Yes, they're dull and implacably earthbound. But they can be good for your portfolio, reducing risk and raising return.

Indeed, real estate investment trusts, otherwise known as REITs, were the lost stepchildren of investing during the Internet era. When I last wrote about them (The REIT Bear Market May Be an Income Opportunity, November 14, 1999) they were providing sweet yields and selling below book value. (http://assetbuilder.com/blogs/post/1173.aspx")

Since then, the Internet era has crashed and burned while REITs have taken off. According to Morningstar, the average REIT has provided a return of 23.10 percent in the last twelve months. During the same period the NASDAQ 100 index lost 50.6 percent of its value.

Things change.

And that's why Ibbotson Associates, the Chicago firm devoted to spreading the gospel of modern portfolio theory, recently blessed REITs. In a new study the firm found that equity REITs (the ones that actually own property rather than trading in mortgages, doing land lease-backs, etc.) not only produced healthy long-term returns but would also reduce the risk in a stock and bond portfolio. Better still, the study found that REIT returns were becoming less correlated with the returns of other assets.

What does that mean in English?

Just this: add a bit of REIT to your portfolio and you'll increase your return, reduce your risk, sleep better, and have more money when you need it.

Measuring portfolio performance from 1972 through 2000, Ibbotson Associates found that a portfolio of 50 percent large company stocks, 40 percent 20-year government bonds, and 10 percent Treasury bills would have had an annualized return of 11.8 percent and a risk of 11.2 percent. (The risk is measured by the standard deviation in the market value of the portfolio, the higher the figure the greater the risk.)

Take 5 percent from both stocks and bonds in the same portfolio; substituting a 10 percent commitment to REITs, and the annualized return rises to 12.0 percent while the risk declines to 10.9 percent. Take 10 percent from both stocks and bonds; substituting a 20 percent commitment to REITs and the annualized return rises to 12.2 percent while the risk declines further to 10.8 percent.

Simple addition of REIT shares provides what we all want: more return, less risk.

Does this mean REITs are the perfect investment?

Not quite.

Here's the pro and con short list:

Pro:

•           Because they are required to pay out the bulk of their earnings,                  REITs generally offer high dividend yields. At the end of April,                the average REIT offered a yield of 7.8 percent. Of the 233 stocks                in the Morningstar database with yields over 7 percent, 120 were                REITs. If you want current income that offers potential growth,                REITs are it.

•           REIT prices don't move in concert with the prices of stocks or                bonds. More important, they became less connected in the last ten                years. This means REIT holdings may act to counterbalance and                smooth out returns from other assets.

Cons:

•           While you may not own real estate in your current portfolio, that                doesn't mean you aren't a real estate investor. Most Americans                have more of their net worth tied up in simple home equity than                in the stock or bond market. Adding REIT holdings could give you                an unhealthy reliance on real estate.

•           Adding REITs to your portfolio will reduce risk for the portfolio                as a whole. That doesn't mean your shareholdings in REITs won't                stop your heart from time to time. The sector, like others, has                had some very tough years.

Want to learn more?

You can get a listing of publicly traded REITs by visiting the National Association of Real Estate Investment Trusts

Check the regularly updated Morningstar listings

Do a fine tuned search on the Microsoft Investor website which subdivides REITs into 7 different types on its Stock Screener