Seeking advice: IPS change / REITS

[AnonJohn]

Hi - When I wrote my IPS in 2014 I allocated 10% of risky assets to REIT index funds. I was motivated by the work of Dale Swansen and the observations that REIT indices and stocks were not perfectly / well correlated.

I am aware of arguments that investing separately in REITs doesn't make sense, as it overweights them and you hold them via total market indices. I am also concerned that holding REITs separately has distorted my domestic / international balance; I intend to hold 70% domestic / 30% foreign. But because of REITs I have 73% / 27%. In the past 9 years I have also paid off my mortgage, so I do hold more real estate. Not sure that matters since it's different kinds of real estate.

I am looking for advice on whether to revise my IPS to simplify it and stop holding REITs. In addition to general advice / theory on REITS, I am especially seeking perspective on avoiding psychological mistakes in revising an IPS. It is hard not to think that this is a bad time to drop REITs. I would not otherwise change the balance of risk. I would sell the REITs and buy stock indices.

Thanks in advance!

John

[er999]

I’m interested in this discussion too since I’ve held 5% reits (as VNQ and index fund) since 2005, bumped up to 10% about 2 years ago when I decided to reduce my bond allocation.

Vanguard does list REITs as a separate asset class in their market outlook (https://advisors.vanguard.com/insights/ ... cember2022) with a return projection of 4.9- 6.9%, comparable to us equities that they project 4.7-6.7%.

I also added REITs as recommended by David Swenson and Burton Malkiel. I think they are less popular now as they crashed more than stocks in 2008, dropping something like 75%.

From reading on here it seems like many recommend a small cap value tilt over REITs so I have considered switching but want to make sure I’m not doing performance chasing. VNQ down -16% past year compared to vbr (vanguard small cap value) only down -0.9% and AVUV (the more small cap value fund) up 4.2% the past year so I don’t want to buy high, sell low if I change my REIT allocation to small cap value now.

[abuss368]

Hi - When I wrote my IPS in 2014 I allocated 10% of risky assets to REIT index funds. I was motivated by the work of Dale Swansen and the observations that REIT indices and stocks were not perfectly / well correlated.

I am aware of arguments that investing separately in REITs doesn't make sense, as it overweights them and you hold them via total market indices. I am also concerned that holding REITs separately has distorted my domestic / international balance; I intend to hold 70% domestic / 30% foreign. But because of REITs I have 73% / 27%. In the past 9 years I have also paid off my mortgage, so I do hold more real estate. Not sure that matters since it's different kinds of real estate.

I am looking for advice on whether to revise my IPS to simplify it and stop holding REITs. In addition to general advice / theory on REITS, I am especially seeking perspective on avoiding psychological mistakes in revising an IPS. It is hard not to think that this is a bad time to drop REITs. I would not otherwise change the balance of risk. I would sell the REITs and buy stock indices.

Thanks in advance!

John

Hi John -

Some things to consider:

* The market weight of REITs are in the Total Stock and Total International funds.

* REITs are argued to be a separate asset class whose correlation fluctuates (as does all asset classes) over time.

* Most REITs are so much financially stronger than pre-2008.

* REITs have shown to increase the portfolio returns over the long term.

* REITs are legally structured different, taxed different, and operate different than other companies.

* The real estate crowd will say REITs are stocks. The stock crowd will say REITs are real estate.

* Your portfolio could be 60% Total Stock and 10% REITs for the US portion and 30% for the international portion.

* REITs should not be a replacement for bonds and cash.

* It is a toss up of simplicity vs. including them. There is no right or wrong answer here.

* Many small cap funds include REITs.

* International REITs are MUCH different than US REITs. Most international REITs are REOCs that are legally structured different, taxed different, and do not have a requirement to distribute 90% of rental income to shareholders. I often say the only thing in common between US REITs and international REITs is the use of the word “REIT”.

