Are REITs a Good Investment? A Brief Lesson in Diversification
Long before Modern Portfolio Theory proved the benefit of diversification, the concept of “Don’t put all your eggs in one basket” was widely practiced. It is logical to spread your income and investing risk to minimize volatility. Diversification and asset allocation aim to balance the ups and downs of different assets, reducing overall risk.
For instance, if you invest solely in a stock market mutual fund, your returns will mirror the market’s performance. But by adding a bond mutual fund to the mix, the bond fund’s returns can offset losses in the stock market during tough times, making your portfolio more stable. Incorporating real estate further diversifies your investments, enhancing returns and lowering overall risk.
By diversifying your investment portfolio across various asset classes, you can decrease risk and potentially improve returns.
What is a Real Estate Investment Trust (REIT)?
“REITs earn a share of the income produced through real estate investment – without actually having to go out and buy or finance property.”
REIT.com
If you’re looking to include real estate in your investment portfolio but are unfamiliar with real estate investment companies, REIT.com defines a real estate investment trust as a pool of companies, akin to a mutual fund, that either own or finance income-generating real estate. There are two main types: Equity REITs and Mortgage REITs.
Equity REITs possess real estate properties, while Mortgage REITs deal in debt instruments, holding various real estate mortgages and loans. Within these categories, there are numerous REIT types, including office, industrial, lodging, self-storage, infrastructure, and more. Investors can opt to invest in a specific REIT type or choose a diversified fund with varied real estate holdings.
Having invested in both physical real estate and REITs, I personally favor REITs.
REIT dividends offer consistent cash flow, eliminating concerns like late-night tenant calls for maintenance issues. Opting for a fund like Vanguard Real Estate ETF (VNQ) ensures peace of mind even if a tenant vacates before the lease ends.
Investing in a real estate fund is straightforward – you can browse available funds and make purchases through your online brokerage account. However, before diving into investments, it’s crucial to weigh the pros and cons of REIT investing.
Types of REITs
Investing in REITs offers income, capital gains, and exposure to niche market segments.
As an investor, I’ve ventured into broadly diversified real estate investment trusts both domestically and internationally. Some may prefer focusing on specific property types like storage facilities or office buildings.
Exploring different real estate trust types might catch your interest in sectors poised for growth.
The majority of investors engage with equity and mortgage REITs, with equity REITs being more prevalent than mortgage REITs. Additionally, there are privately traded and non-listed REITs, typically catering to affluent investors.
Here are various sectors of REIT investments to consider:
- Office
- Industrial
- Retail
- Lodging
- Residential
- Timberland
- Healthcare
- Self Storage
- Infrastructure
- Data Centers
- Mortgage
- Diversified
REIT Index Mutual Funds and Exchange Traded Funds (ETF)
The best REITs for long-term investors can be explored on the NAREIT website, offering nearly 200 different real estate investment trusts. This platform also serves as a valuable learning resource.
Below are several broadly diversified national and international REIT mutual funds and ETFs worth considering for long-term investment:
- VGSIX – Vanguard U.S. REIT Index Mutual Fund
- VNQ – Vanguard U.S. REIT Index ETF
- RWR – SPDR Dow Jones Index REIT ETF
- VNQI – Vanguard Global ex-U.S. Global Real Estate ETF
- FGL – iShares Developed Real Estate (ex-U.S.) ETF International Fund
- RWX – SPDR Dow Jones International Real Estate exchange-traded fund
REIT Example – VNQI
The Vanguard Global ex-U.S. Real Estate ETF (VNQI) offers exposure to real estate stocks in over 30 countries, making it a convenient option for international real estate investments. Vanguard REIT funds are known for their low-cost diversification.
With a 7.49% yield and a minimal 0.12% expense ratio, passive investors seeking cash flow may find this fund beneficial. Despite recent underperformance, the fund’s fortunes might reverse as international real estate growth rebounds.
Companies within VNQ span across various regions:
20.4% Emerging Markets
26.20% Europe
47.50% Pacific
1.0% Middle East
2.20% North America
2.70% Other
Pros of REIT Investing
- REITs guarantee an income stream since they are mandated to distribute at least 90% of their income as dividends, although some REITs may bypass this rule.
- REITs have a proven track record of increasing dividends over time.
- Real estate properties owned by REIT companies can appreciate in value, enhancing your initial investment.
- Professional management of REITs maximizes returns on individual properties.
- REITs offer diversification to a stock and bond portfolio, potentially mitigating losses during market downturns.
- Buying and selling REITs is convenient through online investment accounts, even available in 401(k) plans.
Compare Robinhood vs M1 Finance to determine the ideal platform for your financial goals.
Cons of REIT Investing
- REIT investment risk varies based on the property types in your portfolio. For instance, mortgage REITs might suffer during high-interest rate periods with reduced mortgage uptake.
- Rising interest rates increase real estate financing costs, impacting broadly diversified REIT returns.
- REIT fund values fluctuate like other securities. If you purchase a Vanguard REIT fund at $76.00 per share with a 3.0% yield and its price drops, your investment value decreases, despite receiving dividends.
- While real estate assets offer attractive dividends, they are subject to higher tax rates than traditional dividends. Most REIT income is classified as ordinary income, subject to varying tax rates.
Bonus: Should I pay off my mortgage or invest in the stock market?
FAQ
How do REITs make money?
REITs generate income from rent payments and profits from selling real estate properties.
Can you lose money in a REIT?
Yes, similar to other investments, if REIT share prices decline and you sell, you may incur losses. Diversifying across asset classes can help mitigate losses during market fluctuations.
How is REIT income taxed?
REITs issue IRS Form 1099-DIV to shareholders, detailing dividend distributions as ordinary income, capital gains, and return of capital. Shareholders are taxed based on their applicable tax rates for each income category.
How much do REITs pay out in monthly dividends?
REITs typically distribute around 90% of their taxable earnings as dividends, with actual payout ratios subject to earnings calculation methods.
Are REITs a Good Investment? The Takeaway
Diversifying your investments is key to mitigating risk and maximizing returns, as predicting the top-performing financial assets is challenging. While REITs may not dominate the market in the short term, they have historically offered a reliable avenue for real estate investment, contributing to financial growth.
REIT shares have been a longstanding component of my family’s investment portfolio. Despite the inherent pros and cons of REITs, there is little reason not to include them in a diversified investment strategy.
Related
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- REITs and Crowdfunding – How to Invest
- EquityMultiple Review – Is This Crowdfunding Platform for You?
- Fundrise vs REITs – Which is Best?
Disclosure: I own VNQ, VNQI, and have an account at M1 Finance.
Disclosure: This article may contain affiliate links, which means I may earn a commission if you sign up or make a purchase through the affiliate link, at no extra cost to you. Rest assured, I only recommend products I personally find valuable.
