Why I Don’t Bother With REITs

REITs =/= real estate.

A lot of popular investing advice is unhelpful, irrelevant or just wrong. One particular piece of advice that really annoys me is that if you want to invest in real estate, you should just invest in REITs.

A REIT — or real estate investment trust — is a company that owns and manages a portfolio of real estate. They’re designed as an easy way for investors to gain exposure to real estate without owning and managing the properties directly. These typically come in the form of mutual funds — you may have them in your workplace retirement plan — or ETFs.

Their big value proposition is that they take an asset class that’s traditionally non-liquid and package it into a liquid vehicle. Proponents see them as a diversifier. Some popular model portfolios have quite large allocations to REITs.

The problem is, when the average person wants to invest in real estate, what they mean is they want to buy single-family homes, multi-family homes or apartments and rent them out to tenants. But REITs largely fail to accomplish this. If you look under the hood of a REIT, what you see might not be what you’d expect.

The Vanguard Real Estate ETF (VNQ) is probably the best-known REIT. If you look at the fund composition, you’ll see that only 12.7% is invested in residential real estate. Other major components include:

• Retail – 13.30%

• Telecom towers – 11.90%

• Industrials – 11.40%

• Healthcare facilities – 11.10%

• Data centers – 8.6%

• Self-storage – 7.1%

There’s nothing inherently bad about investing in any of these things. They’re all productive assets. But it’s probably not what the average aspiring real estate investor has in mind. And yet, REITs are still sold as a hands-off alternative to investing in your local real estate market.

What attracts someone to invest in real estate? The first thing they probably have in mind is the physical property. There’s just something people like about the idea of owning something you can see and feel rather than the abstraction of an index fund portfolio. There’s also the use of leverage. Borrowing a significant portion of a home purchase means you can do more with your money and let your rental income pay the mortgage. And then there’s the generous tax code that lets real estate investors deduct all kinds of expenses and delay capital gains taxes indefinitely through strategies like the 1031 exchange. REITs give you none of that.

But the biggest reason to invest in real estate is that it’s a distinct asset class. It serves as an alternative, low-correlation asset to the stock market. REITs, however, are not a distinct asset class. In fact, REITs are not real estate — they’re just stocks. They’re stocks that happen to be in the real estate sector, just like tech companies are part of the tech sector. And there’s no reason the average long-term investor should be buying sector funds.

REITs also have a high correlation with stocks. VNQ has a correlation of 0.76 with Vanguard’s total stock market ETF. The iShares Core U.S. REIT ETF (USRT) has an even bigger correlation at 0.79. This defeats the whole purpose of diversifying into real estate.

If REITs still sound like something you want in your portfolio, good news: If you own a total stock market fund, an S&P 500 fund or even international funds, you already own REITs. They’re part of nearly every index fund already. The Vanguard Total Stock Market ETF (VTI) contains a 2.9% allocation to real estate companies. If you’re an index investor, that’s all you need. By going out of your way to buy REITs on top of total market ETFs, you’re overweighting companies in the real estate sector, which makes you an active investor.

The only times it makes sense to stray from the market portfolio are when you have a sensible bias toward your home country or when you’re trying to gain exposure to academic factors like those in the Fama-French Five-Factor Model, the most well-known of which are size and value. There are decades of research showing evidence that small-cap value stocks may outperform large-cap growth stocks. However, there is no similar research suggesting that REITs have any special diversifying qualities. To the extent that REITs figure into factor models, they’re most often associated with the value factor. But in that case, it would only make sense to invest in funds targeting the value factor.

Buying REITs is a great way to think you’re diversified when in reality you’re just needlessly overweighting a sector that probably won’t outperform the market and comes with its own idiosyncratic, and most importantly, uncompensated risks.

Don’t Bother With REITs

REITs miss the whole point of investing in real estate: to diversify toward assets with low correlation to stocks.

Buying REITs isn’t the same as investing in real estate. It’s just another way to invest in stocks — and an unnecessary one at that. If you really want exposure to real estate, you need to actually become a real estate investor. This involves stepping out of your comfort zone, taking on more risk and doing the hard work of actively building a portfolio of properties. REITs are no replacement.

If you don’t want the responsibility of becoming a real estate investor, stick to index funds, which give you all the exposure you need to REITs.