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Thanks to strong recent performance, there’s investor interest around real estate investment trusts (REITs). But there is some debate about whether REITs are the most effective way to get exposure to commercial real estate.

One potential issue: the risk of a sector overweight. REITs are equities, and as such are represented in most broadly diversified equity funds. Any additional allocation to REITs may result in an overweighting. You should take this into account when determining the REIT allocation in your client’s portfolio.

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Another factor to consider is that REITs can perform like small-cap value stocks. But while higher historical correlations between REITs and small-cap value stocks (versus alternate equity benchmarks) suggest some return variation is related to the movements of the small-value sector, a significant portion of return variation (approximately 50%) is uncorrelated (see chart, “Small caps versus REITs,” this page). This indicates substantial independence.

The main differences between REITs and traditional equities are their core businesses and primary drivers of earnings growth. REIT earnings are driven by the net operating income of the property holdings, and to a lesser degree, the appreciation in the value of properties.

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Small caps versus REITs

In contrast, traditional corporate earnings are driven by growth in sales revenue for products and services. Due to the difference in business fundamentals, there may be other significant variations between traditional small-value stocks and REITs.

Real estate is an asset class on its own. If your clients want to gain exposure, they can invest in diversified, index-based REIT ETFs. A broad REIT market index investment will give you diversification in property-type, managers, and geographic locations.

Other ways to access commercial real estate include:

  • direct investment and management;
  • participation in a private investment pool; and
  • purchasing REIT shares.

Direct investment involves purchasing a property outright and assuming operating control, maintenance, growth, and rent policy and collection. While direct ownership allows the investor to collect rents and the proceeds of any property sales without a management fee, it requires expertise in property management or hiring a third-party manager.

Direct ownership also limits the ability to create a multiproperty portfolio due to the size of the required investments. Because of the challenges of direct ownership, few diversified real estate investors choose this option. Private vehicles provide direct access to commercial properties. However, private real estate can be difficult to include in a diversified portfolio because of high costs, illiquidity, limited transparency, and large required minimum investments.

Even an open-ended commingled fund often requires early notification and substantial waiting periods for account transactions. Finally, to attain portfolio diversification across property types and regions, a share in a vast portfolio, or shares in multiple portfolios, is required.

Individual REIT shares are also an alternative. There is no substantive difference in the underlying real estate exposure between holding an interest in a private real estate partnership and a REIT.

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However, ownership of REIT shares addresses many of the investment concerns associated with private real estate partnerships or pools. REITs offer transparency and liquidity far exceeding that of most private real estate investments, and regional and property-type diversification is easier in public real estate than private. However, you won’t gain the diversification that you would through a broad-based indexed REIT ETF.

Atul Tiwari is managing director, Vanguard Investments Canada.

Originally published in Advisor's Edge Report

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