No. of Recommendations: 56
Once upon a time, not too long ago, REIT stocks were the Rodney Dangerfields of the equities world. They got no respect. Indeed, such had been the plight of the REIT industry for most of its history, dating back to the early '60s – a time when Ike was President and we knew “Ozzie” as the pipe-smoking guy who lived in the 'burbs behind a white picket fence – and who, for some reason, was always home – and not the geek who bit the heads off chickens. There were lots of reasons for REITs' dissing, some of them valid, and they included the construction lending REIT fiasco, the misadventures and eventual tarring and feathering of REITs' bad-boy cousins (the real estate limited partnerships) and, more recently, issues having to do with pie-eating contests, misunderstanding the cost of equity capital and refusals to consider valid buy-out offers.

While the REIT industry (including NAREIT, its trade organization) and others have been doing an excellent job educating investors on the beauties (and, yes, the risks) of REIT investing, REIT stocks also happen to be in the right place at the right time, and their Dangerfield affliction has gone the way of dotcom millionaires. In short, REIT shares are no longer disrespected.

Following the killing of the bear at the end of 1999, the Morgan Stanley REIT index has risen 79.5% from its December 15, 1999 nadir (266.24) to its recent (May 21) closing price of 478.01. During that time, it has outperformed just about every other type of investment known to the modern world. In the three-year period ending April 30, 2003, the NAREIT Equity Index has delivered an average annual total return of 12.86%; few other investments can make that boast. Year to date through May 22, equity REITs delivered a total return of 12.5% (per NAREIT).

Of course, some scoff at these numbers, as they are total returns; they argue, “Back out the dividends, and REIT share prices have barely moved since the spring of 1999. The NAREIT Equity price-only index rose just 4.2% from May 31, 1999 through April 30, 2003.” This is a valid point – share prices are up just modestly. However, popularity is often measured in terms other than stock price appreciation, which for REITs will be modest in any event.

In truth, if the flow of funds into REIT mutual funds can be used as a gauge of romantic interest, investors' love affair with REIT shares is as arduous as ever. Year to date through May 21, according to AMG Data Services, just over $1 billion has coursed into such funds, and the flows seem to be accelerating. Of course, as Bob Dylan once noted, you don't need a weatherman to tell you which way the wind is blowin'. We need only to look at REIT stock prices in relationship to their NAVs, and here the premiums are positive and rising. No, REITs are no longer Rodney Dangerfield look-alikes; rather, they are viewed as a blend of Nicole Kidman and Tom Hanks.

“All right, Block, so what's your point? We already know this. Get on with it.” The foregoing is all preface to the issue of whether REIT stocks have “come too far, too fast” and are ripe for a major correction – as many “pundits” in the popular press and some analysts have been predicting. And there are plenty of reasons to conclude that REIT stocks are, today, somewhat pricey.

First of all, real estate fundamentals aren't getting any better. Occupancy and rental rates continue to fall in the office market, and effective rents (taking leasing commissions, free rents and tenant improvement allowances into account) are falling even faster than market rents. The apartment and industrial markets have seemingly intractable problems of their own. And there are even concerns in the retail sector that flat tenant sales will eventually (but inevitably) kick gaping holes in re-leasing spreads when existing leases expire, thus putting the brake on retail REITs' 7% growth rates.

Furthermore, REIT shares are not cheap by historical standards. Regardless of whose estimates of REIT NAVs we use, they are clearly selling at premiums. Merrill's estimated average NAV premium at May 16 was 7%, and Green Street's average NAV premium, as of May 20, was 12% (Green Street has recently been taking interest rates on indebtedness into account when determining NAVs). This compares with a zero average premium going back to the early '90s. REITs' current AFFO yield (the inverse of the P/AFFO ratio) has compressed to close to 7% (using Green Street's numbers); while AFFO yields were lower (implying higher valuations) in October 1997, that provides small comfort, as (a) the REIT market was horribly overvalued at that time (selling at an average NAV premium of 30%), and (b) that time frame marked the zenith of REITs' '95-'97 bull market.

