Financial planning typically involves deciding how much savings to place in stocks, bonds and other assets while weighing the risks associated with each element of a diversified investment portfolio. A new study from Cornell University examines risk-return profiles and finds that investors see different purposes for real estate investment trust (REIT) common stock and preferred stock depending on their tolerance for risk.
Using a value-based approach and imposing practical constraints on the investor's portfolio, this research shows that risk tolerant investors find REIT common stock beneficial, while risk averse investors find the preferred stock more favorable. This suggests that those who hold investment grade bonds in their portfolios, in particular, should consider adding REIT preferred stock to their portfolios.
A full description of the study, "The Role of REIT Preferred and Common Stock in Diversified Portfolios," by Walter I. Boudry, Jan A. deRoos, and Andrey D. Ukhov, is available from the Cornell Center for Hospitality Research. Boudry is an assistant professor of real estate in the Cornell School of Hotel Administration (SHA), where deRoos is the HVS Professor of Hotel Finance and Real Estate and Ukhov is an assistant professor of finance.
The authors offer two primary reasons for exploring the diversification benefits of the REIT market. First, little is known about the risk-return characteristics of REIT preferred stock. Second, while studies show that investors with well diversified portfolios receive little benefit from REIT common stock, it is not clear whether this is also true for REIT preferred stock.
"In examining the constrained portfolio problem, we find that REIT common stock benefits risk-tolerant investors by allowing them to form high return portfolios," the report states. "In contrast to REIT common stock, REIT preferred stock is valued by moderately risk-averse investors, because it provides a venue for risk reduction. Investors who like investment grade bonds should also consider the REIT preferred stock because it likely has a risk-return profile that suits their investment profiles."
The results of this study also have implications for issuers of REIT preferred stock, the authors note, by showing that the preferred stock is a valuable asset because of its distinctive risk-return profile. As a result, issuers can reduce the yield on their preferred stock and still offer it as a valuable asset class to investors, providing an attractive option for preferred stock investors.
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