The Risks of Real Estate Investment Trusts

REIT Basics: Types, Returns, and Risks

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Real estate investment trusts (REITs) are equities often used by those who want to boost the yield of their portfolio. These investment products offer an easy way to own a share in income-producing real estate property. REITs can have high returns, but like most assets with high returns, they carry more risk than lower yield alternatives like Treasury bonds.

Here are some factors to consider to help you figure out if the potential profits of REITs merit the risks taken.

What Is a REIT?

REITs are firms whose sole purpose is to own and operate real estate properties. Some invest in commercial property such as parking lots or office buildings. Others invest in residential property like apartment buildings or houses. By law, REITs must pass on 90% of their profits in the form of dividends. Most distribute them to their investors quarterly, making them a good interest-earning vehicle for retirees who want a steady stream of income.

Unlike public corporations, REITs often distribute 100% of their taxable income in the form of dividends, which means they do not pay corporate income taxes. After management deductions, profits are distributed pre-tax to investors. REITs have outperformed corporate bonds over the long run, making them more tempting for an investor who can handle the risks.

While REITs often offer lower yields than corporate bonds, only 50% of the returns for the typical REIT investor come from income. The other 50% comes from capital appreciation, which could make REITs more tempting for an investor that can handle the risks.

Risks of REITs

REITs are traded on the stock market, which means they have increased risks similar to equity investments. Real estate prices rise and fall in response to outside stimuli, underlying fundamentals, and a variety of other market forces. REITs, in turn, will reflect any weakness and mirror the effects on prices.

Although REITs’ long-term returns can be large, there have been periods in which they have not. When the real estate bubble burst between early 2007 and early 2009, for example, the price of shares in the iShares Dow Jones U.S. Real Estate ETF (IYR) dropped some 72% from a high of $91.42 to a low of $23.51.

Sometimes REITs are miscategorized as "bond substitutes." REITs are not bonds; they are equities. Like all equities, they carry a measure of risk that is much greater than government bonds

REITs can also produce negative total returns during times when interest rates are high or rising. When rates are low, many people move out of safer assets like Treasuries to find income in other market areas, such as real estate.

Returns of REITs

Measured by the MSCI U.S. REIT Index, the five-year return of U.S. REITs was 7.58% in May 2021, down from 15.76% in May 2020. A return of 15.76% is quite a bit higher than the average return of the S&P 500 Index (roughly 10%). The trust lost half of its returns in one year—a reduced return, but still decent considering the stock market conditions of 2020.

Whether the returns are higher or lower than others for a given period, these are simply a snapshot of returns. They do not show that REITs are a better investment; they only show that returns are different and that you can use them in various strategies.

Returns and performance are important, but whether they are good or not depends upon you and your investing strategy. What's good for another investor's portfolio may not be the best fit for yours.

How to Invest in REITs

You're able to access REITs in several ways. There are mutual funds, closed-end funds, and exchange-traded funds (ETFs) to choose from. Popular exchange-traded funds that focus on REITs are: 

  • iShares Dow Jones U.S. Real Estate (IYR)
  • Vanguard REIT Index ETF (VNQ)
  • SPDR Dow Jones REIT (RWR)
  • iShares Cohen & Steers Realty (ICF)

You can also open a brokerage account and buy into individual REITs directly. Some of the larger individual REITs are:

  • Simon Property Group (SPG)
  • Public Storage (PSA)
  • Equity Residential (EQR)
  • HCP (HCP)
  • Ventas (VTR) 

There are also a growing number of ways to access 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. One example of such an ETF 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. While they are affected by broader market trends, you can expect their performance to deviate somewhat from the major stock indices and bonds to some degree. This performance can make them a potent hedge vehicle, though perhaps not as much as bonds or commodities.

You can use REITs to reduce the overall volatility of your 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.

Frequently Asked Questions (FAQs)

How are REITs taxed?

Dividends from REITs can be taxed as ordinary income, capital gains, or a return on capital. Most dividends can be treated as ordinary income. The REIT will inform you if part of the dividend is a capital gain or loss. Capital gains tax is typically 0%, 15%, or 20%, depending on the investor's income.

What are mortgage REITs?

Mortgage REITs don't own property outright. Instead, they invest in mortgages, mortgage-backed securities, and related assets. Dividends are paid out of the interest earned on mortgages and other assets. Equity REITs own properties outright.