How to Use Real Estate in Your Portfolio (2024)

Real estate—a broad asset class that includes both public and private investments as well as both equity and debt securities—is often touted as a good investment thanks to its potential to improve both returns and portfolio diversification.

In this series on portfolio basics, I’ll explain some of the fundamentals of putting together sound portfolios. I’ll start with some of the most widely used types of investments and walk through what you need to know to use them effectively in a portfolio.

What Is Real Estate?

The most familiar form of real estate for most people is the roof over their heads—the house, mobile home, or condominium they purchase as a place to live. Purchasing a home is often the only type of investment many people have. It can also play a crucial role in helping people lift themselves out of poverty, as monthly mortgage payments are a form of forced savings that build equity over time and offer the potential for building wealth (or simply a place to live) that can help the next generation.

Real estate as an investment asset can take many different forms, though. As mentioned above, real estate covers a broad range of investment types, including private equity investments in commercial or residential properties, private debt securities for similar properties, publicly traded real estate equity (offered via real estate investment trusts), and publicly traded real estate debt (offered via mortgage-backed securities). Many personal finance gurus also advocate investing directly in real estate, which involves purchasing residential or commercial property and using it to generate a monthly income stream.

In this article, I’ll focus mainly on real estate investment trusts and REIT funds, which are the most liquid type of real estate available to the average investor. In contrast to buying real estate directly, REITs don’t involve an extra operational burden of maintaining the property over time.

Based on data from Nareit, assets in REITs totaled about $1.9 trillion globally as of 2022. The broader real estate market of professionally managed real estate totals nearly $10 trillion globally based on data from MSCI. The sheer size of the real estate market would argue for making it a significant portfolio holding for people taking a “market basket” approach to asset allocation.

What Are the Advantages and Risks of Investing in Real Estate?

Real estate has two main advantages: diversification and the potential to perform better than other stocks over certain periods.

In the past, real estate has had relatively low correlations with the broader U.S. equity market. Rolling three-year correlations have dropped below 0.10 during some periods, such as the early 2000s. Being untethered to the overall equity market can lead to better risk-adjusted returns when real estate is added to a diversified portfolio. In recent years, however, real estate has generally moved more in tandem with the broader U.S. equity market. For the trailing three-year period ended Jan. 31, 2024, for example, the FTSE Nareit All Equity REITs Index had a 0.87 correlation with the broader equity market.

There have also been certain periods, such as the late 1970s, early 1980s, and early 2000s when real estate stocks have fared better than the overall U.S. equity market. These periods often overlap with periods of high inflation, as the sector’s limited supply and ability to increase rents can provide a hedge against inflationary pressures.

Along with their return potential, real estate stocks come with certain risks. Real estate is both highly cyclical and subject to periodic downturns, as its double-digit losses in both 2007 and 2008 made clear. Overall, real estate has generated both above-average risk and returns over longer time periods, as shown in the scatterplot below.

Historically, REITs have been subject to some painful downturns, including during the 1990 banking crisis, the global financial crisis in 2007 and 2008, and the pandemic-driven downturn in early 2020. On a quarterly basis, they’ve been subject to losses as large as 30% or more. In the past, REITs have always managed to rise from the ashes; the industry made a strong rebound after the 1990 banking crisis and after suffering double-digit losses in both 2007 and 2008. The Morningstar US REIT Index has recovered from its pandemic-driven losses, but it is still down from its more recent highs in early 2022.

How to Invest in Real Estate Stocks

There are two main ways to invest in REITs: by purchasing individual REITs or by purchasing a mutual fund or exchange-traded fund. There are about 200 U.S.-based REITs that are publicly traded. They span a variety of industry subgroups, including healthcare, hotels and motels, retail, office, industrial, and residential. It’s also possible to invest in diversified REITs, which are involved in buying, managing, and selling a variety of property holdings.

But purchasing a mutual fund or ETF is an easier way to get diversified market exposure for most investors. The table below shows a subset of real estate funds with Morningstar Medalist Ratings of Gold.

Tax considerations are another important point. Because of their legal structure, REITs don’t pay corporate taxes on their earnings. Instead, they’re required to pay out at least 90% of their income as dividends to shareholders, who eventually pay ordinary income taxes on the dividends they receive. For that reason, we’ve typically recommended that investors only hold REITs and REIT funds in tax-deferred accounts, such as 401(k)s and IRAs.

However, the tax-law changes that went into effect in 2018 make REITs and REIT funds slightly more attractive for taxable accounts. Taxpayers can now deduct up to 20% of income earned through qualified publicly traded partnerships and REITs that operate as pass-through entities. The IRS has issued guidance clarifying that this deduction also applies to taxpayers who own mutual funds that invest in REITs. (Note: Check with your tax advisor for more details about this deduction.)

When Do Real Estate Stocks Perform Best?

Like all stocks, real estate stocks typically perform best during periods of strong economic growth and rising corporate profits. As mentioned above, real estate can also perform well during periods of above-average inflation. The table below shows annualized returns for real estate stocks during some of their strongest periods.

How Long Should I Hold My Investments in Real Estate?

Morningstar’s Role in Portfolio framework recommends holding REITs or other real estate exposure for at least 10 years. We came up with this guideline partly by looking at the historical frequency of losses over various rolling time periods ranging from one year to 10 years. We also considered the maximum time to recovery, or how long it usually takes to recover after a drawdown.

How Much of My Portfolio Should Be in Real Estate?

While institutional investors and endowment funds often invest much bigger chunks of their portfolios in real estate (including both public and private debt and equity securities), I’d argue that most individual investors should keep their real estate exposure limited (which Morningstar defines as 15% of assets or less). It’s also worth noting that most broad-market index funds already include exposure to real estate. So, if you already have one of those, you don’t necessarily need a separate allocation to real estate.