The first month of 2024 has almost passed, and I believe most of you have already crafted New Year’s resolutions. This year, I want to hone my professional skills and elevate my passion for investment and my blog to the next level. Also, I hope 2024 will a remarkable year for all of us.
In my last post, we compared the returns and volatilities of REITs with stock. In this post, we’re going to explore REITs with focus on comparing RIETs with private real estate and long-term bonds.
REITs vs. Private Real Estate
One of the most prominent differences between REITs and Private Real Estate is liquidity. Since REITs are traded on exchanges, it’s easier for all kinds of investors to buy and sell, boosting the liquidity. This means that REITs market prices in economic changes, policies, market sentiments, and other significant events more quickly than Private Real Estate market. Due to this nature, REITs can sometimes serve as a leading indicator for Private Real Estate market.
Now, let’s look at the “Cap Rate” movements in REITs and Private Real Estate markets.
Cap Rate is crucial to real estate as it is typically used to calculate property implied valuation. When interest rate climbs, Cap Rate will also increase. This pattern can be illustrated in different ways. As increase rate increases, financing costs grow, suppressing the appetite for real estate investment and causing drops in property valuation. Additionally, the climbing interest rate could increase default risk in investment. Therefore, investors will demand a higher Cap Rate to compensate for the risk.
The graph above illustrates that as the interest rate increases, the private Cap Rate reacts more slowly than the public Cap Rate. When the interest hiking cycle took off, REITs' Cap Rates reacted swiftly and the divergence between these two Cap Rates began to expand. However, over time, the gap narrowed. Therefore, another advantage of REITs is usefulness in tactically building private real estate investment strategies.
REITs vs. Bonds
REITs and Bonds share several similarities. They both provide stable cash flows to investors over the investment period and are sensitive to interest rate movements. However, Bonds typically have fixed payment and a limited lifespan, while REITs are more flexible, more profitable, and riskier. REITs tend to pay rising dividends over time as their cash flow grows, and thus tend to have offer greater capital appreciation potential than bonds.
Based on the absolute returns, REITs does exhibit superior performance. However, when comparing returns across different asset classes, it’s not always accurate to draw conclusions solely based on the absolute returns. It’s important to consider the associated risks as well. The Sharpe Ratio, a commonly used metric for measuring relative returns, indicates that REITs is the more risk-effective than Stocks and Long-Term Bond. I used US T-Bills rate as the risk-free rate to the calculate Sharpe Ratio. The results indicate a Sharpe Ratio of 37.4% for REITs, 21.4% for the S&P 500, and 11.04% for US T-Bond, implying that REITs have the best risk-adjusted performance among the three.
REITs have remained one of conviction asset classes and it has been contributing positively to my portfolio. That’s why I’ve chosen to write this topic. I hope after reading these two posts, you have gained deeper insights into this asset class and feel inspired to consider its inclusion in your investment portfolio. Moving forward, I will show you how I analyse REIT companies and make my decisions.
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