As an alternative asset class, real estate investment trusts (REITs) offer some compelling potential benefits.
REITs — which are defined as publicly traded companies that own or manage income-producing real estate — provide growth potential, typically pay higher dividends than stocks and bonds, and, with their low correlation to equities, have the capacity to help diversify an investor’s overall portfolio.
But REITs can also lose value as interest rates rise, depending on the type of real estate they own, and despite conventional wisdom they aren’t always an effective hedge against inflation.
Given that, then, it’s wise to ask: Are REITs the right investment for you?
The answer is it depends — on your financial goals, your current investment holdings, and the type of account in which you hold them. (Related: Investing basics)
“REITs may be a good addition to anyone’s portfolio, and I do recommend them to average investors, but not all investors are right for REITs,” said Christopher Price, a financial professional with Coastal Wealth in Ft. Lauderdale, Florida. “And not all REITs are right for any investor. It is truly based on the individual investor.”
What is a REIT?
Before exploring the caveats of REIT investing, it is important to educate yourself about what a REIT really is.
According to the National Association of Real Estate Investment Trusts (Nareit) trade group, corporations that are structured as a REIT must pay out 90 percent of their annual taxable income in dividends each year. REITs also enjoy unique tax advantages. They are exempt from paying corporate taxes. Thus, the dividend return from REITs is generally higher than it is for other dividend-paying stocks.1
Most REITs are traded as a security on the major stock market exchanges, like mutual funds, which makes them easier to buy and sell (more liquid) than a physical investment property.
Through the purchase of shares, REITs also make it possible for average investors to gain exposure to the commercial real estate sector — once the domain of the wealthy — without having to own or manage brick and mortar properties.
Many REITs specialize in a specific sector, such as apartment buildings, retail centers (outlet malls and shopping centers), offices, warehouses, hotels, data centers, or medical facilities (hospitals, skilled nursing homes, and senior living centers). But some are broadly diversified among all types of income-producing real estate.
Each performs differently during periods of market volatility. Guidance from a financial professional, who can assess REIT investment options based on their financials, debt levels, ability to collect rents, and the sector’s growth potential, can be instrumental for investors looking to allocate into the sector.
Take note that publicly traded REITs are registered with the Securities and Exchange Commission, but there are some non-traded REITs registered with the SEC that are not traded on the public market. Non-traded REITs involve greater risk as they are generally less liquid, less transparent, and less stable than publicly traded REITs.
For that reason, most financial professionals, including Robert Devine, managing director of The Powhatan Group in Jacksonville, Florida, said average investors should only consider publicly traded REITs for their portfolio.
The potential downside of REITs
All investments have pros and cons.
In the case of REITs, you may collect higher dividends, but you will also generally pay higher taxes on those dividends, typically at your ordinary income tax rate (a maximum of 37 percent, plus a possible 3.8 percent surtax on net investment income) rather than the lower capital gains rate (no more than 20 percent, plus the 3.8 percent net investment income tax) on most other long-term investments. The 20 percent qualified small business income deduction can reduce the amount of qualified REIT dividends subject to income tax.
As a result, Price said that those who do choose to invest in REITs may be better off holding them in a tax-deferred retirement account. (However, the qualified small business income deduction is not available for REITs held in a tax-deferred retirement account.)
“With everything else being the same and a REIT being suitable for an investor, it is better to own a REIT in a tax-favored account,” he said. “This is because REITs are less effective from a tax standpoint than other dividend-paying stocks.”
In light of the current economic cycle, it is also important to note that demand for REITs often drops when interest rates rise as investors seek safe haven securities like Treasury bonds, which are backed by the federal government. (Learn more: How higher interest rates may hit consumers)
On the flipside, REITs historically have outperformed the broader stock market during periods of rising inflation, since rental rates and property values tend to climb as consumer prices rise. To further explain, Nareit noted on its website that long-term leases typically have built-in inflation protection, while shorter-term leases are based on current price levels. The group also points out that REITs keep a portfolio of leases, a portion of which are negotiated every year, so even REITs with longer-term leases have the opportunity to reprice to keep pace with inflation.
That held true in 2021 when inflation hit 7 percent and the MSCI US REIT index posted an annual return of roughly 43 percent against the S&P 500 index’s return of about 28 percent.
But 2022 has been a different story. In his latest market analysis, Morningstar REIT analyst Kevin Brown notes that REITs have not provided the inflation protection many investors expected, in part because not all property types (those with longer leases) were able to pass along higher costs to consumers (through higher rental rates) quickly enough. REITs, he said, also rely on debt to finance growth and rising interest rates mean a higher cost of capital — at least temporarily.
The MSCI US REIT Index was down more than 28 percent year to date through September 2022, compared with a loss of roughly 24 percent for the S&P 500 during the same time period.
According to Devine, REITs may be suitable for investors who seek a source of steady income, a subset that often includes retirees. Unless you have the time and expertise to analyze the commercial real estate industry carefully, however, it is generally best to leave the decisions on which specific REITs to buy or sell to a professional, he said.
“I recommend REITs within a managed portfolio,” Devine said, noting that most investors should limit their REIT exposure to between 2 percent and 5 percent of their overall portfolio.
Here again, a financial professional can help you determine what percentage of your portfolio you should allocate toward REITs, if any. Indeed, if you already have exposure to commercial real estate elsewhere in your portfolio, you may be advised to steer clear of any new REIT investments, lest you overweight the sector.
Devine also recommends REITs for longer-term investors (not active traders).
“The biggest risks of publicly traded REITs would be market volatility and thinking that this is a short-term investment,” he said. “REITs will fluctuate with the market, as proven year to date in 2022. REITs work best when you have time to hold them and can benefit from their dividend payments over the long term.”
If you choose to allocate into REITs, you may wish to consider dollar-cost averaging — buying a small number of shares at consistent intervals over time rather than making a large investment all at once. (Learn more: Understanding dollar-cost averaging)
Alternative assets, like REITs, can potentially help investors balance out a portfolio that is heavy on stocks and bonds. They may even enhance returns. But investors must be sure that they understand the inherent risks of REITs and limit their exposure according to their unique financial profile.
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