Non-traded REITs Can Diversify Investment Portfolios While Reducing Volatility
Kevin Hogan
Kevin is the executive director of the Investment Program Association, where he helps set strategic direction for the organization, manages operations and oversees the IPA’s membership driven committee structure.
“Diversify, diversify, diversify” is a cornerstone of modern portfolio theory. But many leading portfolio theorists responsible for advancing modern asset allocation concepts have suggested that we need to expand the definition of portfolio diversification to include a broader array of asset classes, adding a number of key alternative investments, such as real estate, private equity, commodities and currency to the more typical stocks, bonds and cash approach.
In a study, “Strategic Asset Allocation: Determining the Optimal Portfolio with Ten Asset Classes,” published in 2009 by three Dutch economists (Niels Bekkers, Ronald Doeswijk and Trevin Lam) found that adding real estate, commodities and high-yield to an already diversified portfolio “deliver[s] the most efficiency-improving value for investors,” and that relatively small allocations to these sectors can produce “an economically significant extra return,” ranging from 0.40 percent to 0.93 percent, based on volatility ranges from 7 percent to 20 percent. According to this study and others, alternative investments should not be viewed as alternatives at all, but as essential and valuable components of a well-balanced portfolio, appropriate for a broad spectrum of investors.
This is an argument that advocates of direct investments have been making for some time. The term direct investments refers to a pooled capital structure that enables investors to participate directly in the ownership of big-ticket assets, such as commercial real estate, medical or construction equipment and oil and gas rigs that they could not afford to acquire on their own. Of the primary components of the direct investment sector— equipment leases, oil and gas partnerships, managed futures and real estate investment trusts (REITs) —REITs are the largest and the focus of this article.
REITs fall generally into one of two categories, traded and non-traded. Both are subject to SEC regulations, reporting and oversight. The key difference between them: Publicly traded REITS are listed on stock exchanges where their shares can be bought and sold daily. Non-traded REITs, as the name suggests, are not traded on stock exchanges, which makes them less liquid than traded REITs, but also less vulnerable to the volatility of stock market swings.
LOW CORRELATION TO EQUITY MARKETS
Studies of portfolio performance have found that directly owned real estate has a consistently low correlation to the stock market. What this means for investors is that non-traded REITs have the potential to provide a volatility dampener in a portfolio, insulating it, to some degree, from the gyrations in other asset classes and potentially boosting the overall return.
“In these volatile times it’s never been more important for clients to diversify their portfolios among the various asset classes,” observes Ray Lucia, CFP®, veteran financial advisor and author of two books on investment strategies. While domestic large cap stocks “earned nothing” during the 10-year period ending in December 2009, Lucia notes, real estate stocks were up by more than 175 percent.
“Alternative investments that don’t correlate positively with the market added value,” he says, “and non-traded REITs, despite their illiquidity, delivered a fairly stable, high dividend during a time when many investors were earning paltry yields in bonds and cash. Clients who diversified their portfolio not only made positive returns during the ‘Lost Decade,’” Lucia points out, “they most likely avoided the extreme volatility brought about as a result of the great recession.”
Insulation from stock market swings and the resulting nervousness of public investors also benefits the sponsors of non-traded REIT programs, allowing them to focus more on building the long-term value of their portfolios and less on short-term decisions driven by the quarterly pressures that investor expectations and fickle Wall Street analysts can impose on publicly-traded companies.
While REITs are protected from the emotional reactions that can produce wild swings in the equity markets, they aren’t immune from the economic fundamentals that can affect investments of all kinds. The conditions that affect real estate markets—high unemployment, slow economic growth, and regulatory restrictions, for example— also will affect the performance of REITs investing in those sectors. Still, real estate as an asset class has been, and remains, an effective inflation hedge, another argument for including this sector in an investment portfolio.
LIQUIDITY LIMITATIONS
The low correlation with the equity markets that can make non-traded REITs an effective volatility buffer can be a double- edged sword. Because there is no large secondary market through which they can be readily bought and sold, shares of non-traded REITs also have limited liquidity, which must be factored into any investment decision.
Shares of non-traded REITs aren’t completely illiquid, however. Most programs make provisions for early redemptions necessitated by death, disability, hardship or other circumstances, and many programs also provide for limited share redemptions unrelated to emergencies. But the limitations are strict and investors who sell their shares prematurely will usually have to do so at a discounted price, yielding less than their original investment.
