Should You Own An International Real Estate Fund?

2011 January 18

Yesterday I wrote about a few alternative asset classes that are easy to own, where I listed foreign real estate as one possible asset class but with an asterisk. While two of the most long-standing arguments against owning foreign real estate, cost and transparency, have been eliminated due to the release of Vanguard’s new Global ex-US Real Estate Index Fund (VGXRX), several remain. In particular, there are four main remaining issues that must be grappled with before deciding to own foreign real estate, so far as I can tell.

Taxable Or Tax-Deferred?

With domestic REITs this is an easy one: you should always own REITs in a tax-advantaged account if at all possible. This is because REIT dividends are taxed as regular income instead of the lower tax rates afforded qualified dividends from most other kinds of corporations. However, the foreign tax credit clouds the issue somewhat. Mutual funds owning the stocks of foreign companies are generally required to pay income taxes on dividends received to the stock’s host nation. Normally, you (the investor) can then claim a foreign tax credit to recoup at least some of the taxes paid to foreign governments. The catch is, you can only do this if you hold the fund in a regular taxable account. If you hold the fund in a 401k, IRA, or other tax-advantaged account this tax credit isn’t available to you at all. So you have to choose: do you pay foreign taxes or do you pay domestic taxes? With foreign real estate, you can’t avoid both. Of course, this is true with all foreign stock and it hasn’t stopped me from whole-heartedly recommending foreign stocks. Still, it’s something to keep in mind.

Is It Worth The Higher Expense Ratio?

The Vanguard fund is reasonably priced with an expense ratio of just 0.50%. Still, that’s more than twice the price of domestic REIT exposure. Are the additional diversification benefits of owning foreign real estate worth the price? I have no idea, which leads me to my next point…

Just How Much Diversification Would You Gain, Anyway?

To the best of my knowledge, there is no comprehensive source of data on foreign real estate as an asset class (please correct me if I’m wrong). Would these securities correlate well with domestic real estate?  Or maybe move lock-step with foreign stocks?  If so, there’s not much diversification benefit to be had. The problem is, there’s not enough data to make a reasonable judgement one way or another. Foreign real estate could end up being a great diversifier. Or not. For this reason alone, I probably wouldn’t advocate more than a token 5% allocation to this asset class. For now.

The Inclusion Of Real Estate Related Companies

The REIT legal structure doesn’t exist in many countries, meaning you would also probably own stocks in a few real estate development companies, property management companies, and the like. There’s nothing wrong with owning stock in these kinds of companies, but they don’t exactly provide pure exposure to foreign real estate values. This factor would lead me to believe most foreign real estate funds would tend to be more or less correlated with other more general foreign stock mutual funds. Again, there’s nothing wrong with that, but it’s not really what you signed up for.

So should you own foreign real estate? For me, the negative factors outweigh the positive for the time being. I will definitely revisit the decision after I have a few more years of data to look at, though.

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One Response
  1. 2011 January 18
    Ethan permalink

    Great commentary – thank you for bringing the new fund to my attention. I’m excited by the prospect, but expect the devil is in the details as you do. I’m going to have to absorb the fund filings and seek out some other opinions before I’m comfortable with it.

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