Investing in real estate investment trusts (REITS) has long been an excellent way for investors to diversify stock portfolios. In 2007, the global real estate market represented more than $900 billion of equity capitalization and was growing, according to the National Association of Real Estate Investment Trusts (NAREIT). For the longest time, publicly-traded real estate investment trusts were only available in the areas like the U.S. or Australia; now, more foreign countries are adopting similar structures.

Tutorial: Exploring Real Estate Investments

If you're an investor who owns U.S. REITs, you are only seeing part of the total picture. In fact, a shift toward an international REIT portfolio may be more suitable. Expanding an investment portfolio to include international real estate could open the door to potential return opportunities while further dampening portfolio risk. As is said in real estate, it's all about "location, location, location".

Breakdown of Global REIT Market
Before we begin to dissect the characteristics and benefits of investing in foreign REITs, let us first recap the REIT universe as a whole. A REIT is a corporation that purchases, owns and manages real estate properties and/or mortgage loans. The REIT structure is unique in that REITs are given special tax status that allows them to avoid corporate tax, as long as 90% of the income is distributed to investors. Although the REIT structure avoids double taxation to shareholders, tax losses cannot be passed through. (To read more REIT basics, see What Are REITs? and our Exploring Real Estate Investments tutorial.)

The global real estate securities market has grown significantly as both developed and developing countries move to create REIT or REIT-like corporate structures. Prior to 1990, however, only the U.S., the Netherlands, Australia and Luxembourg had adopted REIT-like structures. In 2007, according to Dimensional Fund Advisors, the global REIT market was dominated by the U.S. (55%), Australia, Great Britain and Japan. Therefore, non-U.S. REITS make up almost half of the global REIT market. The global REIT universe continues to expand; therefore, investors who limit their REIT positions to U.S.-only funds will also likely limit their opportunities. (Keep reading on this subject in The Emergence Of Global Real Estate.)

Benefits of REITs
One of the benefits of REITs when compared to direct equity real estate investments is that investors have the ability to more effectively and efficiently diversify their real estate portfolios because REITs tend to be more liquid. Of course, the biggest advantage offered by REITs is the diversification benefit. Investors strive to locate asset classes that offer low correlations to other positions in their portfolios. The lower the correlation, the lower the idiosyncratic risk. (To learn more about the benefits of diversification, see Introduction To Diversification and Risk And Diversification.)

The chart below illustrates the low correlation that REITs have to other U.S. core indexes over an extended period of time.

Monthly Return Correlation Coefficient: January 1979 to December 2006
-- Equity REIT Index S&P 500 Russell 1000 Value Russell 2000 Russell 2000 Value
Equity REIT Index 1.000 -- -- -- --
S&P 500 0.481 1.000 -- -- --
Russell 1000 Value 0.559 0.941 1.000 -- --
Russell 2000 0.611 0.802 0.759 1.000 --
Russell 2000 Value 0.702 0.777 0.813 0.950 1.000
(Original source data obtained from FTSE Group, National Association of Real Estate Investment Trusts, Standard & Poor\'s Index Services Group and Russell Investments. Republished in white paper by Dimensional Fund Advisors.)

But what happens when we extend these comparisons beyond U.S. investments? If we look at the correlations of developed market REITs and compare them against the correlations of their own broad market equity indexes (ie. S&P 500 equivalent) we find the same consistency. International REITs are not highly correlated with their own markets and, therefore, they offer benefits to both U.S. investors and international investors.

5 Years: April 2002 to March 2007
-- Australia Netherlands Belgium Canada Japan New Zealand World World Ex U.S. U.S.
Correlation Coefficient 0.68 0.53 0.43 0.67 0.33 0.59 0.50 0.59 0.43
(Original source data obtained from FTSE Group, National Association of Real Estate Investment Trusts, Standard & Poor\'s Index Services Group and Russell Investments. Republished in white paper by Dimensional Fund Advisors.)

We can take this analysis a step further and compare some of the regions within the Wilshire RESI Index, which contains non-U.S. REITs. Here again we see that real estate correlations among individual regions is quite low.

