Are REITs right for you?
A real estate investment trust, or REIT, is a type of investment that allows people to pool their money to invest in a collection of real estate assets. So, instead of going out and purchasing a property, fixing it up, and renting it out to tenants, you would simply invest in a REIT to take advantage of both the cash flows and capital appreciation it might offer, without all the hassle of going it alone. The fiduciaries of a REIT have incentive to pay out at least 90% of all the income the REIT generates to not be taxed as a corporation. That income flows through to the investor in the form of a dividend. You sit back, relax, and collect that income.
There are two types of REITs that are entirely different, so it’s important for investors to know which one (if any) is right for them. Equity REITs are the more traditional and stable REIT that most investors would be familiar with. The owners of this type of REIT would buy and usually operate everything from single-family homes to large shopping malls and industrial buildings. The lease payments from the tenants would count as the income that would be paid out to investors and the REIT would make money by retaining the 10% that is not paid out, along with any capital appreciation that would hopefully occur with the portfolio of properties. In contrast, mortgage REITs would tend to borrow at lower, short-term rates and buy at higher, long-term rates. Any spread from the two would become profit for the REIT. The risk involved with mortgage REITs is usually higher than equity REITs because more speculation on interest rates is associated with the former, whereas the latter is more focused on the income the underlying asset produces. Equity REITs would be more similar to a bond and mortgage REITs would be more similar to investing in options, where more leverage is used and more speculation is employed.
How REITs stack up, performance-wise
The best way to measure the performance of a REIT is to take a look at a particular index that would track it. For purposes of this article, we’ll discuss equity REITs. Keep in mind that the annual dispersion of returns for these indexes has ranged from 0.53% to 4.23% over the past twenty years.1 The five indexes that we’ll examine are the Dow Jones, FTSE, MSCI, S&P, and Wilshire. For 2017, if you took the average of these five indexes, your equity REIT would have returned 5.7%. In comparison, the S&P 500 index returned 21.14%, with dividend reinvestment. Of course, not all years will end up like 2017. If we look at the average return of an equity REIT from 2002 to 2016, U.S. REITs returned 12.84%, the highest average among the other asset classes listed in the figure below.2 Global REITs weren’t far behind, returning on average 12.62% over the period. In comparison, large cap stocks returned about 8%.
Figure 1: Total returns by asset class, 2002-2016
REITs, just like any other asset class, have had their bad years. In 2008, the average REIT lost 38% in value; however, had you stuck with the investment for the two years after the Great Recession, you would’ve seen a bounce back of about 28% for both years, essentially erasing the losses in 2008. As avid long-term investors, we’d advise against jumping in and out of REITs as the year-to-year fluctuations can be substantial. A good historical benchmark is to look at REITs over a 10-20 year period, and if you do that, on average, a well-performing REIT should return in the high single digits.
Perhaps one of the most important reasons that REITs manage to attract large amounts of capital is because of the low correlation to the stock market. For example, when the stock market lost 9% in 2000, real estate investment trusts were up 34%, on average. This inverse correlation has changed slightly with the introduction of REITs to the S&P 500 in 2001, but the correlation is still below 1, meaning the two are still not moving in unison. The addition to the S&P, though, did create an environment where stocks and REITs move more in tune with one another. In 2004 the average correlation between the two was 0.44; a decade later it was 0.79.3
Investing should never be an all or nothing mindset. Diversification should be the hallmark of an investment strategy aimed at creating real wealth over time. Having an equity or mortgage REIT in your portfolio will likely protect against the occasional dips the stock and bond markets might experience over time. It will also add an element of income streams to your portfolio in the form of regular dividends that these REITs pay out to retain and attract new investors. Real estate is a good asset class to invest in, and REITs make it possible to enjoy all the benefits without getting your hands dirty yourself.
3. Correlation Building Between REITs and Other Stocks. Morningstar. October 8, 2015