Chapter Six

Conventional Alternatives II: Real Estate

In Real Estate We Trust

Wealth used to be synonymous with real estate (“real” means royal in Spanish). Whether you were King, Queen or just the Duke, Duke, Duke of Earl, your wealth consisted principally of land. The Little Book of Royal Investing, had it existed back in those days, would have advised you to get land and more land, since land was synonymous with wealth. Those without land—nearly everyone else alive at the time—led a hand-to-mouth existence.

The industrial revolution changed all that, catapulting us into a modern world where we have reached a point at which people need to be reminded that yes, real estate is an important asset class to include in their portfolios. Agricultural assets have given way to industrial assets and the financial assets that are predicated upon them, such as stocks and bonds.

There are two types of real estate: residential and commercial. By residential, we mean your house. Your house may well be your biggest asset. If you haven’t done so already, please buy a house. Houses are great—just ask Ben, who owns a surprising number of them. The U.S. government makes owning real estate too good a deal to pass up, especially if you can afford it. However, do not overbuy. As Adam Smith pointed out in The Wealth of Nations (1776), a personal residence is essentially an item of consumption, not an investment, alternative or otherwise. If you keep your home for a long time, it will turn into a significant asset, although beyond the free rent (a considerable advantage) it only becomes useful to you as money when you cash it in. Unless you sell it, downsize, and spend the difference, your paid-off house primarily benefits your heirs.

For more of our deep thoughts on this topic, check out our previous Little Book of Bulletproof Investing, which contains a chapter on residential real estate. Perhaps you are considering buying a vacation home in Aspen and renting it out so that you will end up with a free house, paid for by renters, while you are able to take free ski vacations for the next 30 years. Read our other Little Book first. (When Ben tells audiences the story of his home renovation-at-a-distance in Aspen, it moves them to tears. At least, it moves Ben to tears.)

The point is, even though you own your house, it is not really an investment in the same way your stocks and bonds are. You still can benefit from additional exposure to real estate in your portfolio.

Which brings us to property type number two: commercial real estate. This is everything that is not a house. Say you’re walking down the street and see a skyscraper. This would be an example of commercial real estate. You might want to buy it. Immediately, though, there’s a problem. It’s expensive.

Only rich people—or institutional investors—buy commercial real estate directly. For them, it’s not a hobby. They have to perform due diligence on the buildings they are buying. It’s not smart to buy just one—they need a whole portfolio of properties diversified by type and geography. They have to oversee their entire real estate portfolio, buying and selling properties as it strikes their fancy. Then they need to manage the properties: Collect the rent, fix the radiator, patch the paint, lay the carpet, call the plumber. For a long time, only very large investors dabbled in this market.

This changed on September 14, 1960, when President Eisenhower signed the Cigar Excise Tax Extension. Under the wrapper, this bill contained the Real Estate Investment Trust Act—giving birth to REITs, as they are known. This act was usefully modified by the Tax Reform Act of 1986, which allowed these trusts to both own and manage real estate in one vertically-integrated company. With the stroke of a pen, commercial real estate became available to everyone as an alternative investing option.

How Do Investors Use REITs?

Real Estate Investment Trusts are publicly traded companies that own and operate office buildings, apartment complexes, and the like. To qualify as a REIT under the Internal Revenue Code, the company must invest at least 75 percent of its total assets in qualifying real estate assets and derive at least 75 percent of its gross income either from rents or interest on mortgages. In addition, a REIT must distribute at least 90 percent of its taxable income annually to its shareholders as dividends. As a result, most REITs pay no corporate tax, as the taxes are effectively passed along to shareholders.

The REIT structure solves the problems that kept ordinary retail investors at bay. REITs are liquid, diversified, and professionally managed. This is a big deal. Try selling an industrial park and it may take you a while, but you can sell a REIT that specializes in industrial properties with a click of a mouse.

REITs are run with oversight from a board of directors, and are subject to market discipline as they trade on the major stock exchanges throughout the world. They can be acquired for a few dollars in commissions instead of by hiring a Realtor. Little wonder REITs have mushroomed.

In the United States, there are two types of REITs:

1. Equity REITs, which own income-producing properties.

2. Mortgage REITs, which invest in loans secured by either residential or commercial real estate.

In this chapter, we talk about equity REITs, since mortgage REITs are better thought of as credit (that is, bond-like) instruments. Mortgage REITs have their own unique characteristics. They are generally long-term loans that pay an above-average coupon to compensate for the fact that they will be repaid at exactly the wrong time, when interest rates are falling. We leave it to others to analyze them.

How Do REITs Work?

Here is the secret to how equity REITs work: Landlords collect rents from tenants and distribute them to shareholders. The sustainability of this business model is what makes being a landlord the second oldest profession.

Someday, a worldwide Communist revolution may abolish private property and usher in a worker’s paradise. Until then, the idea of landlords collecting rent is about as durable a business proposition as can be imagined. If you don’t believe us, try not paying your rent next month and watch what happens.

The premise of landlords collecting rent is about as durable a business proposition as can be imagined.