And don't forget the dividend issue. While thus far only a modest number of REITs have cut their dividends – mostly in the hotel sector – the payout ratios in some sectors, including a few larger-cap companies, have become as tight as a 17-inch collar on your humble author's widening neck. If we use reasonable assessments of required capital expenditures in an era of very demanding tenants, very few office REITs have a comfortable margin for error. And the apartment sector is even more problematic. I'm certainly not forecasting a huge new wave of dividend cuts, particularly if the economy begins to flex a few muscles and we see a bit of job growth beginning late this year. However, the dividend coverage issue and the threat of emotional trauma that would occur should a high profile REIT slash its dividend should be sufficient to deliver a blast of cold water to the faces of those who are inclined to pursue REIT shares with irrational exuberance.

And I won't depress you further by reminding you that today's relatively high valuations cannot be supported by the prospects of rapidly accelerating AFFO growth rates or impending declines in cap rates from unsustainably high levels. As for the former, the average '03 AFFO “growth” rate for the 90 REITs I follow is a negative 2.5%, with a modest 3.5% AFFO growth rate next year. And cap rates are at already very low levels; many believe that they can only go up from here (for a different opinion, see below). Rising cap rates could raise havoc with REIT NAVs.

However, before you head for the bathroom and begin praying to the porcelain god, let me hasten to add that there's another side to this REIT valuation conundrum – indeed, this “other side” is very compelling, and causes me to wonder whether, at least for now, those who have been accumulating REIT shares at current prices are really such dummies after all. Here's what I mean:

There is a strong argument that the reasonableness of valuations depends upon one's investment return requirements. Remember back in October 1999 when the typical REIT was growing AFFO at 8-9%, bore a yield of the same amount and yet traded at an NAV discount of 15%? Did anybody want to buy REITs then? Of course not; they were too busy loading up on Priceline at 350x mindshare and going to Henry Blodgett rallies. Today, of course, it's a very different story. The 2-year T-note yields the princely sum of 1.3% and the 10-year delivers 3.3%, implying a sub-1% rate of inflation. Medium-grade bond yields have fallen into the 7% range and appear to be headed lower. Kimco recently issued a new straight preferred with a 6.6% handle.

So what does that tell you about investors' expectations today? Well, they're a lot lower than they've been for decades. One way to look at this is to compare REITs' AFFO yield to the 10-year T-note. Merrill does this in its “Comparative Valuation REIT Weekly.” At May 15, the spread was 422 basis points (7.76% AFFO yield for REITs and 3.54% for the 10-year). That compares with an average spread, going back to 1993, of 353 basis points, indicating that REIT prices haven't even kept up with Treasuries. A similar story is told if we compare REIT AFFO yields to medium-grade corporate bonds; the spread was 60 bps at May 1, per Green Street data; going back to 1993, REITs' AFFO yields and the yields on medium-grade bonds have tended to trade together, making REITs reasonably priced in relationship to BAA bonds. So that suggests that, yes, REIT shares are pricey vs. historical standards, but not when current bond yields are taken into account.

Now let's look at a typical discounted divided growth model, i.e., Stock Value = Current Dividend/(Required Return Rate - Dividend Growth Rate). Let's use Regency Realty, which trades at a typical NAV premium of 8-12%. Its current dividend is $2.04, and we will assume a conservative dividend growth rate of 1.5% annually. Let's make our required return on this investment 7.5%, or 420 basis points over the 10-year (the return requirement for REG is arguably lower than for most apartment, office and industrial REITs, due, among other reasons, to the type, stability and quality of its neighborhood shopping center assets). So, the value of REG would be: $2.04/(.075 - .015), or $34 – roughly where it traded on May 22. Alternatively, the same valuation could be supported by an 8% required return and a 2% dividend growth assumption.

Using such a formula, Equity Office, with a $2 dividend, a 9% discount rate and a 1.5% dividend growth rate would be worth $26.67, just a bit less than where the stock currently trades. My point here is that we can easily justify today's REIT pricing as reasonable, even using low dividend growth rates, if our required rate of return is low enough – and there are, indeed, good reasons for accepting low returns today, especially for some of the safer sectors in commercial real estate. And, even in the less safe sectors, such as office properties, doesn't a 9% required return on EOP adequately discount for the sector's current difficulties and unknowns? After all, that's 767 basis points above the 2-year T-note and 565 basis points over the 10-year. How much of a risk premium do we need?

