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REITs Soar as Home Values Reach 9-Year Low

The headlines keep dishing out more bad news. Recently, the bad news was that our home values reached a nine year low. The 21st century has so far been known for one big real estate bubble, which is part of the reason the US stock market has turned in a paltry 18 percent gain, as measured by the total return of the Vanguard Total Stock Market Index Fund (VTSMX). So why then is the Vanguard Real Estate Investment Trust Index Fund up an astonishing 257 percent so far this decade?

A few ideas
Since our home values have returned to where they were in 2002, I thought I'd go back and see how much of that 257 percent increase occurred between the years 2000 and 2002. What I found was that only 47 percent of the increase came from that time frame. Thus, the majority of that gain came over the past nine years when our houses netted us nothing.

My next hypothesis was that commercial real estate performed much better than our residences. Most REITs are commercial, which might explain the difference. So I went to the MIT Center for Real Estate where I found the Moody's Moodys/REAL Commercial Property Price Index (CPPI). Though this index showed a slight increase in the early years of the century, commercial property is also back to where it was nine years ago. What gives?

Losing interest
I hate it when the facts don't support my theories but I'm not giving up yet. Interest rates plummeted so far this century, and the lower interest rates have two effects on REITs.

  1. By refinancing their debt, REITs have increased their cash flows, even with higher vacancy rates.
  2. Because bond rates declined so much, investors turned to REITs to get income.
Now I suspect there is some truth to my new theory, yet I find it hard to believe it could explain such stellar performance, relative to real estate as a whole.

My final answer
The bottom line is that I really don't know why REITs have racked up such great returns. Though I might be able to explain part of it, I'm at a loss to explain all of it. It's a truthful, albeit not very satisfying, answer from someone who has been through decades of analytical training.

What my ignorance means to you
I've long since accepted the fact that I'm not smarter than the market. I believe that REITs should be a part of many investors' portfolios. Outside of a real estate bubble, they can sometimes provide diversification from a low (but not negative) correlation with the US stock market. This doesn't mean I know when REITs are under or overvalued, though I admit my gut says they are overvalued.

Accept the fact that you don't know either. Set an allocation of no more than ten percent of your US stock portfolio and stick to it. You'll be selling when it's a high performer and buying after a decline.

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