Are the Risks of Real Estate Investment Trusts Worth It?

REIT Basics: Types, Returns, and Risks

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Real estate investment trusts (REITs, pronounced "reets") are investment equities often used by those who want to boost the yield on their portfolio. REITs often claim incredible dividend returns, but like most vehicles with high returns, they carry additional risks. Do the profits merit the exposure to the downside?

What Are REITs?

REITs are simply companies whose sole business is owning and operating real estate properties. A typical REIT may buy and manage apartments. Another may invest in specific types of commercial property, such as parking lots or office buildings.

By law, REITs must distribute 90 percent of their profits in the form of dividends. Most REITs distribute these profits to their investors quarterly, which makes them a convenient interest-earning vehicle for retirees who want a steady stream of income.

Unlike public corporations, REITs do not pay corporate income tax. The profits after management deductions are distributed pretax to REITs investors. Historically, for extended periods—as in the period from 2010 through 2015—REITs have outperformed corporate bonds

Returns of REITs

Measured by the MSCI U.S. REIT Index, the annual performance of U.S. REITs produced an average annual return (from EOY 2010 to EOY 2017) of 12.99 percent. The S&P 500 Index, a broad measure of performance for the U.S. stock market, averaged a return of 10.49% over the same period.

Keep in mind that the higher returns from REITs are simply a measure of performance over a particular extended interval, not an indication that REITs are a superior investment.

In late 2016, the U.S economy's slow return from the Great Recession that began in late 2007 was accompanied by a significantly lower interest-rate environment than in the years preceding the recession, which has contributed significantly to REIT returns. Also, keep this in mind when measuring REIT performance.

As mentioned earlier, although they can yield great returns, REITs are not a demonstrably superior investment at all times. To illustrate, REITs trailed the S&P 500 in the one-, three-, and five-year periods that ended August 31, 2013. REITs should have been outperforming the S&P 500 during that period of quantitative easing but trailed the majority of years since the financial crisis. Although they trailed the general market, that doesn't necessarily mean they performed poorly, since most investment decisions are measured "against the market," meaning the S&P 500, their returns could be considered by some as sluggish.

Risks of REITs

REITs are traded on the stock market, involving the inflated risks that would typical of riskier equity investment. They are also adversely affected by weakness in real estate prices. Although REITs’ long-term returns are impressive, there have also been periods in which they have underperformed significantly.

In 2007, for example, the iShares Dow Jones US Real Estate ETF (IYR) returned -20.35 percent, then followed that with an abysmal return of -40.03 percent (that's including dividend income) during the bursting of the real estate “bubble” in late 2007 and early 2008.

REITs also have the potential to produce negative total returns during the times when interest rates are elevated or rising. When rates are low, investors typically move out of safer assets to seek income in other areas of the market. Conversely, when rates are high or in uncertain times, investors often gravitate back to U.S. Treasuries or other fixed-income investments.

While sometimes carelessly proposed as "bond substitutes," REITs are not bonds; they are equities. Like all equities, they carry a measure of risk significantly greater than government bonds

How to Invest in REITs

REITs are available to investors in a number of ways, including dedicated mutual funds, closed-end funds, and exchange-traded funds (ETFs). Popular exchange-traded funds that focus on REITs are the iShares Dow Jones US Real Estate (ticker: IYR), Vanguard REIT Index ETF (VNQ), SPDR Dow Jones REIT (RWR), and iShares Cohen & Steers Realty (ICF).

Investors can also open a brokerage account and buy into individual REITs directly. Some of the largest individual REITs are Simon Property Group (SPG), Public Storage (PSA), Equity Residential (EQR), HCP (HCP), and Ventas (VTR). Unless you are fluent in REITs, it is advisable to work with a licensed professional.

Investors also have a growing number of ways to gain access to overseas REIT markets. These investments are typically riskier than U.S.-based REITs, but they may deliver higher yields—and since they're overseas, they provide diversification for a profile heavy in domestic real estate.

The largest ETF focused on non-U.S. REITs (as of August 2018) is Vanguard's Global ex-U.S. Real Estate Index Fund ETF (VNQI).

REITs in Portfolio Construction

One REIT characteristic is undeniably positive, namely that REITs tend to have a lower than average correlation with other areas of the market—meaning that while they are affected by broader market trends, their performance can be expected to deviate somewhat from the major stock indices and, to some degree, from bonds. This performance can make them a powerful hedge vehicle.

An allocation to REITs can, therefore, reduce help reduce the overall volatility of an investors’ portfolio at the same time that it can increase yield. Another advantage of REITs is that unlike bonds bought at issue, REITs have the potential for longer-term capital appreciation.

They may also do better than some other investments during periods of inflation because real estate prices generally rise with inflation. Keep in mind, however, that REIT dividends, unlike capital gains from equities held for at least one year, are fully taxable.

It's always a good idea to talk over asset allocation decisions with a trusted financial adviser.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.