* I used to invest in 30 or more individual Equity and Mortgage REITs, invest inc inference calls, on the phone with REIT advisors, newsletters, etc. I learned a lot. Later, I simply held the US and International REIT funds.

* I am very good friends with two investment and financial advisors who are incredibly successful and invest in total market indexes, dividends funds, and REITs. I learned a ton from them and the cash flows from passive income that dividends provide (including REITs).

* A very good friend of the family did the same with total index funds, dividend funds, and REITs and was fortunate to retire very early. The passive cash flows were incredible.

Hope this helps.
Tony

[nedsaid]

Hi - When I wrote my IPS in 2014 I allocated 10% of risky assets to REIT index funds. I was motivated by the work of Dale Swansen and the observations that REIT indices and stocks were not perfectly / well correlated.

I am aware of arguments that investing separately in REITs doesn't make sense, as it overweights them and you hold them via total market indices. I am also concerned that holding REITs separately has distorted my domestic / international balance; I intend to hold 70% domestic / 30% foreign. But because of REITs I have 73% / 27%. In the past 9 years I have also paid off my mortgage, so I do hold more real estate. Not sure that matters since it's different kinds of real estate.

I am looking for advice on whether to revise my IPS to simplify it and stop holding REITs. In addition to general advice / theory on REITS, I am especially seeking perspective on avoiding psychological mistakes in revising an IPS. It is hard not to think that this is a bad time to drop REITs. I would not otherwise change the balance of risk. I would sell the REITs and buy stock indices.

Thanks in advance!

John

The academics have said for a long time that REITs make no difference in a portfolio. Financial industry research showed that REITs did provide a diversification benefit, there was a time when there was a big push for REITs by the mutual fund industry.

I have owned REIT funds for a long time, since January of 1998. To me it made sense that Real Estate was a separate asset class than Stocks and REITs have a legal structure different than publicly traded corporations. So I have been an enthusiastic REIT investor for years though my enthusiasm for them has cooled. I also own a Timber REIT in addition to the REIT funds that I own. I am holding firm with what I have despite what the Academics say.

The research says you can replicate the REIT effect with a combination of Small Cap Stocks and High Yield Corporate Bonds or with Small Cap Stocks and Investment Grade Corporate Bonds. Most REITs are Mid or Small Cap Stocks and use leverage with their Real Estate investments, so the academic research here makes sense. There is a good Ben Felix video on this.

Another big reason is that correlation of REITs with Stocks has increased over the years, making the low correlation argument much less compelling. Keep in mind though that correlation between asset classes changes over time.
Valuations are another big reason, yield chasing during times of very low interest rates pushed prices much higher. REITs once yielded 6% to 7%, right now they yield about 4%. At the peak of the yield chasing, REIT yields were just under 3%.

Larry Swedroe wrote that the real return of REITs after inflation is yield minus 2.9% which implies real returns of about 1% over time with a lot of volatility. Not sure how he came up with the 2.9% figure, I know that a part of your yield with REITs is return of principal.

I might just be stubborn but I am loathe to rearrange my portfolio whenever a new piece of research comes out. Not selling what I have but not buying any more either.

[AnonJohn]

Thanks Tony, Ned. Appreciate the replies and insights. I will be modifying my IPS to reflect the 4% of total domestic that is REITS. That is, reducing the specific allocation from 10 -> 6%. And fixing the international as suggested.

Thanks for helping me think it through.

John

[Gaston]

I might just be stubborn but I am loathe to rearrange my portfolio whenever a new piece of research comes out. Not selling what I have but not buying any more either.

IMHO you are reacting correctly.

[nedsaid]

I might just be stubborn but I am loathe to rearrange my portfolio whenever a new piece of research comes out. Not selling what I have but not buying any more either.

IMHO you are reacting correctly.

Wow. Good to have a cheerleader every once in a while.

I suppose it is a matter of standing by principles, becoming more curmudgeony as I get older, or a bit of both.

