How to Invest in REITs: Should You Add Them to Your Portfolio?
Pros & Cons of Investing in REITs
As an asset class, real estate should be a part of every balanced investment portfolio. That's because real estate investments generally have a low correlation to stocks. When stocks zig, real estate typically zags. This provides your overall portfolio with stability. Financial advisors seem to agree that anywhere between 10% and 26% of your investments should be in real estate. In this article, we'll try to find out if you should choose REIT Investing as a long-term investment.
In this Guide
What are REITs (Real Estate Investment Trusts)?
Real estate investment trusts (REITs) are an alternative to buying real estate directly. They also offer some of the most attractive features of stock investing. REITs have been a popular investment since their creation in 1960. Think of a REIT as a pool of real estate assets traded freely on the stock market exchange.
Are REITs a Good Investment?
REITs are for those who want exposure to real estate but don't have the capital for direct investment, REITs can be a good choice for a financial plan. There are REITs that provide you with the ability to diversify across property types, geographic locations, and more. Plus, there are REITs that pay dividends, so they can be included in income portfolios.
The idea of REITs is that you have exposure to real estate without actually owning, directly, the property. (The discussion about whether REITs actually represent “owning” real estate, rather than just owning a stock, is one for another day.)
Just like real estate, REITs can invest in many categories and many geographical regions. Real estate is typically broken down into these categories:
- Industrial and Office
- Retail
- Residential
- Lodging and Resorts
- Health Care
- Self Storage
- Specialty
Some REITs also include:
- Storage Units
- Mortgages
- Malls
- A mix of investments.
Who Can Buy a REITs?
Buying REITs can be done by nearly any investor, regardless of portfolio size, because of their availability in mutual funds and ETFs. If you're just starting, consider a REIT Index Fund. There are many to choose from, including:
- iShares Cohen & Steers REIT ETF (ICF)
- Vanguard Real Estate ETF (VNQ)
- Vanguard Real Estate Index Investor (VGSIX)
Another option is to check out one of the crowdfunding platforms that offer REITs, like Streitwise or Fundrise. With Streitwise you can invest in private real estate deals with a minimum of $5,000, while Fundrise lets you invest in commercial real estate for just $500.
CrowdStreet is another crowdfunding option for accredited investors and has a $25,000 minimum requirement. It launched its own REIT as well, letting you invest in a diverse basket of commercial real estate holdings.However, not all crowdfunding platforms are REIT-centric. If you're an accredited investor with at least $100,000 to invest, you might be interested in the private equity firm Origin Investments. Origin offers investments into diversified and carefully-vetted real estate funds.
REITs & Liquidity
Liquidity can also be an issue. Because traded REITs (make sure you know the difference between traded and non-traded REITs) can be bought and sold like stocks, they are fairly liquid — unlike direct real estate, which can be difficult to sell quickly if you decide you need to. However, at the same time you do run the risk of losing quite a bit of money if the manager makes a poor decision, or if some of what's in the REIT tanks.
REITs Tax Benefits
The other aspect of REITs over owning real estate is taxes. Based upon the way they are taxed, REITs are best suited to be placed in retirement accounts. Though there is nothing preventing you from investing in REITs in taxable accounts.
Should You Invest in International REITs?
Including international investments in your portfolio can be a good way to add a layer of diversity to your strategy. REITs offer you the chance to add exposure to foreign real estate without the hassle of buying foreign property. This can be especially attractive to those who don't want to deal with some of the red tape associated with being a foreigner and buying a property in some countries.
REITs are generally fairly easy to invest in (they trade like equities on exchanges), and you can see benefits from dividends and improvements in real estate markets. You won't have direct control over the property, though, and you face the possibility of loss — just as you would with any other investment.
Further Reading: Should You Add ADRs to Your Portfolio?
Direct Investment vs. ETFs
If you decide to invest in foreign REITs, you will need to determine whether you will invest directly, buying the REITs on a foreign exchange, or whether you will use some other method of gaining exposure, such as an exchange-traded fund.
Keep in mind that you have special challenges when you invest directly in a foreign market. You face currency risk, possible liquidity issues, and risks associated with what might be an unstable political situation. Some investors, in order to mitigate some of these risks, choose to invest in ETFs that follow REITs. It is possible to invest in low-cost ETFs that offer accessibility to foreign real estate and international REITs. This can be an option for those who want diversity while limiting some of the risks.
What about Taxes?
REITs are not particularly taxed efficiently in general, and this carries over with international REITs. The dividends you receive are taxed as ordinary income, which means they are taxed at your highest rate. For some investors, that's a poor exchange for international diversity.
One way to offset the tax inefficiency is to hold your international (and domestic) REITs in a tax-advantaged account. You can keep these investments in a 401(k), IRA, or HSA. The earnings grow tax-deferred or tax-free (depending on the type of account you have, and whether you have a Roth version), and neutralize the tax problem.
Overall, international REITs can make a solid addition to your portfolio. Make sure you calculate your risk tolerance and determine whether or not adding exposure to foreign real estate will enhance your portfolio and help you reach your goals.
