Real estate has traditionally been the foundation of wealth for investors. In fact, along with oil and inherited wealth, real estate was how most people got rich up until fairly recently.[1]
The biggest names in investing, like Buffett and Gates, all rely on real estate as the pillar of their portfolio. But real estate requires a lot of money for upfront down payments and time — which you probably don’t have — for property management.
That's where Real Estate Investment Trusts (REITs) come in. These are an excellent way to get exposure to the real estate market without actually owning any physical property. And more importantly, without having to fix a leaking pipe in the middle of the night.
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What are REITs?
REITs are investment vehicles that contain a portfolio of income-producing properties across a range of markets and sectors. REITs are managed by financial institutions and private companies and trade on stock exchanges like the NYSE.
They offer smaller investors the chance to make profits on both the rise and fall of prices in real estate. Historically, REITs have delivered outstanding long-term returns, beating the overall growth of major stock indices like the S&P 500 and small-cap Russell 2000. [2]
Besides capital appreciation, one of the biggest attractions with REITs is the reliable and competitive return on capital invested with predictable dividends.
Since REITs consist of portfolios of income-producing real estate, they have little correlation with other financial assets like stocks, bonds, ETFs, and mutual funds. As a result, they make an excellent option for diversifying portfolio risk.
How REITs work
REITs are required to return at least 90% of all taxable income to shareholders, which means they offer higher yields than comparative investments like ETFs and mutual funds.
They pay out through dividends, providing investors with ongoing cash payments. These returns typically exceed the dividends paid out by most other companies that issue shareholder dividends.
REITs come in various formats, with different specializations in the real estate market. The assets in the portfolio may be broad-based or centrally focused on a specific type of real estate.
You can find REITs in the following real estate segments:
- Government buildings
- Apartment buildings
- Hotels and entertainment complexes
- Warehouses and commercial properties
- Healthcare facilities
- Office buildings
- Retail centers such as shopping malls and strip malls
According to the National Association of REITs (NAREIT), there are currently around 200 publicly traded REITs available in US-based stock markets alone. [3]
REITs' primary attraction to investors is that the vehicle provides exposure to the real estate market without the need to physically own or manage any property.
REIT investors get to share these assets' profits without assuming the higher risk involved with owning real estate outright. There's no physical involvement with managing the properties in the REIT, as the asset managers take care of all of that for you.
When investing in REITs, the management team is the most important aspect of selecting the right vehicle to match your investment objectives.
Who can benefit from REIT investments?
There are more than 200 million Americans invested in REITs. That's a sizable market. Investors in REITs can be private individuals, investment firms, ETFs, or mutual funds.
Since REITs are such a stable investment vehicle, they attract institutional investment from endowments, pension funds, insurance companies, foundations, and even bank trusts.
Investors with low-risk strategies can benefit from higher-than-average returns while investing in stable REIT portfolios that contain hard assets.
Past performance
REITs have historically produced higher returns than investing in indices and other stable assets. They are less volatile than stocks, so you won't see interday movements like that of a growth stock like Tesla with a REIT. Investors with longer investment horizons, willing to commit capital for extended periods, are a good fit.
From 1972 to 2019, when the FTSE NAREIT All Equity REIT Index started trading, its total return has averaged 13.3% vs 12.1% for the S&P 500. 10 year total returns for REITs is 13.2% compared to 14.2% in the S&P 500. [4] While that might be lower than investing in stock indices, the longer the investment horizon, the more favorable the returns REITs have.
REIT outperformance accompanies lower standard deviations when adjusted for longer time horizons. This means REITs might underperform in 10 year timelines but they outperform the stock market in investment horizons longer than 16 years.
Tax implications
REIT dividends primarily consist of dividend payouts from operating profits. Shareholders in REITs receive dividends as normal income, taxed at their own applicable marginal tax rate as a non-qualified dividend.
Occasionally, REIT dividends may include portions of operating profits previously sheltered from taxation due to the depreciation involved with real estate assets held in the REIT.
This payout is a non-taxable return on capital. While it may reduce tax liabilities on dividends, it also reduces investor's returns on a per share cost basis. Reductions in share cost basis don't impact the tax liability on REIT dividend income. However, it does increase the tax obligation when selling REIT shares.
Some REIT dividends consist of a capital gain. For example, when the holding company sells assets, realizing profit from real estate sales. Investors holding assets less than 12 months have the same tax liability as marginal tax rates.
Should the REIT hold the property for longer than 12 months, long-term capital gain tax rates apply. Those investors with a 10% to 20% income tax bracket don't have to pay any long-term capital gains tax, but those in higher tax brackets will pay 15%. Those investors falling in the 37% income tax bracket will pay capital gains tax of 20%.
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Advantages of REIT investments
- Shareholders invested in REITs receive all the benefits of investing in real estate while receiving the enhanced liquidity and lower cost of investing in the stock market.
- REITs offer excellent historical performance, and investors receive dividend-based passive income. Some of the other advantages include competitive market performance, excellent liquidity, unmatched transparency, protection against inflation, and portfolio diversification.
Disadvantages of REIT investments
- It's important to note that REITs are not risk-free assets. When interest rates rise such as during a monetary tightening cycle, it reduces the demand for REIT investments.
- Historically, REIT investments won't perform as well as other asset classes like bonds and stocks when interest rates start to rise. Investors will migrate out of REITs into other assets such as US Treasuries, which provide a stable return, less risk, and a fixed interest rate for investors.
- Fees are also another concern for investors in REITs. Most fund managers charge investors rates between 9% and 10%, with some charging 15% or higher.
- Another issue with REITs is the lack of liquidity in the investment. While publicly-traded REITs trade regularly and have strong liquidity, non-traded REITs are somewhat illiquid. Therefore, investors might not find a buyer when they want to sell. Most non-traded REITs have sell bans for a minimum of 7 years, locking up investors' capital during this period.
Verdict
REITs are a great addition to any investment portfolio, providing strong long-term returns, ongoing dividend payments, and limited correlation to stocks, bonds, and other financial assets. Despite their complicated tax implications, REIT investments are a good option for diversifying your existing portfolio of stocks and reducing portfolio volatility.
Article sources
1 Paul Graham. "How People Get Rich Now, http://www.paulgraham.com/richnow.html". April, 2021.
2 Seeking Alpha. "The Data Is In: REITs Outperform In The Long Term, https://seekingalpha.com/article/4390413-data-is-in-reits-outperform-in-long-term". November 20, 2020.
3 NAREIT "REIT and Publicly Traded Real Estate Company Directory, https://www.reit.com/investing/reit-directory".
4 NAREIT "FTSE NAREIT All Equity REITs (FNER), https://www.reit.com/data-research/reit-indexes/real-time-index-returns/fner-ftx".
