rise at inflation or faster. Therefore over time the replacement cost of physical assets rises.

Land is volatile, but again tends to rise with inflation.

Because companies need to continue to pay their landlords to trade, real estate leases have a bond like aspect-- they rank ahead of other creditors if the company is in financial distress. Lots of caveats to that, but generally true.

Thus the cash flows from REITs are lower risk than those of equities generally and have a greater correlation with inflation. Offsetting that to some extent, commercial RE investors make use of leverage, which increases the volatility of returns.

Equity shareholders cannot rely on a primacy of cash flow from a company over its creditors, whereas REITs can (to a point) for the reasons cited above.

Rising inflation, at the very least, has empirically been bad for equities: If you look at the 1970s period, equities did not outpace inflation. They only did so when inflation began to decisively fall, and thus interest rates fell, in the 1980s:

- there are distinct tax drags associated with the effects of inflation on company profits. Profits are overstated because depreciation is only charged at historic rates (new capex is going to cost more)

- rising inflation tends to lead to rising interest rates (nominal) but also rising *real* interest rates, which are generally bad for corporate profits

- because of the 2 above effects, during periods of high inflation stocks tend to trade on lower Price-to-Earnings ratios, which is not good for equity performance

Because costs also rise, it is not clear that inflation is good for company profits. Depends on the ability of a company to pass through cost increases to its customers.

Even here it is asserted that "equities are an inflation hedge". This is largely incorrect. What is true is that equities pay high (but volatile) returns, and therefore they tend to outperform inflation (but beware the 1966-1980 period when real returns on equities were very negative). It is fair to say that as a real asset (as opposed to a nominal one like a US Treasury bond) equities *should* outperform inflation. But equity returns are so volatile that it's very hard to assert that they do.

Empirically one of the problems with REIT correlation with inflation is that the data has distinct trends in it--commercial RE is a very cyclical business (cycles lasting 10-15 years i.e. longer than the economic cycle as a whole). Individual years are not uncorrelated-- the data has autocorrelation in it.

Thus you'd have to detrend the data to strip out the impact of that to assess whether REITs are correlated with inflation to a greater degree than equities as a whole. I am sure that has been done-- have you checked SSRN for papers?
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