A final point. It isn't out of the realm of possibility that today's REIT markets are, once again, ahead of the private markets with respect to commercial real estate valuations. Let's go back to Regency. Green Street's NAV estimate for the company is $30.39. So, at a price of $33.90, the stock's trading at an NAV premium of 11.5%, in line with the REIT industry but expensive from a historical viewpoint, right? But what if the nominal and economic cap rates that Green Street uses, 8.25% and 7.4%, respectively, prove with hindsight to be too high? What if the new economic cap rate for REG's assets is 50 basis points lower, or 6.9% (7.75% nominal), due to private real estate investors' willingness to accept even lower investment returns in a world of no inflation? Then, according to my calculations, REG's NAV would rise by $4.05, to $34.44. Then, instead of selling at an NAV premium, the stock, at $33.90, would be selling at a 1.6% NAV discount. Is the market sending us this message?

In summary, don't send the men with the funny looking jackets after me just yet. I am not trying to persuade anyone that today's REIT prices are cheap, on the basis of underestimated NAVs or any other formula. My effort is simply to encourage us to think analytically before we shoot off our mouths to friends, business associates and magazine article writers regarding REIT stock valuations. REIT stocks may indeed be expensive today, but they may not be. This is clearly an area where reasonable minds can differ, and our return requirements, as well as our cash flow and dividend growth assumptions and longer-term expectations for the economy and interest rates, can make a great deal of difference.

We are now living in a 1% world, and today's markets are adjusting to that. If we return eventually to a 3% world, REIT stocks would probably, with hindsight, have been very expensive in May 2003, and we will all be asking ourselves how we could have been so dumb to be buying Regency at $34 and Equity Office at $27. So you tell me where inflation, interest rates and real estate fundamentals will be two years from now and I'll tell you whether or not REIT shares are expensive today. Personally, I don't care too much, one way or the other; I have my REIT allocation and intend to retain it – even if REIT shares prove, with hindsight, expensive. But, what for what's worth, I don't think they are expensive in relationship to bonds, equities, gold or Mickey Mouse memorabilia.

Ralph
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Reitnut writes (wisely, as always):
"We are now living in a 1% world, and today's markets are adjusting to that. If we return eventually to a 3% world, REIT stocks would probably, with hindsight, have been very expensive in May 2003"

"But, what for what's worth, I don't think (REIT stocks) they are expensive in relationship to bonds, equities, gold or Mickey Mouse memorabilia."
*************************************

This reminds me of the old joke: "How is your wife ? ". Answer: "Compared to what ".

Yes, I agree. Compared to bonds, REIT shares are, indeed, properly priced. The problem is that phrase: "we are living in a 1% world". And the question is: "for how much longer ? ". The Fed is making all kinds of noises about the possibility of deflation, and making crystal clear that if to prevent deflation they need low flying planes dropping dollars, then that is what they will do. I believe them, since that is exactly what governments are fond of doing.

My personal opinion is that the 1% world will not last. Money will, indeed, be printed and the 1% will become a 3 - 4 % world. In that world, bonds will go down and REIT shares will follow.

Obviously, that is not an argument for selling REIT shares. Heresy as it might be, I strongly believe in "yield on purchase". But for new purchases, a temporary 1% might not be a bad idea, particularly when compared to a 7 % dividend that might be obliterated by a (modest) drop of 7 % in the price of the principal.

Writen with all due respect to (my much admired) Mr. Ralph.

Vizcacha

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My personal opinion is that the 1% world will not last. Money will, indeed, be printed and the 1% will become a 3 - 4 % world.

And if we get conditions which lead to a 3-4% world with some inflation, rent rolls will remain stagnant or will they improve?

Bonds are simpler instruments to understand in varying interest rate environments. REITs are different. As long as the inflation you predict is not "stagflation" I'm just not sure REITs as a group will get killed by a little pump priming gone too far.

On the other extreme...clearly deflation is good for L/T treasuries and for many quality bonds out there. Would that be good for quality REITs? I don't think so.

Euro
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my 2 cents.......I do not think reits would be hurt by interest rates 1-2% higher if the rate rise were due to a pick up in economic activity, as is likely.....They should do well in such an environment.
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>> my 2 cents.......I do not think reits would be hurt by interest rates 1-2% higher if the rate rise were due to a pick up in economic activity, as is likely.....They should do well in such an environment. <<

Indeed, real estate is a fairly unique investment in that as rates change, both up and down, there are factors that tend to make the investment *more* valuable and *less* valuable.