Pros & Cons of Investing in REITs
Investing in REITs and direct investment in real estate both come with advantages and disadvantages. In the end, you have to weigh the options and decide which better fits your style. Some investors prefer a mix of REITs and directly owned real estate. Others prefer one type over the other, for whatever reasons. Before you invest, though, make sure you know what you are doing, and understand the risks.
pros
- Guaranteed Dividends — REITs must payout at least 90% of their income as dividends. Management can raise the payout to more than 90%, but by law can't lower it below 90%. This requirement is the number one reason income investors buy REITs.
- Hassle-Free Real Estate Investing — REITs are a hassle-free way to own real estate. They're conveniently packaged into shares that can be easily bought and sold. There are also REIT mutual funds and ETFs (exchange-traded funds) that diversify by investing in many individual REITs.
- Low Minimums — You don't need a lot of money to start investing in a REIT. And owning a REIT index fund gives you exposure to the real estate asset class with very little money.
- Passive Investment — Directly owning and managing a property is a business and requires time and effort. REIT shareholders do not own the property or mortgages represented in its portfolio. As such, they also avoid the headaches many property owners and managers experience, such as maintaining or developing the property, providing landlord services, and collecting rent payments, to name a few. REITs truly are passive investing, like mutual funds.
- Low Stock Market Correlation — REITs historically have a low correlation to other asset classes. This makes it easy to create a diversified investment portfolio by adding REITs.
- Liquidity — Unlike owning property directly, you can quickly sell a REIT if you've made a mistake. Traditional real estate has a long enter-and-exit process, so your investment isn't liquid.
- Better Performance — While some REITs have historically experienced diminished performance when interest rates increase, many REITs outperformed other investments, even in the face of high-interest rates. And REITs often outperform other stocks in a slow economy.
- Mandatory Distributions to Investors — REITs are companies whose assets consist mainly of real estate holdings. This gives them favorable tax treatment. In exchange, they must distribute at least 90% of their income to unitholders. This pretty much guarantees payouts to investors.
cons
When you buy a REIT, you're becoming more of a real estate investor than a dividend stock investor, and there are potential risks to consider:
- Declining Value Properties — As we learned from the housing bubble that burst in 2007–08, real estate doesn't always go up in value. When choosing a REIT, be mindful of the growth prospects of the industries, property types, and geographical locations it is targeting.
- Fees and Markups — While REITs offer the advantage of liquidity, trading in and out of a REIT has a high cost. Most of the fees charged by a REIT are paid upfront. These fees are run roughly 20–30% of the value of the REIT. This takes a sizable chunk out of your potential returns. And because REIT prices are set in the public markets, they can trade at a significant premium to the real value of the underlying assets they hold.
- Potential Market Correlation — Some publicly traded REITs tend to be highly correlated to the broader stock market (most are not). This means that prices for some REITs can go up and down with corporate stocks, regardless of whether the underlying values of the properties within the REIT have changed. You'll want to be careful that the REITs you choose for your portfolio provide the diversification you're seeking.
- Gains Taxed at Ordinary Income Rate — As we mentioned, REITs have to pay out 90% of their income to their shareholders. This gives many REITs attractive yields. But unlike stock dividends, which are currently taxed at a maximum of 15%, REITs are taxed at your ordinary-income rate. So in most cases, you are best to invest in REITs in tax-deferred accounts like an IRA or 401(k) to minimize taxes.
- Inherent Potential Limited Growth — The 90% rule can limit a REIT's future growth. Because the government requires the company to distribute 90% of its income to unitholders, little capital is left over for acquiring or renovating new properties. Some REITs get around this limit by using debt (leverage).
Benefits of Directly Owning Real Estate over REITs
Direct investment in real estate does have some advantages, though. If you can put down a decent down payment, and you have the ability to manage the real estate effectively (or hire someone else to manage it), direct rental property can be a great asset. It is usually best to think of owning a rental property as an investment and business. It's not truly passive compared to owning a REIT, but the amount of direct work can be minimized.
When you own a property, you have more control over the investment. Additionally, you have something physical to fall back on. Even if the market tanks and the property loses financial value, the fact that you still have a tangible asset that you could live in (or on in the case of farmland), or use in some way, remains. As long as the property has tenants, you have a monthly income.
On the downside, though, directly owning real estate means you are responsible for it. You are in charge of addressing tenant problems, and you have to deal with trying to collect rent and choose tenants that aren't going to destroy your property or rip you off. (One way to avoid this is to invest in land that is just sitting there, and that you don't expect income from right away.)
Looking for a mortgage to buy your first home? Here are some interesting options:
In Summary
Real estate has proven to be an excellent long-term investment. Buying property often comes with a sizable monetary investment. REIT investing is a great alternative to owning real estate directly. They do have some disadvantages compared to owning real estate directly. But REITs are a natural (passive) way to gain exposure to real estate with very little money. REITs can add stability and diversity to your overall investment portfolio.
Related: Should You Invest in Bitcoin?
