What Is the Right REIT Allocation?

REITs increasingly are being included in more meaningful allocations in investment portfolios.

Abigail McCarthy

Commercial real estate is a core asset class with unique investment attributes and return drivers. This has been demonstrated over time and is the reason that 83 percent of financial advisors in the U.S. recommend REITs.

Investments in REITs are investments in real estate, providing the same long-term real estate returns and diversification benefits. The defined contribution and financial advisor driven IRA markets are increasingly using REITs to add real estate exposure to diversified portfolios. In the defined contribution market, where the growing use of target-date funds is the dominant investment-related trend, it is estimated that nearly 100 percent of these products feature REIT allocations. Among financial advisors, a Nareit-sponsored survey conducted by market research firm Chatham Partners found that, despite the ongoing pandemic, 92 percent of financial advisors will maintain or increase their recommendation of REITs to their clients in the next one to three years.

The fundamental asset class proposition is based on specific, well-documented attributes of real estate investment, including:

  • A distinct economic cycle relative to the cycle for most other equities and bonds due to supply inelasticity, which reduces the correlation of investment returns from real estate with the returns from other assets,
  • Competitive, long-term investment returns that potentially provide high and growing income from rents plus moderate capital appreciation over time,
  • Potential inflation hedging attributes due in part to the fact many leases are tied to inflation and that real asset values tend to increase in response to rising replacement costs.

What is an appropriate REIT portfolio allocation?

REITs have provided above average returns while exhibiting low, long-term correlations with other major asset classes. Many investors believe a reasonable portfolio allocation to REITs is between 5 percent and 15 percent, and there are two research-based factors that support the idea that allocations to REITs in an optimally diversified portfolio may be at the higher end of the scale for many investors.

First, commercial real estate is the third largest asset (17 percent) in the U.S. investment market, after U.S. equities (37 percent) and U.S. bonds (43 percent). Modern portfolio theory argues that well-diversified investment portfolios should include meaningful allocations to all assets in the market basket, including real estate. It is important to note that, while listed REITs only represent an estimated 10 percent to 20 percent of the above referenced 17 percent real estate asset figure, research by organizations such has Morningstar has found that the real estate market drives REIT returns. For this reason, listed REITs and property companies may be used as a liquid and transparent proxy for gaining access to the entire commercial real estate market, which represents about one fifth of the investable universe in the U.S. It should be noted that listed real estate securities may also be used to invest in the global commercial real estate market.

Second, multiple studies from organizations such as Morningstar and Wilshire Associates have shown that the optimal allocation to listed Equity REITs for certain investors may be between 5 percent and 20 percent, and Wilshire found that the optimal allocation to listed U.S. Equity REITs in a retirement savings portfolio would begin at 15.3 percent for an investor with a 40-year investment horizon, and gradually decline along with other equities as the investment horizon shortens, ultimately to 9.1 percent for an investor at retirement. Not surprisingly, the maximum REIT allocation identified in these and other research studies was comparable to the proportion real estate represents within the U.S. investable universe. It should be noted that optimal portfolio allocations to global REITs and real estate companies were found to be similar.

REITs increasingly are being included in more meaningful allocations in investment portfolios—especially retirement portfolios. The use of REITs in portfolio design is indicative of the growing recognition that real estate exposure provides important benefits for investors.