[comeinvest]

Larry Swedroe wrote that the real return of REITs after inflation is yield minus 2.9% which implies real returns of about 1% over time with a lot of volatility. Not sure how he came up with the 2.9% figure, I know that a part of your yield with REITs is return of principal.

Somehow that cannot be correct, because I think cap rates of REITs are typically mid single digits these days, like 5%. "Cap rate" means operational profit of a property, with expenses already deducted, and obviously not accounting for increasing property values with inflation or due to market supply and demand.
Makes sense, since the long-term returns of REITs should be similar to that of the stock market, because volatilities and drawdowns are also similar.

[dogagility]

Hi. My two cents...

In addition to general advice / theory on REITS...

It's easy for academics to overfit historical data, come up with a mechanistic reason for the better returns to explain the overfitting, and then suggest a portfolio based upon that information.

I am especially seeking perspective on avoiding psychological mistakes in revising an IPS. It is hard not to think that this is a bad time to drop REITs.

I suggest you identify an investing strategy that you can adhere to over decades, despite what the financial gurus, academics, et al are telling you over those decades.

If that strategy is tilting toward REITs, SCV, or anything else, fine. Personally, I don't trust (my psychology haved lived the life of an academic for decades) any past analysis on slicing-and-dicing to predict the future, so I don't overweight sectors.

[nedsaid]

Larry Swedroe wrote that the real return of REITs after inflation is yield minus 2.9% which implies real returns of about 1% over time with a lot of volatility. Not sure how he came up with the 2.9% figure, I know that a part of your yield with REITs is return of principal.

Somehow that cannot be correct, because I think cap rates of REITs are typically mid single digits these days, like 5%. "Cap rate" means operational profit of a property, with expenses already deducted, and obviously not accounting for increasing property values with inflation or due to market supply and demand.
Makes sense, since the long-term returns of REITs should be similar to that of the stock market, because volatilities and drawdowns are also similar.

Well, that is what Larry wrote. Don't know all of the reasoning behind his 2.9% figure. As far as return of capital from dividend yields, I don't know the proportion of that relative to yield and also how that figures in the 2.9% number. My suspicion is that return of capital would come from depreciation, which is an expense but doesn't affect cash flow, and also come from sales of property within the REIT portfolio.

[Caleb4387]

Look into self storage and warehouse reits.

[AnonJohn]

Hi. My two cents...

In addition to general advice / theory on REITS...

It's easy for academics to overfit historical data, come up with a mechanistic reason for the better returns to explain the overfitting, and then suggest a portfolio based upon that information.

I am especially seeking perspective on avoiding psychological mistakes in revising an IPS. It is hard not to think that this is a bad time to drop REITs.

I suggest you identify an investing strategy that you can adhere to over decades, despite what the financial gurus, academics, et al are telling you over those decades.

If that strategy is tilting toward REITs, SCV, or anything else, fine. Personally, I don't trust (my psychology haved lived the life of an academic for decades) any past analysis on slicing-and-dicing to predict the future, so I don't overweight sectors.

Thanks dogagility. I haven't revised my IPS in 9 years, so it does seem appropriate to me to revisit it, given changes in family, financial status, and need / ability to take risks. But in doing so one exposes oneself to questions of behavioural economics ...

But the real reason for revisiting is that two parts of it were inconsistent, namely the focus on REITs and % international. I had made a mistake in implementation.

[Trance]

I hold VNQ in my roth ira to avoid its high taxtion. Like someone else said their performance mimics small cap value and corporate bonds. Based on this its logical that they are going to underperform the market (which is dominated by large cap growth) currently but will out perform during a recession or when the market goes sideways. This is the reason I hold something besides just the total market, so that I have something doing well when the market doesn't. The same reason somone would hold a small cap value etf, for factor investing.

That being said reits are way better positioned now than 2008 based on their debt structure. While the index is much lower, the actual performance of the fundamentals of the companies has been surprisingly strong despite the rising interest rates would normally hurt real estate performance.

I do not hold the international index but domestic reits are starting to go very international already.