Investing in real estate: 4 ways to diversify your portfolio

As an investment class, real estate covers a broad array of potential options. It can include various forms of “equity” investment in real estate, ranging from your own residences to rental property you may own to Real Estate Investment Trusts (REITs). You can also incorporate real estate “debt” into your portfolio mix, utilizing investments such as mortgage-backed securities.

Real estate provides a risk and return profile that generally varies from other asset classes like stocks and bonds. Additionally, the real estate market often responds to economic events in different ways to other types of assets. Incorporating it into your investment mix may help you more effectively manage risk in your portfolio.

Here are some fundamental considerations as you explore your real estate investment options.

Your personal residences and rental properties

The primary way most Americans invest in real estate is through ownership of their own home or homes. Quite frequently, a home represents a significant portion of your net worth. If you carry a mortgage, it’s also likely one of your largest monthly expenses.

In recent years, persistently low mortgage rates contributed to a favorable environment for home values. In many markets, prices rose significantly. The median price of a single-family home in the U.S. shot up from $315,700 in December 2020 to $361,700 in December 2021, a jump of 14.6%.¹

“The upturn in home prices is largely a reflection of the recent low interest rate environment,” says Kevin Weigel, portfolio strategist at U.S. Bank Wealth Management. During much of the last two years, the borrowing rate on a 30-year mortgage was below 3%. In recent months, however, rates have moved higher. “Demand is lower at current pricing since borrowing costs are higher, so that could ultimately have an impact on home prices,” says Weigel.

If you’re interested in purchasing a home or homes to rent as a way to generate income, you may want to temporarily put a pin in that plan. “With prices elevated and interest rates likely to head higher in the future, it’s less attractive as a pure investment opportunity right now,” Weigel says.

Real Estate Investment Trusts (REITs)

You also have the option to participate in the real estate market through Real Estate Investment Trusts (REITs). These investment vehicles are similar to a mutual fund in that they pool capital with investments made by professional managers. However, rather than purchasing stocks or bonds, a REIT owns, operates or finances income-producing properties. Most are publicly traded like stocks.

Investors can choose from different types of REITs. Broad categories include:

• Equity REITs. Most REITs fall under this category. These real estate companies own properties across a range of real estate sectors. Investment value is driven by a combination of dividend income and growth in the underlying value of the properties owned. 

• Mortgage REITs. These are trusts that provide financing for income-producing real estate, either purchasing or originating mortgages. Income is generated from interest earned, with total return also dependent on changes in the value of underlying investments.

• Public non-listed REITS. Similar to equity REITs but are not traded on national stock exchanges. They tend to offer less liquidity than publicly-traded REITs.

• Private REITs. These are not subject to SEC registration and are usually sold only to institutional investors.

Individuals can invest in REITs that focus on a wide range of real estate types or focus on specific sectors. Examples include office properties, industrial properties, retail centers, residential properties, data centers, and other segments of the real estate market.

“REITs tend to perform best when economic growth [as measured by Gross Domestic Product] is accelerating and inflation is moderating,” says Weigel. More problematic may be an environment where mortgage rates are rising and the economy begins to slow, which is a prospect in the months ahead. This could impact both property values and income generated by properties owned by REITs. “If the net operating income of a property is rising, which is the revenue generated by the holding minus necessary operating expenses, higher interest rates should not be a big issue,” says Weigel. He notes that while yields generated by REITs can be competitive, the income stream tends to be volatile and not as steady as income generated from an asset class like utilities stocks.

There are a few segments of the commercial real estate worth watching in the current economy.

• Industrial properties. These are warehouse-type spaces used as shipping facilities for major online retailers like Amazon. With online business booming, property owners in this segment of the market are in a strong position to attract lease activity.

• Data centers and cell towers. As one of the largest segments of the REIT marketplace, these have been strong performers as technology plays a rapidly expanding role for work and school applications. The increased impact of this segment on the real estate sector is likely to continue. It’s considered a less defensive segment of the commercial REIT market, as business prospects for communications infrastructure firms tend to be directly affected by economic activity. Those trends are often reflected in the broader stock market.  

• Office properties. Some companies have adapted a hybrid type of work pattern for employees – with some time spent in the office and some working from home. The question of whether the office environment pre-pandemic will return at full strength remains. Office leases tend to be for a period of years, so rental income has continued to flow to owners of buildings even with empty spaces. It may take a few years for answers about the demand for office space to fully emerge.

   

Mortgage-backed securities

Another way to leverage the real estate market for your portfolio is by investing in mortgage-backed securities (MBS). These can be a diversifier on the fixed income side of your asset mix. MBS are pools of home mortgages bundled together and sold as investments. This has become a well-established segment of the fixed income market. Weigel notes that “mortgage-backed securities represent more than 30% of the aggregate bond market in the U.S.” 

There are two primary forms of MBS – agency or non-agency. Agency MBS are issued by government-sponsored entities and include the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Non-agency MBS are issued by private entities such as banks. A number of these bonds were composed of so-called “sub-prime” mortgage loans and were subject to significant losses during the financial crisis that began in 2007. “Non-agency mortgage-backed securities were considered distressed securities at one time, but they don’t carry the same level of risk today,” says Weigel. He notes that many of the borrowers represented in these mortgage bundles have benefited from the recent dramatic runup in home values. “That lessens the risk of loss to investors if the borrowers should default on their loans,” says Weigel.

Real estate as a portfolio diversifier

“The returns on real estate investments tend to be less correlated to other types of equities,” says Weigel. That lack of correlation means real estate investment opportunities can generate performance that’s distinct from that of the stock and bond markets.

There isn’t a one-size-fits-all strategy to real estate investment. However, depending on your objectives, investing in real estate through personal residences, rental properties, REITs or mortgage-backed securities offers unique opportunities to generate capital appreciation and income within a broad asset mix.

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