In a bull market, stocks reign supreme, but the shift from highs to lows can happen in the blink of an eye. Although bonds and U.S. Treasurys can be a buffer against volatility, that safety often translates to diminished returns when interest rates rise.
So where does the middle ground between risk and reward lie? The answer is real estate, according to a joint paper from researchers at the University of California-Davis, University of Bonn and Germany’s central bank, Deutsche Bundesbank.
The paper found that over 150 years, from 1870 to 2015, housing delivered an average annual return of 7.05 percent, compared to 6.89 percent for stocks and 2.5 percent for bonds in 16 now-wealthy countries, including the U.S. Over that same period, housing carried approximately half the risk of stocks.
[See: The 10 Best REIT ETFs on the Market.]
Housing can offer stability and above-average returns, but owning individual rental properties is cumbersome for investors. A real estate investment trust, on the other hand, provides those same benefits in a streamlined package. REITs may look especially attractive to investors who are conscious about risk and return in today’s market environment.
Tax reform is on your side. The Tax Cuts and Jobs Act includes several provisions that are advantageous to investors in general and real estate in particular. Some of the changes included in the new tax law directly affect REITs.
For instance, the standard corporate structure of REITs means they’ll benefit from new deductions, like the 20 percent deduction on pass-through entity income, says Daniel Milan, managing partner of Cornerstone Financial Services in Birmingham, Michigan. Additionally, REIT dividends have been excluded from the wage restriction, which ordinarily caps deductions for pass-through businesses.
“While most taxpayers will not be able to deduct business interest expenses beyond 30 percent of earnings before interest, taxes, depreciation and amortization, REITs are able to opt out of the new rule,” Milan says. A final benefit of REITs worth noting is the repeal of the rule stating that partnerships would be terminated if 50 percent or more of the interests in its profits and capital were sold or exchanged within one year. “This all leads to more benefits for REIT investors, and especially those focused on income from REITs, as it would be reasonable to expect income to increase.”
Scott Crowe, chief investment strategist at CenterSquare Investment Management in Plymouth Meeting, Pennsylvania, says tax reform is set to have a ripple effect on real estate as a whole. “Not only does the new tax bill allow 20 percent deductibility of ordinary REIT dividends, it’s also very positive for underlying real estate markets as real estate becomes one of the only investments still able to enjoy the full deductibility of interest.”
The tax changes may appeal strongly to investors looking to increase both diversification and income from REITs. Allen Shayanfekr, CEO and co-founder of online real estate investment platform Sharestates, points out that less tax means more profit for shareholders. “The investors that stand to benefit the most are those that can most easily access the most stable and well-vetted REITs.”
Stocks may be overvalued. The Shiller price-earnings ratio is a benchmark for measuring stock valuations. The ratio, which is typically applied to the Standard & Poor’s 500 index, has been on a steady upward climb since bottoming out during the 2008-09 financial crisis. The ratio has since surpassed the high reached just before the 1929 stock market crash, leading many investors to question whether valuations are realistic. REITs, by comparison, may look like a bargain.
[See: 9 ETFs That Go Up When the Market Goes Down.]
According to the National Association of Real Estate Investment Trusts’ 2018 REIT Outlook, REITs were largely overlooked and undervalued in 2017. REITs generated total returns of 9.27 percent, according to the FTSE Nareit All U.S. REITs index, continuing a trend of consistent returns year-over-year. Those returns, however, were lost in the shuffle compared to the S&P 500’s 19.42 percent return.
As stocks continue to climb, REITs may represent a buying opportunity for investors. The question is how valuations and performance may be affected if the Federal Reserve moves ahead with additional interest rate hikes this year. “The relationship between REITs and interest rates is generally an inverse one,” Shayanfekr says, “so REITs are particularly sensitive to changes in interest rates.” If rising rates drive valuations down, investors can hedge against that by choosing a REIT with a high yield.
Investors should also consider how the Fed’s decision-making will influence the stock market in the long run. Crowe says that while the current bull market is aging, it could extend into the 2020s “because of the Fed’s hesitancy to flatten the yield curve, coupled with a late-cycle boost of fiscal stimulus.” He says a mild recession is expected once the market cycle changes direction, but he believes “real estate will remain resilient during the next downturn because it has the benefit of emerging from the last cycle with much more attention to risk.”
Crowe also points to a decreasing correlation between stock and REIT returns over the last five years, “which makes REITs a great diversification play for investors who are concerned about all-time highs in the equity markets.”
Certain REIT sectors are poised for growth. Some REIT sectors may outperform others, creating opportunities for real estate investors to benefit. John LaForge, head of real asset strategy for Wells Fargo Investment Institute in Sarasota, Florida, says investors should consider growth potential when adding REITs to their portfolios. When rates are rising, it’s also important to pay attention to the size of the company and its financial strength. “In the past, when long-term interest rates have been rising, larger-cap REITs with strong financial positioning performed better than their smaller-cap counterparts with relatively weak financials.”
Investors also should consider the overall market forecast. If you believe a correction is imminent, for example, LaForge says health care REITs could be a good bet, as the sector is classically defensive against stock market corrections.
Crowe says that technological innovation and demographic trends especially drive REIT sector growth. On the commercial side, there may be increased demand for technologically sophisticated offices and warehouses. Urbanization is creating opportunities in multifamily housing to meet a changing pattern of demand. Single-family housing may also benefit from increased rental demand and a lack of affordable housing options. “The sectors which have benefited from these secular demand drivers are expected to produce outsize growth over 2018.”
[See: 7 of the Best Health Care Stocks to Buy for 2018.]
The REIT’s underlying assets ultimately will determine its return. “Performance of REITs highly depends on the quality of the asset they’re tied to,” Shayanfekr says.
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3 Reasons to Revisit REITs in 2018 originally appeared on usnews.com