I think this is because REITs have both an equity *and* an income component. The equity component can rise in value as business prospects improve...which at least partially offsets the loss of value in the income component as rates rise.

Similarly, when the economy is pretty bad, the equity component of the business can suffer with weaker economic times, higher vacancy rates, et cetera...but that is offset by falling interest rates making the income stream more valuable.

Neither stocks nor conventional bonds can really do this in the general case. Probably the closest equivalent to REITs I can think of in this regard would be convertible bonds.

#29
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Regarding the future of interest rates and its effect on REIT prices, I don't think anyone has mentioned the strengthening of the dollar. As I see if the dollar strengthens that would help economic recovery, decrease unemployment, and tend prevent deflation. So strengthening of the dollar IMHO is good for the U.S. If the foreign exchange trends continue, or even remains more or less constant, we might see some positive effects next year before the elections.

But will the foreign exchange trends remain favorable to the U.S.? The Euro has strengthened significantly, but the economies of many European countries, particularly Germany, are doing poorly and the strengthening of the Euro is not good for them. Will Europe take steps to weaken the Euro? Can Europe weaken the Euro? The Asian currencies have weakened slightly against the dollar, I think. The Chinese currency trades at more or less fixed rate. So in the last months the Euro has weakened against the Asian currencies also. Will the Asian curriencies continue to weaken against the dollar?

OT, it seems that in Asia, many factories are built just to build products for the export market, primarily the U.S. Why don't they consume more? That would tend to increase their middle class and would be good for them, and it would be good for us too (I think). Anyway I don't see how we can continue running up deficits with the Asian countries forever. Something, like exchange rates, have to change eventually.

klee12
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Ooops, hit reply button by mistake. I meant in the first paragraph strengthening of the Euro, not the dollar. Sorry.

klee12
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As I see if the dollar strengthens that would help economic recovery, decrease unemployment, and tend prevent deflation. So strengthening of the dollar IMHO is good for the U.S.



Not sure I follow. Why is a strong dollar good for the economy at this point in time? I understand the appeal of US invesments to non-US holders if the dollar is expected to strengthen. But for the economy...why do you think is it better to have a stronger dollar from these levels?

ET
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I didn't have my coffee when writing. I meant if Euro strengthens (dollar weakens)... somehow I just got everything mixed up. Sorry.

klee12
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Missash writes:

my 2 cents.......I do not think reits would be hurt by interest rates 1-2% higher if the rate rise were due to a pick up in economic activity, as is likely.....They should do well in such an environment.

That REITs would do well if economic activity picked up is almost beyond question, even if it came with higher interest rates. Employment drives demand for most types of rental space. But my hunch is that REIT stock prices in the short-run would fall even as their FFO improved, as investors raised their return expectations. I think the current high REIT stock prices are a reflection of low returns expected on everything else.
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>But my hunch is that REIT stock prices in the short-run would fall even as their FFO improved, as investors raised their return expectations. I think the current high REIT stock prices are a reflection of low returns expected on everything else. <

I agree. If an improved economy results in a general rise in earnings and the stock market, it would be easy to imagine money flowing out of REITs into other equities with greater perceived growth potential. I think we saw a little of that in today's action, though the rising tide ultimately took most REITs into positive territory as well (from what I could see in my own portfolio).

It is hard for investors to resist switching horses when they see large gains happening "over there" despite the fact that many of these "growth" companies still have negative earnings or high multiples. I should know, I own a couple myself, Amgen and Amazon. The growth guesses which fueled the previous tech surge may have been tempered, but they are not gone. The Greater Fool theory also is alive and well if somewhat chastised by recent history. Perhaps there also is the hope that what goes down must come up. In any case, if the market starts looking for sexy companies again, REITs are gonna have to find an awful pretty dress to compete.

