When the stock market looks scary and bonds are stingy, many investors looking for something different come across real estate investment trusts. But then the options can be confusing.
Some REITs specialize in shopping centers, others in timberland, self-storage units or apartment buildings.
If you’re already scratching your head, don’t feel bad. REITs occupy a niche of their own, and can seem strange to investors who’ve lived in the mainstream world of stock and bond mutual funds. But these real estate investments can be appealing, even if you are happy with your other holdings. They can pay generous dividends and they tend to be “uncorrelated” with the stock market, meaning that if your stocks are down, your REITs may be up.
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That’s because the values of apartment buildings, office complexes, malls and strip shopping centers march to their own tune, which can be quite different from that driving stocks and bonds.
REITs are like mutual funds that own property instead of companies. The REIT firm uses investors’ funds to buy buildings or land, passes at least 90 percent of rental income back to shareholders through dividends, and hopes to profit on rising real estate values over the long term.
It’s a way for ordinary investors to play the real estate market without owning properties themselves, and to rely on pros to do the hard work of purchasing, finding tenants and dealing with upkeep, taxes and governmental regulations.
A single REIT may own dozens of properties, something you couldn’t possibly do on your own.
“With REITs, the investor gets a great deal of diversification,” says Robert R. Johnson, president and CEO of The American College of Financial Services in Bryn Mawr, Pennsylvania. “And unlike direct real estate investments, REITs are very liquid investments — that is, they can be bought and sold in a short period of time at a market-determined price.”
REITs can also offer built-in inflation protection, since property values tend to rise as inflation does, says Eric Meermann, certified financial planner with Palisades Hudson Financial Group in Scarsdale, New York.
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The National Association of Real Estate Investment Trusts, a trade group, lists 18 categories and sub-categories of REITs, including some pretty small niches like timberland, infrastructure holdings, data centers and those self-storage units. Sixteen categories own actual real estate, while two invest in mortgages.
Johnson suggests an ordinary investor consider keeping 10 percent of a portfolio in REITs, and he believes now is a good time to invest in equity REITs — the kind that own properties — because historically REITs have performed well when interest rates were rising, as many experts expect over the next few years. Mortgage-owning REITs tend to do poorly when rates go up, since investors shun older mortgage securities with stingy interest earnings, he says.
Scott Crowe, chief investment strategist for CenterSquare Investment Management of Plymouth Meeting, Pennsylvania, says that although the Federal Reserve is likely to raise short-term interest rates, long-term ones will remain low. That should make it inexpensive to fund real estate purchases, propelling prices upward.
“On a global basis, we currently prefer the U.S., where we see the strongest fundamentals and attractive valuations,” he says. Currently, his firm favors real estate investments in properties that will benefit from growing e-commerce, such as distribution warehouses and data centers. The same forces, however, could be damaging to traditional retail properties such as malls, so his firm favors retail centers anchored by grocery stores, which are likely to be immune from e-commerce competition.
Currently, a number of REIT categories pay dividends exceeding 3 or 4 percent, in some cases even more, according to NAREIT. That’s pretty generous compared to Treasury bonds or many dividend-paying mutual funds, but it does come with risks.
Last year, total REIT returns — dividends plus share price changes — wandered the lot, from gains of more than 40 percent for REITs that own self-storage units to a loss of more than 24 percent for ones specializing in lodging and resorts. The average REIT returned 2.83 percent.
What’s the downside? Unfortunately, REIT dividends are generally taxed at ordinary income tax rates, which for many investors are higher than the 15 percent rate on stock dividends.
“Despite the benefits of REIT exposure, a major drawback of REITs is that they are highly tax inefficient,” Meermann says. “Therefore, whenever possible, place your REITs in tax-deferred accounts such as an IRA or 401(k), or a tax-free Roth IRA.”
REITS can also be volatile, he says, noting that the ups and downs can be dampened by investing in a mutual fund that spreads the risk by owning a number of REITs. While there are some REIT-owning index funds, he prefers actively managed funds, believing the REIT market is not covered very thoroughly by analysts, allowing managers to spot bargains.
Among the most prominent REIT categories:
Industrial. This includes anything from warehouses to distribution centers to manufacturing space.
Office. These own office buildings, renting space to tenants. They typically specialize in cities or suburbs, or in buildings with certain types of tenants.
Retail. Retail REITs typically specialize in one of three major sub-categories: shopping centers, regional malls or freestanding stores.
Residential. REITs in this category typically specialize, owning apartment buildings, manufactured homes or single-family homes.
While some REIT investors make short-term bets, financial advisors generally caution against speculating on temporary price swings, in part because two REITs in the same category may behave differently because their properties are in different markets.
“Our firm’s approach is to build a long-term strategic allocation for our clients rather than engage in market timing,” says Rafia Hasan, director of investments at Wipfli Hewins Investment Advisors in Westchester, Illinois. “REITs have had a good run recently, and this may lead some to believe that now is not a good time to invest in REITs.”
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“However, the evidence shows that it is very difficult to make accurate predictions about which asset class will do well in the future,” she says. “For this reason, an investor should consider the role that REITs will play in her portfolio over the long term and whether it makes sense to include them, rather than fixating on the right time to get in or out.”
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4 Types of REITs for Investors originally appeared on usnews.com