Real Estate Correlations of Americas, Europe and Asia-Pacific
-- Americas Europe Asia-Pacific World
Americas 1.00 -- -- --
Europe 0.57 1.00 -- --
Asia-Pacific 0.53 0.60 1.00 --
World 0.95 0.75 0.72 1.00
Source: SSGA funds

Competitive Returns
Both U.S. and international REITs have significant low correlation benefits to improve a portfolio. But what type of returns might we expect from this investment? Relative to other core asset classes, international REITs can deliver competitive returns.

Real Estate Index Returns vs. Broad Equity Index Returns Data ended Sept. 30, 2006
-- 1 Year 3 Years 5 Years
DJ Wilshire Ex –US RESI Index 31.8 % 33.5% 27.0%
DJ Wilshire 5000 Index 10.4% 13.3% 8.6%
MSCI EAFE Index 19.7% 22.8% 14.7%
DJ Wilshire US REIT Index 28.1% 27.4% 22.9%
Source: Zephyr StyleADVISOR, data republished by
State Street

.

The flip side of handsome returns is often high levels of risk. Let's see what type of volatility we might expect from an international REIT position:

Real Estate Index Returns vs. Broad Equity Standard Deviations Data ended Sept. 30, 2006
-- 1 Year 3 Years 5 Years
DJ Wilshire Ex - US RESI Index 10.27% 10.29% 11.34%
DJ Wilshire 5000 Index 7.29% 8.32% 12.74%
MSCI EAFE Index 10.60% 10.29% 13.46%
J Wilshire US REIT Index 12.59% 16.40% 14.77%
Source: Zephyr StyleADVISOR, data republished by Dimensional Fund Advisors

Historically speaking, it appears that international REITs were right in line with the risks of other core asset classes, in some periods, they were actually lower. Coupled with the benefits of low correlations, the international REIT asset class looks like it could be a good long-term bet.

Potential Concerns
So, now that we've identified the many benefits of investing in international REITs, what concerns should we have about them? Directly investing abroad, whether in equities or real estate, carries with it other implied risk, particularly when making direct investments in foreign securities. For example, some concerns might include potential currency risk, limited public information, illiquid trading and a range of different political environments.

While transparency and governance have improved, they are certainly not perfect. However, many of these risks associated with a direct investment can be avoided or diminished if you invest indirectly via domestically based mutual funds or exchange-traded funds (ETFs). (To learn more, see Finding Fortune In Foreign-Stock ETFs.)

Furthermore, like their U.S. counterparts, international REIT funds can be highly tax inefficient, exposing investors to ordinary income at the highest possible tax rates. An asset location strategy, which is the placement of specific asset classes/funds in specific accounts of money, will be critical with this. International REITs should probably limited to your tax-free or tax-deferred accounts such as IRAs or 401(k)s, not taxable brokerage accounts or trusts.

Finally, you may wish to consider that some international REIT products may include real estate in both developed and emerging economies. But if your tolerance for risk is more limited, you may wish to find a fund that invests only in developed economies overseas (like the U.K., Australia, Japan, etc.). Similarly, you may wish to be wary of funds that overweight any particular region or country, as this may mean exposure to greater country- or region-specific risks. (Keep reading about emerging economies in What Is An Emerging Market Economy?, Re-evaluating Emerging Markets and What Is International Trade?)

Market Accessibility
The emergence of liquid, securitized and tax transparent real estate investment vehicles has opened up a new horizon for investors everywhere. The increased accessibility of REITS via dedicated mutual funds and ETFs has furthered real estate's allure in the global capital markets. Traditionally, choices were limited and potentially expensive. This trend is changing, with a number of low cost index funds and index tracking ETFs from well-known providers now available in this space.

The Bottom Line
The global real estate market is undergoing huge transformations. REIT and REIT-like structures are rapidly gaining popularity, both in the developed and developing foreign markets. For investors, the growth of the public real estate market has created more opportunities to access attractive potential returns with the added benefit of dampening portfolio risk. As investors search for diversification, income and total return opportunities, the securitized international real estate market offers a compelling addition to investors' diversified portfolios.

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