Are Real Estate Investment Trusts Right for You?

REIT Basics: Types, Returns and Risks

Person holding house keys
••• Image Source/Getty Images

Real estate investment trusts, or REITs, are investment equities often used by those who want to boost the yield on their portfolio. But as always, with higher returns come additional risks. 

What Are REITS?

REITS are simply companies whose business is owning and operating real estate properties. A typical REIT, for example, may buy and manage apartments. By law, they must distribute 90% of their profits in the form of dividends. Most REITs (pronounced “reets”) distribute these profits to their investors quarterly, which makes them a convenient interest-earning vehicle for retirees who want a steady stream of income. REITS, unlike public corporations, do not pay corporate income tax; the profits after management deductions are distributed pre-tax to REITs investors.

Historically, for extended periods -- as in the period from 2010 through 2015 --REITS  have outperformed corporate bonds.  

Types of REITs

REITS come in three flavors:

  • equity REITs, which own and operate income-producing real estate 
  • mortgage REITs, which lend money to real estate owners and operators or invest in mortgage-backed securities or loans  
  • hybrid REITs, which do both.  

Returns of REITs

As measured by the MSCI U.S. REIT Index, as of June 23, 2016, U.S. REITs had produced an average annual return in the prior 5-year period of 12.34%  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. It’s important to 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 fact, REITs trailed the S&P 500 in the one-, three-, and five-year periods ended on August 31, 2013.

In late 2016, the U.S economy's slow return from the Great Recession that began in late 2007 has been accompanied by a significantly lower interest rate environment than in the years preceding the recession. This has contributed significantly to REIT returns. It's important to keep this in mind when measuring REIT performance. REITS are not demonstrably a superior investment at all times. In fact, REITs trailed the S&P 500 index in the one-, three-, and five-year periods that ended on August 31, 2013.

Risks of REITs

REITs are traded on the stock market, and they involved the risk that would typically be expected of an 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, the iShares Dow Jones US Real Estate ETF (IYR) returned -20.35%, then followed that with a return of -40.03% (with dividend income included) during the bursting of the real estate “bubble” in late 2007 and 2008.

Investors who are looking for alternatives to bonds need to be aware of the risks involved.

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. Among the 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 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).

Investors also have a growing number of ways to gain access to the overseas REIT markets. These investments are typically riskier than U.S.-based REITs, but they also have higher yields and the potential to provide greater diversification. The largest ETF focused on non-U.S. REITs is SPDR Dow Jones International Real Estate ETF (RWX).

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.

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 advisor.

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.