The limited liquidity of non-traded REITs may count as an argument against them for some investors; it is clearly a factor that all investors and the professionals advising them should consider. On the other hand, real estate should be viewed as a long-term investment, and if the liquidity features of nontraded REITs make this clear to investors, that is not necessarily a bad thing.
RISKS AND BENEFITS
Like any investment, non-traded REITs have risks that investors must recognize and consider. In addition to the liquidity limitations already discussed, these risks include:
• Early termination. If the program is unable to achieve its funding goals during the offering phase, the sponsor may end the program and return funds to the early investors.
• Loss of value. The value of REIT assets may decline, reducing the value of investors’ shares. Share values could fall below the offering price.
• Poor performance. The REIT may not achieve its desired diversification or stated investment objectives, or it may be unable to pay dividends.
• Adverse conditions. An economic downturn could affect the income of commercial property; new regulations targeting REITs could affect their operating costs, reducing their earnings and dividends.
On the benefits side, REITs offer the potential for both current income through dividends and long-term growth through property appreciation. They also can provide significant tax benefits for investors. REITs are structured as corporations, but their income is not taxed at the corporate level, so they can pass on more of their earnings to investors. In fact, REITs are required by law to distribute at least 90 percent of their taxable income to investors in the form of dividends.
Because a portion of REIT income is considered nontaxable in the current tax year, investors can defer taxes on a portion of the dividends they receive. Investors can also use depreciation of the properties in the REIT portfolio to offset dividend income. Alternatively, investors may be able to defer tax payments until the REIT holdings are sold, at which point the income they received would be taxed at the lower long-term capital gain rate.
TWO LEVELS OF DIVERSIFICATION
Of the many benefits REITs can provide, diversification is the one that probably deserves the most emphasis, because it is so often overlooked or undervalued. Non-traded REITs provide diversification at two levels: within an investor’s portfolio, by adding a counterpoint to assets highly correlated with the stock market, as already discussed; and among REIT programs themselves, which offer investors a wide range of options.
Once limited almost entirely to office, retail and industrial properties, the REIT menu now encompasses health care, lifestyle and self-storage facilities, among others. Some REITs concentrate on a single property type while others combine different property classes in a single program. A few REITs are focusing on international properties, opening a door to foreign property ownership that is otherwise virtually closed to individual investors.
Because of the multitude of offerings, investors don’t have to approach non-traded REITs as a generic investment asset class; they can choose programs and advisors can recommend them based on their assessment of specific markets and property types, producing investment decisions that are more finely tuned for investors and their portfolios. Although non-traded REITs have broad investor appeal, clearly they aren’t appropriate for all investors. Their long-term investment horizon and limited liquidity features make non-traded REITs inappropriate for investors for whom liquidity is a priority. But the combination of current income and appreciation potential may make these programs appealing for investors approaching retirement, as they shift their emphasis from maximizing growth to preserving capital and generating current income.
Financial advisors who are familiar with non-traded REITS are usually enthusiastic about them, recognizing the vital role they can play in a diversified portfolio. But for many advisors, non-traded REITs and direct investments generally remain unfamiliar if not unknown, an alternative they do not often consider or recommend.
EDUCATING ADVISORS
To address this information gap, the Investment Program Association (IPA), a national trade association representing the direct investment industry, has formed a partnership with The American College to produce an interactive, online learning program that broker-dealers and program sponsors can use to educate registered advisors about non-traded REITs and other direct investment products. The course consists of eight training modules, including individual segments focusing on the various types of direct investments such as equipment leases, oil and gas, managed futures and private equity funds.
The IPA hopes to eventually create a curriculum that is broad enough and deep enough to support a formal industry designation denoting expertise in direct investments. But the organization’s immediate goal is to give advisors the information they need to include direct investments among the investment options they discuss regularly with their clients.
“The investing public is becoming more savvy, the Internet is full of advice, both good and bad, and investors more and more are listening to financial talk shows and reading financial publications,” Lucia says. Advisors, he emphasizes, will have to meet their clients’ increasingly demanding expectations for information and advice.
Expanding the pool of financial advisors who understand direct investments will accelerate their movement into the investment mainstream and into portfolios, enabling more investors to benefit from the value direct investments add and the diversification they bring.
