This content is from: Corner Office

RIAs Are Choosing REITs to Diversify Portfolios

Real estate investment trusts are well positioned to offer diversification and yield when interest rates eventually start to rise.

Last year JJ Feldman, portfolio manager at Miracle Mile Advisors, found a new investment opportunity for his clients in a somewhat unexpected place: real estate investment trusts. The Los Angeles–based registered investment adviser’s strategy is focused on exchange-traded funds, and for a few years REITs and REIT ETFs didn’t fit the bill; their performance was unremarkable, and volatility was high. But in late 2013 Feldman discovered a historical trend of REITs performing particularly well in a rising interest rate environment.

“I looked at a lot of research and found that in periods where rates rise, REITs will all almost overwhelmingly do as well as, or even better than, stocks until they get to a certain point,” Feldman says. “That point could be three years away, so at the end of last year we homed in.”

Miracle Mile focused on the Vanguard REIT ETF, the largest such vehicle and also one of the cheapest. It is highly diversified, with health care, hotel, industrial, public storage, office, residential and retail REITs, and at the time it was trading below net asset value. Historically, when REITs or REIT ETFs are trading at a discount to NAV, “it’s a good time to get in,” says Feldman.

And that may ring true for the foreseeable future, depending on how interest rates move, he says. When interest rates spiked during the so-called taper tantrum last year, REIT prices dropped, sending yields higher — a status that Feldman expects to stick around so long as the rise in interest rates is slow and steady. For now, his investment in the Vanguard ETF is definitely paying off: The REIT index is up about 26 percent this year, including dividends, beating the broader U.S. equity market and “just about anything else.”

Feldman and Miracle Mile aren’t alone in this strategy. RIAs have increasingly looked to real estate — specifically REITs — over the past year in an effort to take advantage of the opportunity to snag relatively low-risk returns in a low-yield climate and ride them through the eventual interest rate hikes. News like last week’s $2.29 billion initial public offering from office REIT Paramount Group, after a bit of a lull in deal activity for 2014, only adds to the optimism.

For many RIAs, REITs are attractive in part because they represent a unique way to mitigate the risk of a sharp downturn in equities, which has become increasingly important since the 2008-’09 financial crisis. “The use of alternative investments or ‘hard assets’ has become more and more [common] as investors look for something to have a noncorrelated performance metric than stocks generally,” says Frederick Baerenz, president and private wealth adviser at AOG Wealth Management in Great Falls, Virginia.

But what was once a portfolio add-on has become its own pillar of alternative investing. Real estate companies and REITs have gained respect and status over the years by performing along with or ahead of the broader market and providing diversification without too much additional risk. Highlighting this trend was the announcement last week by S&P Dow Jones Indices and MSCI that they would add a new global industry classification standard for the real estate sector.

REITs are significantly undercovered by equity analysts, which makes them even more attractive for some investors, according to Joseph Fisher, Chicago-based co-lead portfolio manager and co-head of real estate securities in the Americas for Deutsche Asset & Wealth Management. The lack of research coverage presents active managers with an opportunity to gain an informational advantage by talking to brokers or private market participants about property fundamentals and asset pricing, he says.

Right now, correlations between REITs and the wider equity market are near historical highs, and choosing between, say, a retail-based REIT or an office one doesn’t make much difference. But Fisher and others see that changing in the near future as interest rate increases squeeze capital availability, potentially pushing down demand for property. This will encourage individual property sectors to adjust asset valuations, breathing diversity back into the market.

“We’re reverting more to a focus on fundamentals that can drive the core underlying business, and I think that’s where active managers can excel,” Fisher says.

For many RIAs, the real frontier-building alternative may be nontraded REITs. RIAs have long shied away from these products, in part because they often have to be handled on a commission basis, which is not easy to do as an RIA, and also because of their relative illiquidity. Several giant nontraded REITs sponsored by investment services firm American Realty Capital and based in New York, have changed all that in recent months.

ARC, headed up by entrepreneur Nicholas Schorsch, who is also co-founder and chairman of American Realty Capital, went on a deal spree that culminated in Realty Income Corp.’s $1.9 billion acquisition of American Realty Capital Trust Inc. in 2013. Many analysts say it’s hard to ignore its success with the nontraded model.

The success of ARC's nontraded REITs may be changing some investors’ tunes. They have caught the eye of the National Association of Real Estate Investment Trusts, a Washington-based trade association, which has begun to pay closer attention to nontraded REITs as their relevance to the wider market becomes more apparent.

Miracle Mile’s Feldman isn’t enthusiastic about the nontraded side, but he believes traded REITs and REIT ETFs are worth a second look: “If rates stay low and increase at a gradual pace, REITs can do really well.”

Follow Kaitlin Ugolik on Twitter at @kaitlinugolik.

This article has been updated to reflect a correction in the name of American Realty Capital.

Related Content