REITs (pronounced “Reets”) are companies that invest in real estate, like shopping malls, apartment complexes, office buildings, medical facilities, and other types of commercial real estate, and pay out dividends to shareholders.
Our preferred way to buy REITs is within a mutual fund or exchange traded fund, so with one purchase, we can own a broad portfolio of real estate properties, covering several geographic areas and real estate types. That diversification can protect you from overexposure if one type of real estate (say, outlet malls) or one region (for example, the Sunbelt) is doing poorly.
Why invest in REITs?
So why do we like to invest in REITs?
- REITs have traditionally paid above-average income.
- REITs are good portfolio diversifiers.
- REITs have offered solid performance over the years.
But even seasoned investors have some misconceptions about REITs that may make them shun this attractive asset class.
Here are some of the most common myths about REITs.
Myth #1: REIT prices move up and down with housing prices
After the housing market crashed, I had clients say that they didn’t want to own REITs in their portfolio, because real estate looked like such a bad investment.
But it’s important not to confuse the residential housing market, like the house you live in, with the commercial real estate market that REITs invest in.
REIT investment returns don’t have much in common with residential real estate movements.
Professor Michael Finke of Texas Tech says there is virtually no correlation between various REIT indexes and residential housing prices, as measured by the Case Shiller housing price index.
That’s not that surprising. No one would expect your home’s value to have much in common with the value of self-storage units, or a nursing home, or a strip mall, in your town.
Myth #2: REIT prices move in tandem with interest rates and bonds
If you mention investing in REITs, many people will say “No way. REITs will get killed when rates go up.”
Not so fast.
Believe it or not, REIT prices don’t really move in sync with bonds or interest rates. “REITs aren’t that sensitive to rising rates because managers have the power to raise rents,” says Finke.
Surprisingly, REIT returns have actually remained positive during the five periods of rising interest rates since 2002, points out Finke. During three of these rising rate periods, REITs performed better than stocks.
So don’t assume that REITs will face more problems than other investments when rates rise.
Myth #3: REITs no longer pay much income
Real estate investment trusts are required to pay almost all (90%) of their taxable income to shareholders each year. Over the longer term, REIT dividend yields have reached as high as 7% to 8%.
“At the height of the boom in technology stocks, the blue-chip S&P 500 Index was generating a yield of around 1%, while REITs were averaging payouts of about 9%,” says investment advisor William Bernstein, in a Wall Street Journal interview.
Even in today’s lower-income environment, most REITs pay from 3% to 5%, more than your typical stock investment.
Even better, REIT payouts tend to rise with time, making them effective inflation-fighters in your portfolio.
Myth #4: REITs are too correlated with stocks to provide portfolio diversification
The correlation between REITs and stocks is still low enough to provide diversification advantages. “From 1980 through 2006, (REIT prices) moved in tandem with the broader market only 47% of the time,” says the Wall Street Journal.
However, correlations have tightened up since the recession. When stocks go down, REITs are likely to go down too, leading Professor Finke to observe that “REITs are certainly not a hedge against a bear market for equities.”
Myth #5: REITs are stodgy performers
REITs aren’t ready for the rocking chair on the porch quite yet.
In the twenty year period from 1982 through 2012, REITs actually outperformed both the Dow Jones and S&P 500 stock indexes on a total return basis, albeit with a rockier ride.
By the way, that increased volatility is one reason to include REITs in your portfolio, but keep their percentage weighting within reasonable limits.
Myth #6: REITs lack liquidity
It is true that non-traded REITs, those favored by brokers who sell them at a steep mark-up, lack liquidity, as there is no organized market to buy and sell.
But the REITs that we prefer, and most investors use, are packaged inside mutual funds and ETFs. They are highly marketable and can be bought or sold on any day the market is open. After a sale, you’ll receive your funds promptly.
So what’s the verdict?
REITs have provided strong returns historically and are a good complement to stocks and bonds, says Finke.
Including REITs in your portfolio can definitely improve your risk-adjusted portfolio performance. That’s investment jargon meaning that you can achieve better returns for the same level of risk.
Like all other growth-and-income investments, REIT prices can go up and down, so you need to plan on investing for the longer-term, paying attention to valuations and how the asset is priced when you buy.
Best of all, REITs give you access to professionally-managed real estate without the 3 a.m. phone calls about broken toilets or noisy neighbors. What’s not to like?