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Is real estate a safe alternative to bonds?

(MoneyWatch) With interest rates at very low levels, many investors want to know how they can get more yield. Some people turn to real estate (in the form of real estate investment trusts), thinking it may be a safe alternative to high-quality bonds. As we'll see today, that hasn't been an acceptable substitute.

We'll start by looking at the Vanguard REIT Index Fund (VGSIX), which currently yields about 3.2 percent. That high yield can be enticing, especially for those of you who aren't receiving much from your bonds and other fixed income. Another attraction is that REITs have a relatively low correlation with stocks -- in other words, when stocks zig, REITs zag. In technical terms, the annual correlation of REITs to the S&P 500 is about 0.4. (A correlation of 1 means assets move in lockstep, -1 means one tends to have below-average returns when the other has above-average returns.)

REITS, however, are definitely not substitutes for safe fixed income investments -- the annual correlation of REITs to 5-year Treasuries is actually negative, at about -0.2.

Compounding the surge in interest for REITs is that they have done well recently, and investors are notorious return chasers. They love to buy what did well recently and sell what did poorly recently, which is what leads them to buy high and sell low. The table below shows the annual returns of VGSIX since 2009. (The 2012 returns are through Oct. 4.)

My colleague and "Right Financial Plan" co-author Kevin Grogan provides the following warning: If investors venture into these areas in search of yield, they should go in with their eyes open. It's almost a certainty that when you find higher yield, you've also found higher risk, whether you can identify the risk or not.

When looking at the various high-yield alternatives, it doesn't take long to discover that they are risky. The table below shows the returns of these asset classes in addition to 5-year Treasuries during the last four quarters in which the S&P 500 Index was down at least 10 percent.

As is often the case with risky strategies, they don't perform well when the markets are down. This evidence demonstrates that these asset classes are not replacements for buying treasuries, government agencies or AAA/AA rated municipal bonds. It also shows that among the alternatives presented, REITs tend to perform the worst, just when you need the safety of fixed income the most.

Master limited partnerships represented by the Alerian MLP Index. Dividend-paying stocks represented by the Dow Jones U.S. Select Dividend Index. REITs represented by the Dow Jones US Select REIT Index. Preferred stocks represented by the S&P Preferred Stock Index. High-yield bonds represented by the Barclays Capital Corporate High Yield Index.

Money house image courtesy of Flickr user 401(K) 2012