Although I think investors will be much more conservative than they were in the tech bubble, REITs have the current disadvantage of being more highly valued than during the last market run up and are facing financial challenges which are easier to understand than, say, the challenges a biotech faces. Reitnut's analysis is fascinating and fits with my gut feelings about how hard it is to make buy and sell decisions in this REIT market. One strategy I'm considering--jettisoning my riskier REITs (which no longer pay the fantastic yields they once did because of generally rising REIT share prices) and sticking with core winners (like the Bluest of the Blue) which have management in place likely to weather any temporary battering by the market and any temporary downturn in FFO (and management which might be able to take advantage of generalized distress in the real estate market for future gain.)

hailcom
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hailcom,

As usual, a very good post. You have certainly become a welcome new addition to the board, and I hope you'll continue posting for a long time to come.

Although I think investors will be much more conservative than they were in the tech bubble, REITs have the current disadvantage of being more highly valued than during the last market run up

I think this depends on how one defines "highly valued" and also "last market run up". For example, if you consider the premium over NAV as being your determination of value, and you consider the time period of the start of the '98 - '99 REIT bear as the "last market run up", then we are still far below that high watermark. If you consider average dividend vs. the 10-year Treasury, well, I guess I don't need to go there!

OTOH, if you compare the current commercial fundamentals versus the late '90s ... yeah, ugly. (But the interesting thing to point out with that comparison is, although the "current fundamentals" during the late '90s were fantastic, they were peaking, and as we know, about to fall off a cliff. The current "current fundamentals" are pretty terrible, but perhaps they are about to greatly improve.)

Ken (would LOVE to be able to time the market, but ...)
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Interesting, detailed post. We run REITs in our portfolios as a bond alternative, and we've made huge returns over the last three years in REITs. To a large extent, they've saved our client portfolios.

That said, I thinks REITs are cheap compared to investment-grade bonds, expensive compared to stocks, and on the expensive side of fair value compared to the underlying property values. In short, agruably still a sound diversification play, but no longer a good value play. If I understand your post, that is exactly what you are using them for.

JoeJoe
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fwiw Its worth remembering the reciprocal nature of markets.

Because RIETS are respected, ( vs their crisis in the 70s ) that makes them worthy ?

It doesn't matter what people think, it matters what is.

Are they cheap vs what people think or expensive ?

ESO in this group, that used to be a "sideways collect the dividend arena,"
has to have seduced corp mgmts into accounting games. maybe delaying necessary maintenance or 6 other things.

I think anyone has to consider that metric.

asymmetry? If the group was NOT respected,, it would be more worthy of a look.

gladhanding crowds congratulating each other for all knowing to own REITS!! ,, doesn't a picture of capitalistic opportunity make.
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Jim Luckett says, "That REITs would do well if economic activity picked up is almost beyond question, even if it came with higher interest rates. Employment drives demand for most types of rental space. But my hunch is that REIT stock prices in the short-run would fall even as their FFO improved, as investors raise their return expectations. I think the current high REIT stock prices are a reflection of low returns expected on everything else."

Like most of what Jim posts, I agree. However, I also think there is a fair chance that this may not happen and REIT stock prices will hold firm even in a world where interest rates move from 1% to 4%. This could be for several possible reasons:

1. REIT shares have pretty much been accepted into the mainstream investment world, and more and more financial planners, investment advisors and do-it-yourself advisors are making REIT allocations. Thus the outflow of capital from those who increase their investment return expectations may be offset by inflows from new investors who are underweighted in them. This is part of the secular bull case for REIT shares.

2. The importance of dividend yields to today's investors may not be as cyclical or fleeting as many think, and we may not quickly return to the late '90s when the name of the game was capital gains. Let's not forget that millions of investors suffered major financial damage over the past few years, and many of them have developed a very healthy respect for yield -- which may not go away for at least a few more years. And let's not forget the ageing baby-boomers who are nearing retirement and may have become more risk-averse (perhaps I should say loss-averse). If yield remains important, there will still be strong demand for REIT shares.

3. A corollary to the above point is that even on an after-tax basis in taxable accounts, REIT shares generate higher yields than non-REIT equities, and the spread will increase if the non-REIT market rises faster than REIT stocks. Thus the quest for yield (if I'm right about this) could act as a floor under REIT prices, and this quest will increasingly take place in 401k accounts where full taxation on REIT dividends won't matter at all. REIT mutual funds are grossly under-owned in 401k plans, but they are growing in importance.

