One of the assets classes you might want to consider in your overall asset allocation is Real Estate. One of the ways you can access Real Estate in your portfolio is through Real Estate Investment Trusts also called REITs (pronounced like beets).
What are REITs?
REITs, like many other investment options are a basket. In the case of REITs the basket holds real estate and normally it holds commercial real estate. REITs can also hold mortgages. The REITs then collect income in the form of rent and capital gains if the property appreciates or in the case of REITs that hold mortgages the income will include interest payments.
How can I own REITs?
You can purchase individual REITS, much like stocks. There are listed and non-listed REITs. Listed REITs are traded on exchanges. Non-listed REITs are not traded on exchanges and can be difficult to sell. To me, because of the lack of liquidity, non-listed REITs are not a great alternative for most people.
You can also own REITs through Mutual Funds and ETFs. For instance you can purchase a REIT Index Mutual Fund or ETF through Vanguard (not a recommendation). This investment owns a number of REITs.
What is the Advantage of owning REITs?
REITs can provide additional diversification and risk reduction in a portfolio. Real Estate is not normally closely correlated with the stock market. The correlation between Real Estate and US Large-Cap Stocks (the S&P 500) is 0.60. This means that Real Estate tends to move in the same direction as US Large-Cap Stocks, but not always. Low correlation reduces risk and may even increase gains. Here is an example from Morningstar…
Assume a portfolio composed of the following asset classes:
From 1972 – 2013 the above portfolio would have returned an average of 8.6% with a Standard Deviation (how investment advisors measure risk) of 10.8%.
Now let’s modify the portfolio to the following:
10% Real Estate (REITS)
Over the same time period the modified portfolio would have returned an average 10.3% (1.7% higher) with a Standard Deviation of 10.4% (0.4% lower). Investment alchemy…increased returns with reduced risk.
Like any investment REITs have risk. You can lose money investing in Real Estate (not that we need to be reminded about that).
The bigger issue though is taxation. REITs produce a dividend income and here is the kicker…the dividends are NOT qualified. That means they are taxed at your marginal rate which could be 28% or more. So, you generally want to hold REITs in tax advantaged accounts. 401(k)s and Traditional IRAs would be good choices.
Wrapping it up
Real Estate can be an appropriate asset class to include in your portfolio. Using REITs to access Real Estate can reduce the overall risk of a properly constructed portfolio and potentially increase the portfolio’s return.
Do REITs make sense for you? A complete financial plan will help you know for sure.
Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US.
He specializes in assisting transitioning Senior Military Officers reach their financial goals.