What in the world is a REIT?
A Real Estate Investment Trust (“REIT”) is an exchange-traded security that trades like an equity and invests directly in income producing real estate assets. U.S. REITs must comply with certain requirements in order to receive favorable tax treatment, including:
- Investing at least 75% of its assets in real estate
- Deriving at least 75% of gross income from rents or mortgage interest
- Distributing at least 90% of taxable income to shareholders through dividends
REITs are generally classified by the types of real estate assets they invest in. Here are a few examples:
- Retail: REITs that typically focus on shopping malls and freestanding retail real estate investments.
- Residential: REITs that own and operate apartment buildings and other multi-family housing.
- Office: REITs that make investments in office buildings that receive rental income usually from long-dated leases.
- Healthcare: REITs that focus on investments in senior living facilities, hospitals, medical centers and nursing homes.
- Mortgage: REITs that invest in mortgages and real estate debt as opposed to equity ownership interests in properties.
When should you hold REITs in your portfolio?
REITs are income producing assets and typically pay dividends on a monthly or quarterly basis. Therefore, it usually makes the most sense for an individual investor to hold REITs in tax-advantage vehicles such as a 401k plan, Traditional IRA or Roth IRA.
Why? Well, it does not make much sense to hold REITs in a taxable brokerage account because the regular dividends would be classified as taxable income. Therefore the ideal vehicles to hold REIT investments are your tax-deferred 401k or Traditional IRA. The government does not tax the income received from interest, dividends and capital gains until you retire and actually withdraw money from your 401k or IRA. As an investor, a tax-deferred account is a powerful savings tool; however the annual limits imposed by the IRS means that your tax-advantaged savings capacity is constrained. In addition, you could also hold REITs in an Roth IRA funded with after-tax funds as long as your annual income is below the Roth IRA phase-out range & limits. The Roth IRA would also shield your REIT dividend income from taxes just like a 401k or Traditional IRA.
REIT investment Performance
Generally speaking, REITs have generated solid investment returns relative to the S&P 500 Index over the past 10 years. For example a $1 investment made in the Dow Jones Equity REIT Index in August 2001 would be worth approximately $1.65 today (a 65% return) whereas a $1 investment in the S&P 500 would be worth slightly less than $1 today.
However, the chart above is illustrative of the volatility that can occur in REIT investments. From 2001 through mid-2008 the Dow Jones Equity REIT Index clearly and consistently outperforms the S&P 500 Index. However, when the subprime crisis takes hold in late 2008 and early 2009 the REIT index declines at a much steeper rate than the S&P 500 Index. My point is that REITs do offer a significant diversification benefit during “normal” market periods and are somewhat uncorrelated to the greater equity market. However, during times of extreme stress, especially a real estate specific stress, the REIT index becomes correlated to equity markets. It is important to note that since mid-2009 the REIT Index has recovered nicely and is performing as it did historically.
There are many opinions on this topic, but my belief is that investing in a fund dedicated to purchasing a basket of individual REITs is the most efficient way to incorporate indirect real estate investments into your investment portfolio. REIT funds come in various forms such as mutual funds, exchange-traded funds (ETFs), closed-end funds (CEFs) and others. The key benefits to investing in funds are:
- All-in-one diversification: Purchasing a single fund can provide exposure to a host of REITs with exposure to various types of real estate investments such as retail, residential, mortgage, etc (see above). You can also purchase REITs based on region or country such as the U.S. REIT fund, UK/Europe REIT or local equivalent.
- Funds (specifically ETFs and CEFs) are traded on an exchange: The means that funds can be sold easily and electronically through a discount broker just like placing an equity trade. However, when a stress event occurs in the real estate market (just like in 2008/2009) your investment may experience significant and sharp price deterioration and your ability to execute fund trades may also be impacted.
- Outsourced management: Fund managers select the portfolio, and manage the purchase and sale of REITs as well as collect dividends payments and re-distribute income to investors in exchange for a fund-management fee.
Consider purchasing an ETF, CEF or REIT Index Fund in a tax advantaged account such as an IRA or 401k.
Example REIT Funds:
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