Commercial Real Estate Investments and REITS: The Outlook

REITs are the easiest way to take the pulse of commercial real estate, and they are down so far this year.  Capital Spectator voiced some doubts about their outlook, but added an interesting comment:

… your editor has become increasingly cautious on the prospects for REITs in recent years. For as long as he’s embraced the view, he’s been wrong. Eventually we’ll get it right, although there’s no guarantee as to when. Meanwhile, even a broken clock offers an accurate reading twice a day.

I had to check that comment–I thought I might have written it.  I started selling the REITs in my own portfolio over a year ago.  Too soon, but with lots of profits.

What’s the outlook?  I’ve looked at REIT returns during periods of rising interest rates (similar to what I posted regarding the stock market and rising long-term interest rates) and REIT prices seldom boom when long rates are rising.  But, they usually continue to pay very nice dividends.

The issue that has worried me for some time is broader than just REITs; it applies to all investment real estate.  (And this issue is relevant to REITs, because their prices are driven by the value of their underlying properties).  Here’s the issue:  institutional investors (pension funds, endowments, etc.) have been increasing their investment in real estate.  Will that continue or be reversed?  They’ve had two reasons for investing in real estate.

1. Real estate is a great way to diversify a portfolio heavy with stocks and bonds.  The returns are almost as good as stocks, and the correlation is moderate, meaning a blended portfolio has a much lower risk than either all stocks or all real estate.  (Explained in more detail here.)
2. Real estate for several years has been last year’s top asset class.  Many investment managers, even professionals, blindly and stupidly chase the most recent trend.

This issue is important because if answer 2 predominates, then look for institutions to bail out when real estate softens.  And the illiquidity of real estate can become terrifying to investors used to calling in trades in the morning, and having their broker execute them by the end of day.

I posed the question, "Which of these explanations is strongest," to Rance Gregory, who runs a real estate investment fund.  His key points (as I recall them):

• many funds are still below a reasonable allocation to real estate
• most funds that have targeted some real estate are currently below their desired allocation to real estate
• if real estate underperforms the entire investment universe, some institutions will add more dollars to real estate to stay at their desired asset allocation percentage.

He concedes that there may be some investors who panic, but believes the positives will offset.

I think he may be right, but I’m still nervous when I hear that there are investors who have not lived through the risks of the types of investments they have made.  I have seen panic.  It is not pretty.