REITs vs Nifty Realty Index – What gives better returns?

The recent launch of India’s first REIT and InvIT index by the NSE has raised an important question for investors: Which option is more likely to provide better returns – investing solely in REITs, the Nifty Realty Index, or a combination of both?

In this article, we’ll dive into the details of our research findings and provide insights to help you make informed investment decisions.

Understanding REITs and Nifty Realty Index

REITs, or real estate investment trusts, are companies that own, operate, or finance real estate properties. They allow individual investors to invest in real estate without personally owning entire properties, similar to mutual funds. By pooling money from multiple investors, REITs generate dividends from rental income and capital appreciation on the stock market.

In India, REITs made their debut in 2019 with Embassy Office Parks REIT, and three more options followed: Mindspace Business Park REIT and Brookfield India Real Estate Trust and most recently, Nexus REIT. 

REITs primarily focus on owning and operating income-generating properties like office buildings, shopping malls, and apartment complexes. They are required by law to distribute a significant portion of their earnings as dividends to shareholders, limiting the amount of retained profits available for growth activities. So due to limited growth prospects, REITs may have lesser stock appreciation.

On the other hand, the 10 Indian realty companies in the Nifty Realty Index, concentrate on developing and selling new properties. They reinvest the profits into expanding their business and acquiring new development projects. So, the properties owned by realty companies have more potential for market appreciation. As they have relatively better growth prospects, they can generate better returns for investors through stock appreciation. 

So, while REITs offer the advantage of regular dividend income and stability, their focus on rental cash flow may result in relatively lower stock appreciation compared to traditional realty companies that reinvest profits for growth. 

With these distinct characteristics in mind, let’s evaluate portfolios with varying allocations of REITs and Nifty Realty Index and identify the most optimal portfolio allocation.

Methodology

To conduct our analysis, we constructed a REIT-only index of three prominent REITs: Embassy Park, Mindspace, and Brookfield, as they had sufficient listing history. We considered the time period between 1 April 2019 and 9 May 2023. 

The weights of securities within the index were based on their free-float market capitalisation, which is the total market value of a company’s outstanding shares. This ensured companies with larger market capitalisations had a greater impact on the index’s movement. We focused on price appreciation between the two dates to calculate returns. Dividends were not included in the return calculation. Additionally, risk-adjusted returns were assessed using the Sharpe ratio. 

Results and Findings

Our analysis revealed that a sole investment in REITs yielded the lowest return of 1.7% due to their limited price appreciation. Conversely, investing in the Nifty Realty Index presented the highest return of 13.4%, but it also came with a significant drawdown of 51%. The drawdown refers to the drop in the stock’s value from its highest point before bouncing back up.

Optimal Portfolio Allocation

As the portion of REITs increased and the portion of the Nifty Realty Index decreased, both returns and risk declined accordingly.

For instance, if we allocated 40% to REITs and 60% to Nifty Realty Index, the portfolio yielded a return of 10.1%. We also calculated the risk-adjusted returns, which helps us assess the return in relation to the level of risk taken. In this case, the risk-adjusted return was 0.4, indicating a favourable balance between risk and return.

Interestingly, when we allocated equal weightage to both REITs and realty stocks, the risk-adjusted return remained the same at 0.4. However, the absolute returns decreased to 9%. Despite this, the risk was considerably lower compared to the portfolio with a 40:60 allocation.

Lastly, the portfolio with 30:70 allocation to REITs and realty stocks struck the best balance between risk and return. This allocation resulted in the highest returns of 11.1% during the analysis and the highest risk-adjusted return of 0.5. Also, the volatility of returns was significantly lower in this portfolio compared to others. 

*CAGR Returns are calculated from 1 April 2019 to 9 May 2023. Dividends are not included in the return calculations.

#Max drawdown refers to the drop in the stock’s value from its highest price.

^Risk-adjusted are calculated based on the Sharpe ratio. The higher the risk-adjusted return, the better it is.

Conclusion

These findings highlight the importance of striking a balance between risk and return. While allocating more to realty stocks can yield higher returns, it also increases portfolio risk. Conversely, an equal allocation balances risk but may result in slightly lower returns. The optimal risk-adjusted returns were achieved with a 30% allocation to REITs and 70% to Nifty Realty Index. However, investors must evaluate their own risk tolerance and return expectations before deciding on the ideal allocation between REITs and realty stocks.