Do REITs Add Value to a Portfolio?

Owning REITs no longer makes you cool all by itself. REITs are such a common alternative investment that—as with commodities—they are not really alternative anymore.

As investments, REITs have several beguiling features:

The fact that the real estate is set inside an equity wrapper and traded alongside other stocks on the stock exchange means that it is going to behave something like a stock. The fact that REITs represent pass-through vehicles for the rents they collect makes them something like a bond, or a curious cocktail of stock plus bond plus real estate. REITs will behave like stocks and bonds, losing value when interest rates rise and gaining value when they fall, other things being equal.

Did we mention that REITs are leveraged? These managers aren’t dumb; they don’t usually pay all cash for their properties. They borrow money to finance them, typically to the tune of about 40 to 50 percent. This is less leverage than is used on most commercial real estate, and less than most people use when buying their houses.

In practice, REITs have produced high returns with high volatility. From 1990 to 2005, they had a mean return of 11.4 percent per year and an annual standard deviation of nearly 25 percent. The first decade of the 21st century was called a “lost decade” for equities, but the Vanguard Real Estate Index fund (ticker: VGSIX) was up 10.3 percent over that 10-year stretch, which is not great but is still 11.4 percent better than stocks. Before you back up the truck, remember that REITs were down 38 percent when Krypton exploded in 2008—even more than the stock market. They diversified you down, exactly when you needed them to pull you up.

Just because an investment doesn’t perform perfectly doesn’t mean we should avoid it. Berkshire Hathaway stock—one of the greatest investments of all time—has, on three occasions, lost half of its value. There were other bad times for stocks when REITs were in there pitching. During the inflation of the 1970s, REITs were the single best performing asset class. REITs generally have a low to moderate correlation to the rest of the stock market (in the 0.40 to 0.70 range, although the correlation rose to 0.79 in 2008).

Notably, REITs contain two hedges against inflation: rents and property. Many leases contain clauses allowing for periodic inflation adjustments. During inflation, investors tend to shift from paper assets to real assets, driving up property values. REITs add tremendously to a portfolio’s inflation-fighting ability. Consider that the baby boom generation is now on the cusp of retirement, desperately in need of a rich income stream, and that inflation is a retiree’s worst enemy, and you will understand how an allocation to REITs is justifiable even if their performance in the future turns out to be less exceptional than it has been in the past.

How Do We Invest in It?

One way to invest in commercial real estate is to buy a small apartment building in your hometown. This hobby is not going to be as much fun as it sounds. Your authors have already confessed to incidents from their own younger days as tenants when they were guilty of incurring a landlord’s displeasure, including the notorious affair of the second-story waterbed where the unattended hose that was filling the mattress slipped out, filling the apartment building with water instead.

If you, landlord, are up to these challenges, God bless you. You are banking on your sweat equity and local knowledge of real estate conditions to come out ahead. Against this, though, you are concentrating your real estate eggs in your hometown basket, which may or may not turn out to be a great idea. It is an added risk for which you are not being compensated.

There is an easier way, and that way is to buy REITs. You can always try to pick individual REITs if that is your passion, but your life will be simplified by picking a mutual fund that samples the entire REIT universe. All the arguments against individual stock picking apply to REITs as well, and the REIT index funds outperform the actively managed funds by similar margins. Buying a REIT index fund can offer us a small piece of virtually every publicly traded property on the planet. This diversifies away all the idiosyncratic risk, and does it for peanuts.

There are lots of excellent REIT mutual funds that charge low expenses and give investors access to the entire REIT asset class. Which ones to choose? Once again, the world bifurcates into investors who use investment advisors and those who do it themselves. Those with advisors will gravitate toward the passive offerings from Dimensional Funds, domestic (ticker: DFREX), international (ticker: DFITX), or both in one global fund (ticker: DFGEX).

For those going it alone, the many retail REIT index funds have subtle differences but their similarities are even greater, so you should shop by price. You can’t beat Vanguard’s MSCI REIT index exchange-traded fund (ticker: VNQ), which charges an astonishingly low 0.13 percent a year, along with its international REIT cousin (ticker: VNQI), which charges 0.35 percent.

Since REITs are pass-through structures, they leave the taxes to be paid directly by the shareholders. Only about 40 percent of the dividends are taxed at the lower dividend tax rate; the rest are taxed as ordinary income. This makes REITs an ideal candidate for your IRA, annuity, 401(k), or other tax-deferred account (although future changes to the tax law may alter this opinion). Because REITs also hold out the prospect of significant capital appreciation, they should be some of the first things you load into your Roth IRA.

The Alternative Reality

No controversy here: There is widespread agreement that portfolios benefit from a separate allocation to REITs, in spite of the fact that REITs are already present in equity market index funds.

Why? Some say it’s because the total stock market weightings do not take into account the vast real estate holdings in private hands, so that a special allocation is required to more accurately mirror the market-wide holdings of all participants. Who knows? The availability of many excellent REIT index funds makes this now-conventional alternative easy to include in your portfolio.