Despite surging 16% in 2019, REITs are not very well understood by the average investor. That’s a shame because they can be great investments. Legendary money manager David Swensen puts 20% of Yale’s $30 billion endowment into real estate. In Four Pillars of Investing, William Bernstein recommends allocating 15% of your portfolio to REITs.
REITs do come with a few cons: namely, tax-inefficiency and low-growth potential. But they can be a useful tool for investors who seek income or want to diversify their portfolio.
How do REITs Work?
You can buy REIT shares, the same way you buy shares in a corporation like Amazon.
Retail-focused REITs purchase malls and lease out storefronts to brands. Multi-family REITs will purchase apartments and lease them to families. Self-storage REITs will purchase storage facilities and rent the units out to people who need extra storage space.
REITs make money from collecting rent from their tenants. They then disperse this rent back to investors every year in the form of a dividend. Congress mandates that REITs distribute at least 90% of their profits back to investors, which is why REITs are great investments for people looking for income.
When it comes to REITs, one of the most important metrics is the yield. If you buy one share of Fake REIT Corp for $100 and you collect $10 in dividends in a year, then Fake REIT Corp has a 10% yield.
Net Asset Value
Dividends aren’t the only way shareholders get upside. A REIT’s share price can also increase. This brings us to the question, how are REIT shares priced?
Since the function of REITs is to own and lease properties, we value a REIT by its real estate portfolio. We estimate the market value of the properties using the NAV metric. The NAV is calculated by dividing the operating income generated by the properties by a cap rate that’s in line with the market.
Note: the share price of a REIT isn’t always equal to its NAV. REITs can trade at a premium or discount to its NAV. For the past few years, retail REITs have traded at a huge discount to their NAV because investors are afraid of the Amazon effect.
According to the FTSE US REIT Index, which tracks domestic REITs, from 1970 – 2018, REITs had 12% compounded annual returns. They outperformed the S&P by about 1% during this period. This tracks total returns, which include dividend payouts as well as stock price appreciation.
Pros of REITs
REITs Provide Income
On average, REITs have higher yields than stocks, since they are required to distribute 90% of their profits back to shareholders. While the S&P yields a paltry 1.92% (as of February 26, 2019), REITs averaged 4.03% in March 2019.
Non-traded REITs have Even Higher Yields
Non-traded REITs are REITs that aren’t listed on a public stock exchange.
One of the largest non-traded REITs, Blackstone’s BREIT yields 5.9%. Other “eREITs” like Realty Mogul and Fundrise yield between 6%-7% annually.
Before you chase high yields, you should keep in mind that non-traded REITs come with a lot of risks.
The trade-off for non-traded REITs’ higher yields is 1) lack of liquidity (there’s no market for you to sell your shares on 2) lack of transparency around corporate structure/fees 3) a history of high, hidden fees and paltry results
Improves Portfolio Returns
Imagine you have $100,000 to invest in 1994. Can you guess which of the three allocations will net you the highest return in 2018:
- Portfolio A is comprised of 100% US equities
- Portfolio B is comprised of 75% US equities and 25% REITs.
- Portfolio C is comprised of 50% US stock, 25% bonds, and 25% REITs.
After backtesting all three scenarios with Portfolio Visualizer, it turns out that Portfolio B (75% US equities and 25% US REITs) nets you the highest returns. Your assets would have grown from $100,000 to $995,000 with Portfolio B. That’s about $25,000 more than if you’d only invested in stocks.
Diversification is said to be the only free lunch in investing
By spreading your assets across different sectors and assets, you decrease the risk of any one slumping asset bringing down your whole portfolio. Better yet, you can decrease risk without lowering your expected return.
Adding exposure to real estate can help smooth your portfolio’s volatility since real estate is weakly correlated with stocks and bonds. A Wilshire report shows that from 1975 to 2017, REIT prices are 58% correlated with the US Large Cap Index.
In other words, it often happens that when stocks perform poorly, REITs perform well, and vice versa.
“Unless you have a crystal ball that tells you how the markets will move, it’s better to diversifying across different types of assets.”
For example, in the past twelves months ending January 2019, REITs way outperformed the S&P, yielding a 10.3% to the S&P’s -2.3% decline.
In the Four Pillars of Investing, William Bernstein highlights why it is important to hold US stocks and REITs by giving the following example:
In 1998, US large stocks did the best, but REITs lost a lot of money. Many investors got discouraged that year and sold their REITs. They were soon sorry because by 2000, stock returns were generally poor and REITs were the only stock asset with superlative returns. Foreign and US large stocks, which delivered excellent returns in the first two years took a nosedive in 2000.
Hedge Against Inflation
REITs are good investments during times of high inflation since they collect rent from tenants and rents rise with inflation.
Between 1974 and 1980, the average rate of inflation was 9.3%, much higher than the historical rate (1972–2017) of 4.0%. During this time, bonds yielded 8.4% from income, but prices declined by 2.7%, resulting in a total return of 5.6%—way short of inflation.
