REIT Portfolio Risk Management
There are hundreds or even thousands of REIT articles here on Seeking Alpha, yet one topic remains to be discussed: REIT portfolio risk management. In this article, we will not discuss a specific REIT; instead we will discuss how investors can seek to maximize their risk-adjusted returns by properly structuring their REIT portfolio. Many often think of real estate as just one single market, moving along one same cycle. This is a misconception; there is not one real estate market but many real estate markets, each with its own supply and demand fundamentals and cycles. Different property types and different regions of the world do not perfectly correlate together; in fact, in certain cases they might strongly diverge in their performance.
REITs are today invested in all continents of the world and in almost every property type. They allow investors to easily allocate capital in a multitude of real estate markets, and diversification capabilities are hence considerable. To increase the diversification of a given REIT portfolio and better manage its risk, it is important to understand what drives different real estate markets. One property type may be negatively affected by a given factor, while another one may actually benefit from it for instance. In this sense, our objective is to identify factors that may cause different REIT markets to behave differently so that we can capture diversification benefits and develop hedging strategies.
7 Ways to mitigate the risk of your REIT Portfolio
- Include international REITs into your portfolio. Different markets have different cycles. While the hotel market may be saturated in New York, it may be strongly undersupplied in Paris, as an example. Moreover, investing internationally reduces the exposure to rising US interest rates, which may negatively affect U.S. REITs. There is a clear uptrend in interest rates in the U.S., but much less so in many other parts of the world. Exposing a real estate portfolio to different market cycles can hence help to reduce its volatility.
- Mix a few mortgage REITs with your regular equity REITs. This can help to mitigate interest rate exposure as well because certain mortgage REITs may actually benefit from rising short-term rates. Apollo Commercial (NYSE:ARI) noted in a recent presentation that each rate bump would positively impact its bottom line because it borrows fixed rate debt but lends variable rate. Equity REITs, on the other hand, may suffer from interest rate increases in the short run.
- Combine retail REITs with industrial REITs. Mall REITs are negatively affected by the rise of e-commerce, which lowers traffic, revenue and possibly rents in the long run. However, it causes the demand for another types of real estate to increase, namely warehouses and distribution centers. As such, one can seek to hedge his/her exposure to malls by investing in industrial REITs in parallel to mall REITs.
- Pair your hotel REIT investments with self-storage REITs. Hotel REITs are very cyclical and tend to strongly underperform during recessions. However, an argument can be made that self-storage properties benefit from downturns. During recessions, consumers and businesses downsize to adapt to the environment and this often leads to an increased demand for self-storage space.
- Invest in REITs following different underlying strategies. Private equity real estate investors often separate real estate strategies into three distinct groups: Core, Value Add, and Opportunistic. Each has its own risk and return profile, and it may hence be beneficial to gain exposure to all three strategies. In this sense, Washington Prime (NYSE:WPG) could be considered Value Add because it is going to have to improve certain malls in the near future to increase their appeal to consumers. Simon (NYSE:SPG) could be considered Core due to the high quality of its current portfolio. Finally, I would consider Seritage Growth (NYSE:SRG) to be Opportunistic because it may have to redevelop a very large portion of its portfolio in the future.
- Invest in long duration REITs and short duration REITs. A long duration REIT is one that has a long weighted average lease term remaining (WALT). These often include office REITs, net lease REITs and industrial REITs. On the other hand, short duration REITs have much shorter WALTs and include hotel, apartment and self-storage REITs. It is important to include both in one's portfolio because they tend to react very different to macro events including interest rate movements. The long duration REITs have long leases and are hence better protected in case of a downturn. However, during expansions they may not be able to increase rents as fast as short duration REITs. This is why in times of rising interest rates, hotel REITs tend to outperform as they are able to adjust their ADR (average daily rate) immediately.
- More advanced investors may want add some short exposure to their REIT portfolio and/or implement option strategies. Short positions, especially when paired with other long positions, can help to reduce the exposure to a given market. Moreover, options can also help to reduce exposure in varying ways. I occasionally sell put options in order to complete my riskier positions. When I took a position in WPG at around $9.5, I did not feel comfortable taking a full position because I felt that the market might give me a chance to invest at an even cheaper price in the future. So what I did is buy about half of my position in common stock and sell puts for the remaining half at a lower strike price. As such, my losses were limited when the share price of WPG dropped in recent weeks.
To summarize, I believe that one can improve the risk profile of a REIT portfolio by doing the following:
- Include international REITs to your portfolio.
- Invest in REIT implementing different investment strategies.
- Do not only concentrate on Equity REITs. Include a few mortgage REITs to your REIT portfolio as well.
- Retail exposure should be combined with industrial exposure.
- Hotel exposure should be combined with self-storage exposure.
- Mix long duration REITs with short duration REITs to mitigate macro risk.
- Protect downside with short positions and/or options depending on your risk tolerance.
The first step to building a well-diversified portfolio of REITs is to recognize the investment characteristics of the underlying assets. Because REITs are today exposed to almost all aspects of the global economy, possible investment strategies are almost limitless. So take advantage of this and properly diversify your portfolio to mitigate risk when possible.