Perhaps the best-known guideline in buying, selling, renting or appraising real estate is "location, location, location." A comparable mantra for investors in general would be "diversification, diversification, diversification." It turns out that giving real estate a place in your overall portfolio is an essential step toward optimal diversification.

In this case, real estate refers to real estate investment trusts, and the performance of REITs predominately represents commercial real estate rather than residential real estate. This is a powerful investment. In fact, as shown in the Seven Core Assets chart on the next page, REITs constitute the best-performing "core" asset class over the past 42 years.

In the below chart, the 42-year historical performance of large-cap U.S. equities was represented by the S&P 500, while the performance of small-cap U.S. equities was captured by using the Ibbotson Small Companies Index from 1970-1978 and the Russell 2000 Index from 1979-2011. The performance of non-U.S. equities was represented by the MSCI EAFE Index. U.S. bonds were represented by the Ibbotson Intermediate Term Bond Index from 1970-1975 and the Barclays Capital Aggregate Bond Index from 1976-2011. As of late 2008, the Lehman Brothers indexes were renamed Barclays Capital indexes.

The historical performance of cash was represented by three-month Treasury bills. The performance of real estate was measured by using the annual returns of the NAREIT Index from 1970-1977 (annual returns for 1970 and 1971 were regression-based estimates because as the NAREIT Index did not provide annual returns until 1972). From 1978-2011, the annual returns of the Dow Jones U.S. Select REIT Index were used (before April 2009, the index was known as the Dow Jones Wilshire REIT Index). Finally, the historical performance of commodities was measured by the Goldman Sachs Commodities Index. As of Feb. 6, 2007, the GSCI became known as the S&P GSCI.

PERFORMANCE BASED

Assessing the performance of REITs is straightforward since there are a number of mutual funds and ETFs that focus on this asset class. The Big 25 chart shows the largest REIT funds as of Dec. 31, 2011. To be included, a fund had to be categorized by Morningstar as real estate, had to list real estate as the prospectus objective and needed to have a Morningstar equity style consistency rating of medium or high. The last filter was used to eliminate funds that have an overly creative definition of what a REIT fund should invest in. In all, 62 REIT funds met the three criteria.

The largest six hold nearly 60% of the assets of the entire group, and three of those six are index-based. The two Vanguard funds track the MSCI U.S. REIT Index, while the iShares Dow Jones U.S. Real Estate (IYR) exchange-traded fund tracks the Dow Jones U.S. Select REIT Index.

Whether actively or passively managed, nearly all of the funds in the table had similar performances in the three years that ended last Dec. 31. When comparing performance over the past 10 years, some material differences emerge. For instance, IYR produced the lowest 10-year average annualized return, 8.67%; at the other extreme was Nuveen Real Estate Securities (FARCX), which had a 10-year return of 12.34%.

A PIECE OF THE WHOLE

A real estate investment should only be a portion of a portfolio, so a head-to-head comparison of real estate funds somewhat misses the point. More to the point is a comparison of what each REIT fund adds to a portfolio, rather than its performance as a stand-alone asset.

Consider a simple two-asset portfolio consisting of 60% large-cap U.S. stocks and 40% U.S. bonds - the old balanced model. Using the SPDR S&P 500 (SPY) as the stock measure and the SPDR Barclays Capital Aggregate Bond (LAG) as the bond standard, the 10-year average annualized return of a 60/40 portfolio (with annual rebalancing) from January 2002 to December 2011 was 4.61%.

Next, replace part of the stock position with REITs. The new asset allocation is 40% SPY, 20% REIT fund and 40% LAG. This 40/20/40 asset allocation was tested using all of the REIT funds in The Big 25 chart with 10-year performance histories. The average 10-year annualized return for the 40/20/40 portfolio was 6.27%, with a high of 6.63% (using FARCX as the REIT fund) and a low of 5.93% (using CSEIX as the REIT fund).

Two observations: after adapting a traditional 60/40 portfolio to include a REIT component, the results over the past 10 years were uniformly improved. The smallest performance enhancement from adding REITs was 132 basis points (which would have produced an ending balance more than $2,100 higher than a 60/40 portfolio, assuming a starting lump-sum investment of $10,000), and the largest performance enhancement was 202 basis points (an ending balance more than $3,300 higher than a 60/40 portfolio). This added performance came with no additional risk. The standard deviation of the 10 annual returns in the 60/40 portfolios was 11.4%, while the average 10-year standard deviation of the 40/20/40 portfolios was 11.8% - a trivial increase in volatility.

Some advisors refer to real estate as an "alternative" asset class. They shouldn't. Research shows that REITs should play a fundamental role in any investment portfolio.

Craig Israelsen, Ph.D., is a Financial Planning contributing writer and an associate professor at Brigham Young University. He is author of 7Twelve: A Diversified Investment Portfolio with a Plan.