Quality in the Selection of REITs

Abstract

Quality real estate has historically offered an attractive return, but that return sits behind high barriers to entry. Physical property is costly to own and illiquid to trade. Publicly listed real estate investment trusts (REITs) were conceived as a means for shareholders to own property in a more divisible and tradable way. Over time, REIT shares have grown into a more than trillion dollar market. Historically, REIT shares have tracked long term real estate returns while also outperforming the stock market. They have combined bond-like regular payouts with the capital appreciation aspects of ordinary stocks. As such, they offer a long-term diversification benefit versus other traditional asset classes. However, REIT investing comes with two specific risk characteristics. One: an asymmetric risk profile, i.e. stable revenue and an absence of windfall profit possibilities limit the reward for taking incremental risk. Two: a high debt burden relative to companies in other sectors.

In this paper, we investigate quality-based characteristics that can improve the risk-return profile of REIT investing. Specifically, we study portfolios of REITs formed based on four characteristics: profitability, leverage, valuation and yield. We find that a portfolio that removes low quality REITs has historically outperformed the broad REIT benchmark. We highlight an approach of using these four characteristics to build a broad, statistically robust REIT portfolio, with each characteristic being additive to the REIT selection process. Importantly, the approach is based on fundamental real estate investment principles.

Keywords: Real Estate Investment Trusts (REITs), Quality Factor, Smart Beta

JEL Classification: G12, R30