Are REITs a Good Investment? A Brief Lesson in Diversification
Long before Modern Portfolio Theory proved the benefit of diversification, “Don’t put all your eggs in one basket” was practiced. Intuitively, it makes sense to spread your income and investing risk around. The rationale behind diversification and asset allocation is that when one asset goes down in value, another may go up. Spread your investments and risk around and you’ll decrease the volatility of your returns.
For example, invest only in one stock market mutual fund and when the stock market falls 20% in a bad year, so do your investment returns. Add a bond mutual fund to the stock fund and even if the returns on the stock fund fall, the bond fund’s returns might go up 15% and make your total portfolio value more stable. Add real estate to the mix and the added diversification, and lower correlation with the other asset classes increases returns and lowers overall risk of your portfolio.
By adding various asset classes to your investment portfolio your portfolio risk declines and return improves.
What is a Real Estate Investment Trust (REIT)?
” REITs earn a share of the income produced through real estate investment – without actually having to go out and buy or finance property.”
REIT.com
So, you want to add real estate to your investments but don’t understand the whole real estate investment company idea.
According to REIT.com, a real estate investment trust is comprised of many companies, similar to a mutual fund, that own or finance income-producing real estate. There are two general varieties, Equity REITs and Mortgage REITs.
Equity REITs own real property, while mortgage REITs are actually debt instruments and own various types of real estate mortgages and loans. Drilling down, there are many distinct types of REITS from office, industrial, lodging, self-storage, infrastructure, mortgages, diversified and more. Due to the vast choices in real estate, investors can choose to invest in a specific type of REIT, like a mortgage REIT, or go with a broadly diversified fund with many types of real estate holdings.
I’ve invested in both bricks and mortar real estate and REITs and I’m a fan of REITs.
REIT dividends provide steady cash flow and allow you to sleep at night. You’re not going to get a tenant calling at 2 am with a broken pipe. When investing in the Vanguard Real Estate ETF (VNQ) fund you won’t worry when a tenant moves out before the lease is up.
Investing in a real estate fund is as easy as reviewing a list of available funds and clicking “buy” at your online discount brokerage account. But before you rush out to invest, check out the advantages and disadvantages of REIT investing.
Types of REITs
The benefits of investing in REITs include income, capital gains, and capturing assets in a niche corner of the market.
As an investor, I’ve bought broadly diversified real estate investment trusts in the U.S. and abroad. You might prefer to invest your money in specific types of property like storage or office buildings.
The types of real estate trusts might spark an interest in shares in an area you believe is poised to grow.
Most investors will buy and sell equity and mortgage REITs. Equity REITs are more common than mortgage REITs. Although there are also privately traded and non-listed REITs, typically for wealthier investors.
Here is a list of the types of REIT investments you might consider from various sectors:
OfficeIndustrialRetailLodgingResidentialTimberlandHealthcareSelf StorageInfrastructureData CentersMortgageDiversified
REIT Index Mutual Funds and Exchange Traded Funds (ETF)
The best REITs for long term investors can be found on the NAREIT website. You’ll find nearly 200 different types of real estate investment trusts. This is also a great site to learn.
Here is a list of several broadly diversified national and international REIT mutual funds and ETFs. These are some of the best long-term REITs to gain exposure to a wide swath of the real property market.
VGSIX-Vanguard U.S. REIT Index Mutual FundVNQ-Vanguard U.S. REIT Index ETFRWR-SPDR Dow Jones Index REIT ETFVNQI-Vanguard Global ex-U.S. Global Real Estate ETFFGL-iShares Developed Real Estate (ex-U.S.) ETF International Fund.RWX- SPDR Dow Jones International Real Estate exchange-traded fund.
REIT Example – VNQI
The Vanguard Global ex-U.S. Real Estate ETF (VNQI) is a path to becoming an international real estate mogul. Well, almost. This REIT is a handy way to own real estate stocks in more than 30 countries.
You can count on Vanguard REIT funds to offer low-cost diversification.
With a 7.49% yield, passive investors seeking cash flow might benefit from the fund, with a rock-bottom 0.12% expense ratio. Recent lackluster performance may turn around as developing nations and other international real estate growth rebounds.
VNQ companies are distributed across the globe:
20.4% Emerging Markets
26.20% Europe
47.50% Pacific
1.0% Middle East
2.20% North America
2.70% Other
Pros of REIT Investing
REITs provide an income stream as they are required by law to pay out at least 90% of their income in dividends. Although there are some REITS that circumvent the 90% rule.REITs have a long track record of growing their dividends.The properties owned by REIT companies can appreciate in value over time, thus growing your initial investment.REITs are professionally managed, to get the greatest returns on the individual properties.REITs provide diversification to a stock and bond portfolio and can curb portfolio losses should stock prices fall.REITs are easy to buy and sell through your online investment account. My spouse even invests in a REIT fund in his 401(k).
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Cons of REIT Investing
REIT investment risk might depend upon the type of properties you’re invested in. For example, mortgage REIT returns could suffer if interest rates are high and fewer investors are taking out mortgages.As interest rates rise, financing real estate will become more expensive and borrowers will pay higher interest costs. This can put a damper on broadly diversified REIT investment returns.REIT fund values go up and down, like most securities. Imagine that you buy a Vanguard REIT fund like VNQ for $76.00 per share and a 3.0% yield. If the price falls, your investment will be worth less. You’ll still receive your dividend payment, but the total value of your investment will decline.Although you typically earn a juicy dividend on your real estate assets, you’ll have to pay taxes on those dividends, typically at a higher rate than the 15% levied on most dividends. This is because most REIT income is considered ordinary income, although this varies by REIT.
Bonus: Should I pay off my mortgage or invest in the stock market?
FAQ
How do REITs make money?
REITs make money from rent they receive. They also make money when they sell real property for a profit.
Can you lose money in a REIT?
Yes. Like most investments, if the share price goes down, and you sell your investment, then you would lose money. When investing, it’s best to own various asset types, so that when one falls in price, others will remain steady or increase.
How is REIT income taxed?
REITs send IRS Form 1099-DIV to their shareholders. The form breaks down the dividend distributions into ordinary income, capital gains, and return of capital. Investors pay taxes according to their tax rate for each category of income.
How much do REITs pay out in monthly dividends?
REITs pay out roughly 90% of their taxable earnings. The actual REIT payout ratio depends upon how those earnings are calculated.
Are REITs a Good Investment? The Takeaway
You diversify your investments because you don’t know which financial assets are going to shine and which ones will lag. Even if REITs aren’t the best stocks in the next year or two, over the long haul, they’ve proven to be a solid way to invest in real estate and grow your financial net worth.
My family investment portfolio includes REIT shares and has for decades. Like any investment, REITs have pros and cons. Although, there’s really little reason not to invest in REITs in a diversified portfolio.
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Disclosure; I own VNQ, VNQI and have an account at M1 Finance.
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