As we discussed in part 1 of this article ("Why not a REIT?"), Institutional Private REITs and old-school non-listed REITs have significant limitations that make them inaccessible or unsuitable for most investors. 

 

There's another type of REIT, called a publicly listed REIT. Unlike the previous types, a publicly listed REIT may have a role to play in your real estate portfolio. However, it's important to understand the limitations, and why it may not play a core role.

 

Publicly listed REITs

 

Publicly listed REITs trade on the stock exchange. As a result, you can cash in and cash out of your investment at any time. This is a significant advantage over the other types of REITs, and direct real estate investment too. All of these require you to lock up your money for some period of time. 

 

But this liquidity isn't free. It comes at a cost: volatility, loss of diversification protection and the liquidity premium. 

 

Volatility: courtesy of "Mr. Market"

 

Public REITs experience many more negative years, than private direct real estate.

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Compare the index for public REITs (on the top) with the index for private, direct real estate (on the bottom):

 

 

 

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From 1978 to 2014, publicly listed REITs lost money twice as many years as direct real estate (8 years versus 4). Also, the up-and-down gyrations are more severe.

 

Why are public REITs so much more volatile? Both of them are investing in the same thing, so you might think they should act the same. 

 

The difference is that public REITs are traded on a public stock market. And everything sold on the market gets sucked into periods of overvaluation and undervaluation as public sentiment overvalues and undervalues the market. You can see from the above graph, that public REITs go negative when the stock market goes negative (every 5 years or so).

 

Direct real estate is much steadier, and only goes negative during financial crises (every 15 years or so).

 

Benjamin Graham is the father of "value investing" and was the mentor of the most successful investor in the world (Warren Buffett).  Graham described the stock market's behavior with a metaphor, that he called "Mr. Market". Many people believe the stock market always reflects the perfect price for a stock, but Graham firmly believed that Mr. Market is highly irrational and volatile. Mr. Market routinely gets swept away in irrational exuberance (overvalues his stock), and excessive pessimism (undervalues his stock). This up-and-down behavior is why anything traded on the public stock market will be more volatile, than if it were not.

 

Bye-bye diversification

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This correlation with the stock market, creates a second weakness of publicly listed REITs. One of the main advantages of real estate investing is that it's not correlated with the stock market, which protects your portfolio from downturns and increases your overall returns. 

 

But as the above graph showed, public REITs go up and down with the stock market. Public REITs do not diversify or protect your portfolio as well as direct real estate. This negates one of the main benefits of investing in real estate: the diversification (and the decreased risk and increased return that diversification brings).

 

Liquidity: "It aint free"

 

The biggest advantage of public REITs is their liquidity. You can get in and cash out whenever you want.

 

However, nothing comes for free, and this flexibility is a double-edged sword because it also increases the cost of a public REIT. This is called the "liquidity premium".

 

This academic paper from the University of Cincinnati, found that there is always a significant liquidity premium for public REITs.  And it quotes another researcher who estimated it can cost as much as 12-20% during certain periods.

 

Any money invested in a premium, is money that's not making any money for you in the actual investment.  

 

And worse, the premium itself gyrates along with "Mr. Market". So to avoid losing your premium, you can only sell your public REIT when the premium is equal to or higher than when you bought it. If you need to sell when its lower, you will be taking a loss. So, this further increases the price you pay for the liquidity.
 

How I deal with the liquidity premium

 

Personally, I'm not comfortable letting up to 1/5 of my investment sit idle, and also having "Mr. Market" dictate when I can or cannot cash out. So here's what I do.

 

Everyone agrees that real estate isn't a short-term investment. You should only be funding it from long-term funds that you don't need immediately.

 

So in my opinion, if my real estate money is truly long-term, it's foolish to pay a liquidity premium of up to 20%, just for the knowledge that I "could" take it out, tomorrow, if I wanted to. It's much better to set aside enough money for an emergency fund, and not invest that in real estate. Instead, I place that in a 100% safe, short-term appropriate investment.

 

This way, I'm not unnecessarily risking my emergency money, and both my emergency and long-term money are yielding the maximum that they can.

 

(A good trick I use for emergency funds is to break it into 10 chunks and place each into five year CDs. If I have to dip into it, I only lose a few months interest, and only on that small chunk, rather than the whole investment.)

 

Advanced investors: public REIT diversification

 

Despite the drawbacks mentioned above, public REITs have 2 advantages that you might want to exploit.

 

First, over very long periods, they tend to slightly outperform direct real estate. Second, they don't correlate exactly with the stock market (close, but not exact) nor with direct real estate.

 

So, in my opinion, an advanced investor with a very long-term hold period (multiple decades), might want to add a dash of public REITs to their overall real estate portfolio, to decrease correlation, reduce risk, and spice up returns. That diversification effect, might be worth taking on all the negatives of public REITs for that investor. That's what this paper from BNY Mellon argues.

 

Although the paper doesn't give any specifics, I could imagine an advanced investor might want to invest up to 10-20% of their real estate portfolio in public REITs, and the remainder in direct real estate.

But I personally wouldn't do this with a shorter hold period, because of the volatility of public REITs.  And I would personally need to feel that the diversification advantages outweighed the significant negatives.

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