Real estate is an asset class that investors can use to further diversify that provides plenty of upside growth potential and income too. The easiest way to gain access to real estate, without having to become a property owner outright and manage and maintain buildings, deal with tenants and collect rent, is via real estate investment trusts (REITs). REITs trade like stocks on major exchanges and the sector includes rental real estate, office buildings, malls etc. There are plenty of advantages to owning REITs so let’s examine the most obvious reasons to include them in your portfolio.
Advantages:
- REITs offer access to real estate ownership that you might otherwise not be able to have. Through a publicly-traded REIT you can own a piece of shopping malls, residential real estate or apartment complexes in a certain region in the U.S. or even get real estate exposure abroad.
- No management or maintenance duties. Owning a REIT allows you to have access to rental real estate without the hassles of dealing with tenants, upkeep, management, tax and depreciation considerations, illiquidity etc.
- REITs are required by law to pass through 90% of their rental income to you. As a REIT owner you not only have an investment that can grow over the years, but you also receive excellent cash flow.
- REITs have historically offered some diversification away from stocks. In vicious bear markets REITs may become highly correlated to stocks (when all asset classes decline), but in normal markets they will show some non-correlation to stocks, which can help smooth out the returns of the entire portfolio.
- REITs can offer access to diverse real estate sectors. Owning an index of REITs or a broad-based individual REIT portfolio allows you to have access to very diverse real estate sectors that would otherwise be impossible. Again, you can have access via mutual funds, index products like ETFs or individual securities.
- REITs typically offer higher yields than stocks. Since REITs are required to distribute 90% of their income to shareholders, they typically offer higher yields and more current income than most stocks.
- REITs offer stable, consistent income. REITs offer steady income and many have a history of raising dividends consecutively, at least 5 years or more.
Disadvantages:
- Not enough diversification away from stocks. In times of illiquidity or during a bear market, REITs often move like stocks and decline just as much as equities. So, the added diversification benefit may at times not be helpful or apparent.
- REITs, like stocks or bonds, can become quite overvalued. When REIT income is low relative to prices, be careful. While REITs are usually considered a high yielding asset class, if prices have increased dramatically and yields are low, there is a good chance REITs are overvalued and are overdue for a correction in pricing. When this is the case, be careful and focus on risk control.
- Income from REITs doesn’t receive a preferential tax rate. REIT income doesn’t fall under the same qualified rate as dividend income from stocks. So, the taxes you pay are typically higher for REITs. REIT income is typically taxed as ordinary income – same as bond interest, which is usually much higher than the rate paid on qualified stock dividends.
- REITs can be difficult to value. REITs are challenging to value for many investors since price-to-earnings ratios are not as relevant for this asset class. Some use the FFO payout ratio as a benchmark to determine valuation – this is the Funds from Operations payout ratio. Looking at the current yield, rather than price-to-earnings ratio, can give a more accurate valuation since REITs are required to distribute nearly all of their income to shareholders.