The Risks of Real Estate Investment Trusts

REIT Basics: Types, Returns, and Risks

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Real estate investment trusts (REITs) are investment equities often used by those who want to boost the yield on their portfolio. REITs have high dividend returns, but like most vehicles with high returns, they carry additional risks, and it's up to investors to determine if the profits merit the exposure to the downside.

Defining REITs

REITs are companies whose sole business is owning and operating real estate properties, and some invest in specific types of commercial property, such as parking lots or office buildings. By law, REITs must distribute 90% of their profits in the form of dividends, and most 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 pre-tax to REITs investors. Historically, for extended periods, REITs have outperformed corporate bonds.

Risks of REITs

REITs are traded on the stock market, which means they have increased risks that would be typical of riskier equity investments. They are also adversely affected by weakness in real estate prices. Although REITs’ long-term returns are impressive, there have been periods in which they have underperformed significantly. In 2007, for example, the iShares Dow Jones US Real Estate ETF (IYR) returned -20.35%, then followed that with an abysmal return of -40.03% (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 miscategorized as "bond substitutes," REITs are not bonds; they are equities. Like all equities, they carry a measure of risk significantly greater than government bonds

Returns of REITs

Measured by the MSCI U.S. REIT Index, the annual return of U.S. REITs is 12.99%. The S&P 500 Index, a broad measure of performance for the U.S. stock market, averages a return of roughly 10%. 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. For instance, 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 2008 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 (S&P 500), their returns could be considered by some as sluggish.

How to Invest in REITs

REITs are available to investors in several ways, including dedicated mutual funds, closed-end funds, and exchange-traded funds (ETFs). Popular exchange-traded funds that focus on REITs are: 

  • iShares Dow Jones US Real Estate (ticker: IYR)
  • Vanguard REIT Index ETF (VNQ)
  • SPDR Dow Jones REIT (RWR)
  • 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)
  • Ventas (VTR). 

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 is Vanguard's Global ex-U.S. Real Estate Index Fund ETF (VNQI).

REITs in Portfolio Construction

REITs tend to have a lower-than-average correlation with other areas of the market, so although 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 reduce the overall volatility of an investors’ portfolio while simultaneously increasing its 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. 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.