10 things you need to know about REITs
Reprinted courtesy of MarketWatch.com.
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If you’ve been paying attention, you may know that REITs, real-estate investment trusts that invest in all sorts of commercial real estate, have been paying off quite well for investors in recent years.
But I’m willing to bet you don’t know everything you should about REITs. Here are 10 examples:
One: Not like buying a house
Though they are based on real estate, REITs are nothing like traditional homeownership. A REIT is much like a specialized mutual fund that may invest in any of a wide variety of companies that build, own and manage commercial real estate.
More than 300 of these companies are registered with the Securities and Exchange Commission. REITs own more than 40,000 commercial properties in the U.S.
REITs give you a chance to own small slices of shopping centers, condominiums, office buildings, housing developments, hospitals, student housing, timberland, parking garages, factories and all sorts of other real estate that (usually, and if properly managed) makes money.
Two: REITs are often volatile
REITs aren’t boring, steady investments. On the contrary, they sometimes go up and down in a big way, and move sharply in and out of favor with investors. When I wrote about REITs in 2007, investors couldn’t get enough of them. Two years later when I wrote about them again, investors didn’t want any part of them.
How’s that for hot and cold?
Three: Strong long-term performance
REITs have a long history of producing good returns. From 1975 through 2006, U.S. REITs had an annualized return of 16.7% — hence their popularity in 2007. From 1975 through 2014, the figure was almost as favorable: 14.1%. That’s more than the 12.2% return of the Standard & Poor’s 500 Index SPX, +0.94% but less than the 15.1% return of U.S. large-cap value stocks.
In fact, in six of those years, REITs had the very best performance among the 11equity asset classes that I recommend. However, see my next point.
Four: Short-term performance can break your heart
The short-term performance of REITs can be awful. The Dow Jones Wilshire REIT Index WILREIT, +0.12% lost half its value in just two years, falling 17.6% in 2007 and another 39.2% in 2008.
Five: Diversification tool
While their long-term returns are similar to the S&P 500 and to U.S. large-cap value stocks, REITs seem tailor-made for diversifying a portfolio. From 1975 through 2006, a portfolio divided 50/50 between the S&P 500 and a REIT index returned 15.2%, vs. 13.5% for the S&P 500 alone. The frosting on the cake: Risk was 12% lower than that of the S&P 500 by itself (see the following item).
Six: Reduce portfolio volatility
The main reason to own REITs isn’t to improve your portfolio’s return, though sometimes that will happen. The bigger reason is to reduce volatility, increase diversification and provide a source of income.
How do REITs reduce volatility? By turning in performance that is often quite different from that of other major equity asset classes. In approximately one out of every four calendar years since 1975, REITs’ returns differed by 25 or more percentage points from those of the S&P 500 Index. In the majority of those years, REITs’ returns were higher.
Seven: Distributions taxed as ordinary income
REITs can be tricky at tax time. By law, REITs must pass 90% of their income through to shareholders, who are liable for taxes on that income without the benefit of a favorable capital-gains tax rate. The distributions are taxed as ordinary income, in other words. That’s not great news for investors in high tax brackets.
However, there’s a good side to this arrangement. REITs’ income is taxed only once, at the shareholder level. This is unlike corporate dividends, which are taxed once at the corporate level and then taxed again to shareholders. Hence the term double taxation.
Because of this, REITs are best suited for tax-deferred entities such as IRAs and 401(k) accounts.
Eight: You can buy individual REITs
You can buy individual REITs, just as you can buy individual stocks and bonds. But by far the best way to own REITs is through a mutual fund. Vanguard’s low-cost REIT Index fund VGSIX, -0.17% is hard to beat. It is broadly diversified, holding 142 REITs compared with only 57 for Cohen & Steers Realty Shares CSRSX, -0.16% a popular actively-managed REITs fund.
Over the past 15 years, the Vanguard fund’s performance was almost one full percentage point higher than the average REIT fund.
Nine: You can buy international REITs
Now it’s possible to invest in international REIT funds; some are global; others own only properties outside the U.S. These multinational funds don’t have long return histories, but the experts who follow them believe that combining U.S. and international real-estate investments will produce higher returns than the S&P 500 index, along with currency diversification.
Ten: Not all REITs trade on an exchange
Not all REITs are likely to be your friends. The REITs I have been describing are publicly traded on stock exchanges. But I think you should beware of another type, known as nontraded REITs.
Sales commissions on nontraded REITs are high — up to 15%. A recent study found that average returns of nontraded REITs lagged behind their publicly traded counterparts by 3.6 percentage points.
Because publicly-traded REITs trade on stock exchanges, their value is constantly reset by investors. Nontraded REITs, by contrast, are so illiquid that investors sometimes can’t determine what they are worth for months, or even years.
Fortunately you can easily avoid these companies by investing in REIT funds, as I recommend.
I believe that REITs are worthwhile for part of your equity portfolio. Now you know why. And you know how to invest in them.
Richard Buck contributed to this article.