4. REIT shares may presently incorporate a risk premium for potential dividend cuts, particularly in certain sectors such as apartments. A stronger ecomomy with job growth could decrease that risk premium, thus offsetting some of the compression on multiples resulting from higher return expectations in a 3% world. Thus price increases in, say, the apartment and office sectors could offset weakness in retail where dividends are not much of an issue.

5. If REITs are at risk of underperforming should we return to a 3% world, consider the damage that will be done to bond prices. It won't be pretty. Thus there is the possibility that the expected decline in REIT shares under that scenario will not occur, as more and more investors dump bonds and rotate the proceeds into REIT shares which would benefit, to some extent, in a rising economy with the prospects of 3%+ inflation. Indeed, I just received an e-mail from a financial planner who I have never met, asking me whether it would make sense for him to shift his clients from bonds into REITs.

6. We have already seen a major snap-back in non-REIT shares this year, and the NAZ is up something like 20% year to date (that number is off a bit, as I am going only from memory here). If I had known in January that the equities markets would have been this strong this year, I would have guessed that REIT shares would be gross under-performers, maybe even in negative territory. But they are not, and are holding their own against their non-REIT brethren. While this is probably a function of very low interest rates, perhaps it is also telling us something about the sustainability of interest in REITs, which could even out-last a 3% world? After all, as seen in TIPs pricing, most investors do believe that interest rates won't stay down here for another 12 months; why aren't they selling their REIT shares right now, in anticipation of that? Or, to borrow from Sherlock Holmes, is this the dog that didn't bark?

But let's put this in some perspective. I very much agree with the excellent post suggesting that REITs have both equity and bond components, which makes their performance in specific economic and market environments over the short term difficult to predict. (The small size of the REIT industry also makes price swings less predictable and of greater magnitude). And I certainly agree that a stronger economy will be good for all RE owners and longer-term REIT shareholders, regardless of the higher interest rates that would be part of that scenario.

I also agree that there is a good chance that REIT prices back-track for a while when the 1-year T-note yields 4% and the S&P 500 is 15% higher than where it is today, as there will no doubt be some investors who, having invested in REITs for yield only (or perhaps as a "port in a storm", or even for momentum investing reasons), will bail out. We saw some of that last week. But there is, I think, a fair chance that REIT prices will remain firm even under that rosy economic scenario (though they would probably underperform other equities). The only losers will be those who view REITs as trading vehicles; those who maintain meaningful REIT allocations and stick to them will come out just fine under any scenario short of depression.

Ralph
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Ralph,

I hope you advised that advisor who was thinking of advising his clients to shift their bond allocation to REITs that that would be bad advice. He should be helping his clients to construct "all-weather" portfolios, not betting on one economic scenario. Obviously, REITs are equity and deserve some portion of one's equity allocation. The bond allocation is the bond allocation and it would be all you could count on in a deflation scenario (and only then if they are good bonds!) Don't you agree?

Jim
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Jim, you post:

<<I hope you advised that advisor who was thinking of advising his clients to shift their bond allocation to REITs that that would be bad advice. He should be helping his clients to construct "all-weather" portfolios, not betting on one economic scenario. Obviously, REITs are equity and deserve some portion of one's equity allocation. The bond allocation is the bond allocation and it would be all you could count on in a deflation scenario (and only then if they are good bonds!) Don't you agree?>>

YES. While REITs do have a "bond" component to them, they are NOT bonds, and their correlations with bonds, historically, haven't been very strong. My philosophy is that investors should create a portfolio mix, based on their financial objectives and tolerance for risk, and stick to it, through thick and thin.

Of course, some allocations can be set up so that the investor can tinker around with them, but not alter them substantially, e.g., there's a financial planner in Arizona who likes to set his "REIT band" within +/- 10%, i.e., between 15% and 25%, with the exact number to be determined by his perception of the relativeness "cheapness" or "dearness" of that asset class. But I do not think he would go 50% or 0% in REITs, as that would exceed the band.

And I think that the bond allocation would work much in the same way. Today I would be on the "light side" of my bond allocations, but wouldn't forego them entirely. We buy bonds for one principal reason: If we own a diversified mix of quality bonds, they will, indeed, provide the best protection against secular deflation, certainly much better than REIT equities. Your suggestion of 30-year Treasuries makes eminent sense in this context.

Ralph


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