One of the main selling features of using a model portfolio is that you can quickly add various asset classes to create diversification benefits within a static framework. This includes a hefty dose of alternatives and non-correlated securities and assets. One of the easiest and most common to add is real estate.
Real estate can provide plenty of income and inflation protection to a portfolio.
However, getting that exposure can vary. Owning physical properties versus public securities as well as betting on mortgages/loans are very different animals. Choosing the right way to get exposure and integrating it into your model is key to getting the benefits you want.
A Broad Asset Class
Adding alternatives to a portfolio is on the rise as investors look to find noncorrelated returns. Real estate has long been one of the easiest to access. And with the growth and simplicity of model portfolios, more investors — both big and small — have added a swath of real estate to their holdings.
But real estate isn’t just a one-off solution: It’s a broad asset class. This can include public and private investments in both equity and debt securities. So, you can purchase private equity investments in commercial or residential properties, loan out money for the construction of properties, purchase mortgage-backed securities from the U.S. government, or buy publicly traded shares of real estate investment trusts (REITs). This is just scratching the surface of ways to add real estate to a portfolio.
Despite this broadness of asset class, real estate does have some benefits no matter how you slice it.
When it comes to equity — that is, either owning shares in a firm that owns properties or physically owning a building itself — the benefit lies within a noncorrelated source of return. Returns are driven by two ways. The obvious one is rent income. Tenants pay rent to property owners in order to use the space. This steady source of monthly income provides a base of stable returns. And thanks to various tax benefits for both property owners and REITs, much of this income returns to investors as high yields. Better still is that rents often move higher during periods of rising inflation. This provides protection for investors and growing income.
Investors also can make additional returns from selling those properties for gains over time. Here again, tax benefits allow for these gains to be booked at lower or no tax depending on how the proceeds are distributed.
On the debt side, here again, steady interest payments from loans and MBS securities can provide a noncorrelated source of return. In the case of U.S. agency MBS bonds from Fannie Mae and Freddie Mac, investors can get higher yields than Treasuries with virtually the same levels of credit quality.
Real Estate in a Portfolio
Stable returns driven by cash flows greatly impact a portfolio and its diversification.
According to Morningstar, of the 39 empirical academic studies issued from 1978 through 2022, roughly 75% of them showcased that adding REITs to a mixed-asset portfolio offers diversification benefits over long time horizons. This is due to the low correlation to broader equity markets.
J.P. Morgan also suggests that private real estate can do even better on a non-crafted front, providing a negative 0.1 correlation to the U.S. stock market since 1980. This chart sums up their findings.
Source: J.P. Morgan
The debt side is similar. Mortgage-backed securities offer noncorrelated returns with regards to their respective sides of the market — investment grade or high yield. Additionally, investors can often get higher yields with a higher degree of credit quality. After all, mortgages are secured by a property. In the event of bankruptcy or default, foreclosures and seizes can occur.
This noncorrelated factor can provide a portfolio with a different set of returns, smooth out a portfolio’s overall ride over the long term, and create a more positive return.
Working Real Estate Into a Model
So, real estate offers a great portfolio addition. The cash-flow-driven nature of its returns provides a chance for investors to realize a different set of returns than equities and other assets.
According to Morningstar, adding as little as 5% weighting to real estate in a model can provide diversification benefits. However, adding real estate to as much as 15% of their weightings can significantly increase the chances of positive performance. Over the last 46 years, a portfolio that includes real estate (51% stocks, 34% bonds, and 15% real estate) managed to outperform a traditional 60/40 stock/bond portfolio 56% of the time. 1
The question is, how to get that exposure?
Private real estate vehicles, such as BlackStone’s BREIT and similar funds from Nuveen and KKR, offer exposure to direct property ownership. However, these so-called interval funds don’t come with much liquidity. That’s ok if an investor is willing to lose that liquidity. Likewise, owning physical property yourself comes with a different set of issues and risks.
A better choice — particularly for model portfolios — remains REITs and the funds that track them. Investors get one-ticker diversification across regions, property types, and management styles as well as large yields. And it’s that yield that helps drive real estate’s noncorrelated returns. As such, using an ETF to gain real estate exposure makes a ton of sense. Investors and advisors can quickly scale a real estate allocation and allow for simple rebalancing.
REIT ETFs
These funds were selected based on their exposure to REITs at a low cost and are sorted by one-year total return, which ranges from 1.6% to 8.1%. They have expenses of 0.07% to 0.69% and yields from 3.2% to 5.2%. They have assets under management between $73M and $63B.
| Ticker | Name | AUM | 1 Yr Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| USRT | iShares Core U.S. REIT ETF | $2.3B | 8.1% | 4.3% | 0.08% | ETF | No |
| XLRE | Real Estate Select Sector SPDR Fund | $5.9B | 7.4% | 4.4% | 0.09% | ETF | No |
| VNQ | Vanguard Real Estate Index Fund | $63B | 6.2% | 5.1% | 0.12% | ETF | No |
| SCHH | Schwab U.S. REIT ETF | $6.4B | 5.7% | 3.24% | 0.07% | ETF | No |
| DFAR | Dimensional US Real Estate ETF | $885M | 5.2% | 5.2% | 0.20% | ETF | Yes |
| JPRE | JPMorgan Realty Income ETF | $320M | 5.2% | 3.7% | 0.69% | ETF | Yes |
| PSR | Invesco Active U.S. Real Estate ETF | $73M | 1.6% | 3.2% | 0.35% | ETF | Yes |
In the end, alternatives have continued to find their way into portfolios — and real estate is arguably one of the best to choose from. Offering cash-flow-driven returns and a noncorrelated inflation-protected nature, real estate can smooth out returns and help a portfolio perform better. With the use of ETFs, adding real estate to a static model has never been easier. That’s great news for investors looking to build better portfolios and generate strong outcomes.
Bottom Line
Model portfolios are wonderful for building a collection of various asset classes. To that end, real estate needs to be on every investor’s list. Offering noncorrelated and steady returns, real estate can provide plenty of benefits to a portfolio. And with ETFs and a model portfolio, getting these benefits is easy.
1 Morningstar (January 2023).
