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As an asset class, real estate should be a part of every balanced investment portfolio. That’s because real estate investments generally have a low correlation to stocks. When stocks zig, real estate typically zags. This provides your overall portfolio with stability. Financial advisors seem to agree that anywhere between 10% and 26% of your investments should be in real estate.
Investing in real estate is different from investing in stocks and mutual funds in several ways. For one, real estate has always been and continues to be a long-term investment where short-term selling doesn’t make financial sense. The transaction costs are high. The sale takes time (you have to find a buyer and sell a tangible asset in whole). And appreciation is typically slow and steady. So you want to hold longer to reap the benefits of owning a real asset like real estate.
Real estate investment trusts (REITs) are an alternative to buying real estate directly. They also offer some of the most attractive features of stock investing. REITs have been a popular investment since their creation in 1960. Think of a REIT as a pool of real estate assets traded freely on the stock market exchange.
Just like real estate, REITs can invest in many categories, and/or many geographical regions. Real estate is typically broken down into these categories:
- Industrial and Office
- Lodging and Resorts
- Health Care
- Self Storage
Advantages of REITs – Real Estate Investment Trusts
REIT advantages include:
- Guaranteed Dividends — REITs must payout at least 90% of their income as dividends. Management can raise the payout to more than 90% but by law can’t lower it below 90%. This requirement is the number one reason income investors buy REITs.
- Hassle-Free Real Estate Investing — REITs are a hassle-free way to own real estate. They’re conveniently packaged into shares that can be easily bought and sold. There are also REIT mutual funds and ETFs (exchange-traded funds) that diversify by investing in many individual REITs.
- Low Minimums — You don’t need a lot of money to start investing in a REIT. And owning a REIT index fund gives you exposure to the real estate asset class with very little money.
- Passive Investment — Directly owning and managing a property is a business and requires time and effort. REIT shareholders do not own the property or mortgages represented in its portfolio. As such, they also avoid the headaches many property owners and managers experience, such as maintaining or developing the property, providing landlord services and collecting rent payments, to name a few. REITs truly are passive investing, like mutual funds.
- Low Stock Market Correlation — REITs historically have a low correlation to other asset classes. This makes it easy to create a diversified investment portfolio by adding REITs.
- Liquidity — Unlike owning property directly, you can quickly sell a REIT if you’ve made a mistake. Traditional real estate has a long enter-and-exit process, so your investment isn’t liquid.
- Better Performance — While some REITs have historically experienced diminished performance when interest rates increase, many REITs outperformed other investments, even in the face of high-interest rates. And REITs often outperform other stocks in a slow economy.
- Mandatory Distributions to Investors — REITs are companies whose assets consist mainly of real estate holdings. This gives them favourable tax treatment. In exchange, they must distribute at least 90% of their income to unitholders. This pretty much guarantees payouts to investors.
Disadvantages of REITs – Real Estate Investment Trusts
When you buy a REIT, you’re becoming more of a real estate investor than a dividend stock investor, and there are potential risks to consider:
- Declining Value Properties — As we learned from the housing bubble that burst in 2007–08, real estate doesn’t always go up in value. When choosing a REIT, be mindful of the growth prospects of the industries, property types and geographical locations it is targeting.
- Fees and Markups — While REITs offer the advantage of liquidity, trading in and out of a REIT has a high cost. Most of the fees charged by a REIT are paid upfront. These fees are run roughly 20–30% of the value of the REIT. This takes a sizable chunk out of your potential returns. And because REIT prices are set in the public markets, they can trade at a significant premium to the real value of the underlying assets they hold.
- Potential Market Correlation — Some publicly-traded REITs tend to be highly correlated to the broader stock market (most are not). This means that prices for some REITs can go up and down with corporate stocks, regardless of whether the underlying values of the properties within the REIT have changed. You’ll want to be careful that the REITs you choose for your portfolio actually provide the diversification you’re seeking.
- Gains Taxed at Ordinary Income Rate — As we mentioned, REITs have to pay out 90% of their income to their shareholders. This gives many REITs attractive yields. But unlike stock dividends, which are currently taxed at a maximum of 15%, REITs are taxed at your ordinary-income rate. So in most cases, you are best to invest in REITs in tax-deferred accounts like an IRA or 401(k) to minimize taxes.
- Inherent Potential Limited Growth — The 90% rule can limit a REIT’s future growth. Because the government requires the company to distribute 90% of its income to unitholders, little capital is left over for acquiring or renovating new properties. Some REITs get around this limit by using debt (leverage).
In most cases, you are best to gain REIT exposure via an index-based mutual fund or ETF. When a REIT fund is indexed, it is based upon MSCI REIT index. Which has a weighting in these categories:
So if you have other real estate investments (which can include primary residence) make sure you don’t have too much invested in residential real estate. An argument against using an index based REIT is too much allocation in one specific sector. If that is your concern, you can add specific REITs to your portfolio.
Real Estate Investment Trusts Summary
Real estate has proven to be an excellent long-term investment. Buying property often comes with a sizable monetary investment. REITs are a great alternative to owning real estate directly. They do have some disadvantages compared to owning real estate directly. But REITs are a natural (passive) way to gain exposure to real estate with very little money. REITs can add stability and diversity to your overall investment portfolio.
You can invest in REITs by using popular crowdfunding platforms, such as Fundrise, Roofstock and Realty Mogul. These platforms are great options in case you’d like to protect yourself from risks that may occur in traditional investing methods.
Investing in REITs can be done by nearly any investor, regardless of portfolio size because of their availability in mutual funds and ETFs. If you’re just starting out, consider a REIT Index Fund. There are many to choose from including:
- iShares Cohen & Steers REIT ETF (ICF)
- Vanguard Real Estate ETF (VNQ)
- Vanguard Real Estate Index Investor (VGSIX)