Conventional asset allocation theory suggests that investors should diversify away from their biggest risk. If you work for a tech company, for example, underweight tech stocks. The same reasoning would seem to apply to real estate, if you’re a homeowner.

Real Estate Investment Trusts are classified as financials, theoretically exposing an investor to the same risks and rewards as bank and lifeco stocks – with less of a buffer, since banks and lifecos have diversified lines of business. This came to the fore last spring, when a sharp uptick in long-term interest rates clobbered REITs.

Yet, in the U.S., REITs are considered a separate asset class from financials, with unique correlation characteristics. Thus David Swenson, leader of the market-beating Yale Endowment, recommends a 20% allocation to real estate for retail investors.

What makes the Canadian REIT market even more interesting is its evolution. Major institutions have been unloading their trophy buildings, the latest being Bank of Nova Scotia. It has even been suggested that the Government of Canada turn over its properties to a REIT. Finally, retailers have jumped on the bandwagon; first Sobeys, then Loblaws and potentially Hudson’s Bay Company, moving their store leases to stand-alone REITs.

While that may unlock value for investors, are REITs a stand-alone asset class? Long-time investment advisor Rick Ferri thinks so. In a recent blog, he argued: “Adding a unique asset class to a portfolio that has positive real returns and low or varying correlation with common stocks helps increase long-term returns. A well-diversified portfolio that holds an economic allocation to REITs has shown to be a more efficient portfolio than one that includes a market-weight allocation.”

Note that he emphasizes “economic allocation,” In the U.S., REITs account for 3% of market capitalization. But commercial real estate represents 13% of the U.S. economy. Naturally this shifts the balance from pure market capitalization to an approach closer in line with economic footprints.

Scot Blythe is a Toronto-based financial writer.
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