The U.S. property market has provided stellar returns to investors throughout history. Investors, analysts and economists keep a close eye on this industry to gauge a measure of the level of economic activity. While there are many ways to invest in this sector, including directly purchasing properties, real estate investment trusts (REITs) have gained in popularity over the last couple of decades as one of the most convenient ways of gaining exposure to real assets. In the first half of this analysis, I will discuss the performance of REITs in 2019 and the expectations for 2020, the reasons behind investing in this asset class and some of the REITs that gurus are bullish on.

Why investors should consider real estate investments

Not every asset class has the same characteristics, and understanding the intrinsic nature of different types of investments is important to build a portfolio that provides an acceptable return under various market conditions. One of the primary reasons to invest in real estate is the potential for generating a higher average return over any other asset class.

The inflation-adjusted average annual return of various asset classes in developed countries:

Source: The Atlas (data as of December 2017)

Diversification benefits provide another reason to consider this investment vehicle. In a study conducted by Dr. Jeffery Fisher of John Hopkins University, it was revealed that real estate investment returns have a low correlation with stock markets around the globe, which is proof that this sector has the potential to reduce the overall risk of an investment portfolio.

Among investment gurus, Ray Dalio (Trades, Portfolio) stands out as one of the most prominent investors who have remained bullish on real estate for decades. In an interview with CNBC, Dalio said:

"Keeping take advantage a bank account is that the worst thing you'll do because it's the surest tax on your money. You will bleed slowly to death because the after-tax returns are less than inflation by a touch per annum . It's important to know how to diversify into non-cash assets like stocks, bonds, and real assets."

For his book "Money: Master the Game," Tony Robbins interviewed over 50 legendary investors, including Warren Buffett (Trades, Portfolio), Carl Icahn (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and Steve Forbes, and based on the input from these successful investors, suggested that the below asset allocation strategy is what gurus believe would deliver attractive returns in all market conditions.

Source: "Money: Master the Game"

This illustrates the important role real assets such as properties play in an investor's portfolio.

Another reason to invest in this sector is the hedge provided against inflation. In an inflationary environment, it is entirely possible for a certain asset class, including stocks, to provide meager returns that do not beat the rising cost of living. According to a study conducted by the Massachusetts Institute of Technology, property prices have exhibited a high correlation with inflation from 1978 to 2016.

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Source: MIT

As evident from the above illustration, both retail and apartment properties have proved to be complete hedges against inflation, whereas the other two segments have provided an acceptable level of correlation.

Performance of REITs in 2019

Stocks reached record highs in 2019 as the S&P 500 Index delivered a staggering 32% total return. REITs did not disappoint investors either, generating a return of 28.7% in this period. The below breakdown of segmental performance indicates that REITs that specialize in a few property types have outperformed others by a considerable margin.

Source: The National Association of Real Estate Investment Trusts

The low interest rate environment, the continued growth of the U.S. economy and the geopolitical stability achieved toward the latter half of the year were the main drivers of this sector in 2019.

The outlook for REITs in 2020

The financial performance of the real estate sector primarily depends on the health of the economy. Whenever recession fears emerge, investors punish REITs in a bid to diversify their investments to safer asset classes. With the signing of the Phase 1 trade deal between the U.S. and China, the possibility of an economic downturn in 2020 has significantly reduced. Economists polled by Wolters Kluwer Blue Chip Economic Indicators in December believe that there's a 33.1% chance of a recession this year, down from 38.4 % reported in June.

Barclays economist Jonathan Miller, wrote:

"We now see the risks as being more balanced with the work figures highlighting the likelihood that household spending could also be carrying more momentum into 2020."

This continued growth of the U.S. economy is a good sign for the real estate sector as a higher level of disposable income generally translates into higher spending, which is a blessing for many types of properties, including malls, offices and residential units.

The low interest rate environment helps the sector from two fronts as well. First, companies representing this industry can borrow funds at a low cost, and empirical evidence suggests that REITs tend to use debt to purchase new properties. This eventually leads to higher revenue and earnings as occupancy rates remain high during a period of economic growth. Second, consumers borrow more at more reasonable costs, leading to higher spending on both discretionary and non-discretionary products and services. Credit growth, therefore, is vital for the survival of this industry, and the prevailing conditions are tailor-made for continued growth in 2020.

The below graph illustrates the relationship between interest rates and the performance of REITs:

Source: The National Association of Real Estate Investment Trusts

In the most recent tightening cycle that lasted from the beginning of 2016 to 2018, the correlation between the performance of REITs and yields has been negative, which led to significant underperformance of this sector. However, in 2019, this reversed along with the decision by the Federal Open Market Committee (FOMC) to cut rates. The minutes from the Fed meeting released in December indicate that policymakers are confident of a stable monetary policy in 2020.