REITs had been an extremely popular asset class through the first half of 2016 when they took a turn towards significant underperformance. And as blind value chasers beat the REIT cheerleading drum, there are reasons to believe they could continue to underperform for decades. For example, REITs are no longer the attractive “bond proxy” as interest rates are now increasing, and these heavily-debt-reliant businesses could face tremendous headwinds if rates were to eventually rise back to over 15% as they were in the early 1980's.

The above chart shows total returns (price gains, plus dividends) for REITs versus the S&P 500. The underperformance begins in the second half of 2016 when interest rate hike expectations began to rise and as the forward-looking stock market shifted its focus to pro-growth businesses. The trend continued as the new pro-growth administration in the White House was elected and eventually took office. Also worth recalling, REITs became the 11th official market sector when they were carved out from Financials after the market close on August 31st, 2016. The lead up to the separate REIT sector arguably contributed to the market's REIT hype and then the sector’s relative decline.

Not All REITs Are Created Equally:

As we play "devil’s advocate" in suggesting REITs could underperform for decades, it is important to understand that not all REITs are created equally. For example, mortgage REITs (such as New Residential (NRZ)) are very different than retail shopping mall REITs such as CBL & Associated (CBL). Despite the pressures that REITs could face going forward, we believe there are still select attractive REIT opportunities for income-focused investors if you carefully select them, as we describe in these two articles:

Also worth pointing out, the lower-yielding REITs could face more pressure than the higher-yielding REITs considering their yields are becoming particularly less attractive relative to other market opportunities. For example, investing in a 2.5% yield REIT is not attractive to some investors when they can invest in a “risk-free” 10-year treasury that yields now 3.0%. And this contrast will become more pronounced as rates keep rising per expectations.

Conclusion:

No one has a working crystal ball. And while we can all make educated guesses based on the information that is available, no one knows for certain where treasury yields will be in 5-years, and no one knows exactly how REITs will perform over the next 5-years. For these reasons, we believe income-focused investors would be wise to select attractive higher-yielding opportunities across multiple market sectors (not just REITs) because it can keep expected income high and risk exposures lower.

How Much of Your Nest Egg Should Be In REITs?...

Considering the headwinds REITs could continue to face, and the benefits of diversifying into other market sectors (or other asset classes, such as bonds), how much of your investment portfolio should be invested in REITs? Well, for some perspective, here is the sector breakdown for the Russell 3000 ETF (the Russell 3000 is a market cap weighted index representing approximately 99% of the publicly traded equities in the U.S. market).

Importantly, REITs make up less than 4% of the total US equity market. However, many income-focused investors end up putting a very large percentage of their investment portfolios into REITs (because they are attracted to the high-yields). In our view, we wouldn't put all of our "REIT money" into 1 REIT (we'd be very selective, but we'd still own multiple), and we wouldn't put much more than 15% of our total investment portfolio into REITs without a really good reason. Every investor is different, but there are a lot of attractive high-yield opportunities in other market sectors and in other asset classes such as bonds. Selective yet diversified long-term investing is a proven strategy for success.