Stocks did outpace inflation during this time. They returned a total of 10%: five percent from dividend income and 4.8% from price growth.
But REITs bested both. REITs returned 17.9% for this time period.
The income return of REITs alone was 10.4%, higher than the 9.3% rate of inflation.
Cons of Investing in REITs
Leverage Can Backfire
REITs use leverage which is like gasoline, magnifying returns in both directions.
In 2008, a driving force behind the market’s dismal performance has been rising debt levels in many REITs.
Joel R. Bloomer, a senior equity analyst at Morningstar, told the NYT, “They took advantage of all the cheap credit that was once available and overextended themselves, often buying overvalued properties using excessive leverage.”
Don’t expect them to match Facebook or Google’s performance, REITs are not high growth stocks.
And that is by design.
Since they distribute 90% of the income back to investors every year, REITs trade off price appreciation for income.
“My optimistic prediction is that the better REITs and their Wall Street advisors will begin to effect an overall shift, from growth investors to value investors, who will enjoy the limited risk, steady cash flow and periodic undervaluation of REIT shares.” The Real Estate Game
And while some REITs have appreciated quickly (for example, data center REITs have been on a tear since 2008), don’t fall in love with high growth REITs. In real estate, chasing growth at all costs usually means speculating on appreciation or aggressively using leverage.
- Case Study
According to William Poorvu, author of The Real Estate Game, in the 1990s, REIT managers tried to stay competitive with growth stocks. Despite the fact that buying real estate traditionally returned 10% per annum, they set the REIT shares at a huge premium to the market value of the properties at IPO. This pressured managers running these REITs to continue to push for growth. They became more likely to buy on slimmer margins, or to go further out the risk curve in the type of quality of properties they buy. In an effort to satisfy the current Wall Street appetites and fads, they are more likely to take a short-term view.
Won’t Protect You in Times of Financial Disaster
However, REITs and stocks are not perfectly uncorrelated. In extreme recessions, they can move together.
In 2008, when the S&P 500 fell 36.6%, the index of equity REITs also fell 37.3%.
A 2012 study from Zhou and Anderson, Extreme Risk Measures for International REIT Markets, found that the timing of extreme market movements between REITs and stock indexes is almost perfectly in sync. They concluded the diversification benefits of REITs are sometimes not present when they are needed most.
How REITs are Taxed
Unlike dividend from companies AT&T, the dividends you receive from REITs are taxed at ordinary income rates, rather than capital gains rates. If you want to be precise, on average, 76% of the annual dividends paid by REITs qualify as ordinary taxable income.
There are a few exceptions:
- Return of Capital Distribution (taxed at capital gains rate): 10% of distributions will be a return of capital. This occurs when the REIT’s current distributions exceed its earnings. Most distributions in the early stages of a REIT will be a return of capital, simply because the REIT hasn’t had a change to purchase and lease properties yet.
- Long-term Capital gains: 14% of distributions qualify as long-term capital gains
The fact that REIT distributions are, for the most part, taxed at ordinary income rates means the effective return for high-wage earners will be much lower than the advertised yield.
For example, a person taxed in the top bracket in California receiving a 6% yield, actually receives an after-tax yield of 3.5%.
There are a few brights spots in the tax code for REIT investors:
- As we mentioned earlier, REITs aren’t double taxed. Unlike most corporations, REITs doesn’t pay corporate income tax as long as it distributes 90% of its taxable income.
- Depreciation is deducted from the REITs’ earnings, which shelters some income from tax.
- Trump’s 2017 Tax Cuts and Jobs Act gives REIT investors a 20% tax reduction on the pass-through income received. For an individual REIT shareholder, this 20% deduction means that the maximum effective rate on ordinary income from dividends is now 29.6% (37% x 80%).
- If you hold the REIT stock for longer than a year, the stock gains are taxed as long term capital gains.
How Much of Your Portfolio Should be in REITs?
- Bernstein (The Four Pillars of Investing) recommends a maximum of 15% of the equities portion of your portfolio be dedicated to REITs. In The Investor’s Manifesto (2010), he lowered that recommendation to 10% of the equity allocation.
- Famed institutional investor David Swensen, Chief Investment Officer at Yale, allocates at least 15% of his fund to real estate.
- Malkiel, author of A Random Walk Down Wallstreet, writes, “I think they deserve a place in all portfolios.” In the 5th edition of the book, he recommends allocating “15% to REITs to give some income growth to cope with inflation.”
- In the past decade, six major studies suggest that 20% should be allocated to REITs to best take advantage of their diversification benefits. Twenty percent is proportionate with the size of the investment real estate market.
REITs can provide income, liquidity, diversification, access to high-quality properties. If you would have diversified 25% of your portfolio into REITs in 1972 versus staying 100% stocks, you would’ve added 2% to your returns.