Direct real estate should be part of every balanced portfolio because it can generate healthy returns through rental income, tax advantages and capital appreciation. However, direct real estate tends to tie up cash for long time horizons and can require a lot of work or trust in a third-party manager. However, publicly-traded real estate investment trusts (“REITs”) are a way to gain exposure to real estate and potentially earn higher returns.

Public REITs are companies that are traded on national securities exchanges, and these companies pool capital from many investors to own portfolios of income-producing commercial properties that would likely otherwise be out of an individual investor’s reach. REITs typically vary in focus. They can have equity investments in a wide variety of properties (from multifamily and office buildings to hospitals, shopping centers, hotels or even land) or may lend money to real estate buyers though debt instruments such as mortgages, mezzanine loans and preferred equity structures.

Past performance shows that public REITs have outperformed the broader S&P 500 on an absolute and risk-adjusted basis over the last 40 years.1 Better yet, they yield a healthy passive income stream because by law they must pay 90% of their earnings as dividends, a benefit for investors who need cash for expenses. The FTSE Nareit All Equity REIT Index yielded dividends that averaged 92% more than those generated by the S&P 500 between 2009 and 2018, according to Bloomberg data.Its 20-year total return average from 1998 to 2018 also averaged 12.55 percent compared to 7.73% for the S&P 500.

20 year average annual total return
Source: Nareit, REITWatch®, Page 18, December 2018.
https://www.reit.com/sites/default/files/reitwatch/RW1812.pdf

These numbers make REITs a wunderkind of the investment world, yet J.P. Morgan data shows that the average investor only generated 2.6% in returns between 1998 and 2017, which suggests many investors may have overlooked this asset class.

20-year-ann-returns-by-asset-class-1999-2018
Source: JP Morgan, Guide to the Markets®, Page 64, June 30, 2019.
https://am.jpmorgan.com/blob-gim/1383407651970/83456/MI-GTM_3Q19.pdf

But like every investment, public REITs have pros and cons. Here are some to consider before investing in public REITs:

Pro: Liquidity. Public REITs are traded directly on major stock exchanges, so they’re typically liquid investments. Like stocks and bonds, they can generally be bought or sold in a day. Many investor portfolios need liquidity to fund living or educational costs, pay emergency expenses or meet capital commitments made to private investments. Public REITs allow investors to participate in real estate without necessarily locking up their assets for extended periods.

Con: Volatility. Liquidity has a downside—public REIT share prices can generally go up and down the same way stocks do, even when the value of a public REIT’s underlying properties may be stable. This has the potential to introduce volatility to a portfolio depending on what other assets are held. Investors must be prepared to handle the daily ups and downs, although other factors in the equity markets also affect the price volatility of REITs.

Pro: Passive income. To comply with favorable tax regulations, REITs must distribute at least 90 percent of taxable income to shareholders annually as dividends, which creates yields typically ranging between 2% and 10%.  The distributions can reduce or even fully eliminate their corporate taxable income and maximize passive income. REITs follow the same valuation and accounting rules as corporations. Dividends “pass through” as ordinary income on investors’ personal income taxes. Today, the Tax Cuts and Jobs Act (which went into effect January 1, 2018) has made public REITs an even better investment by extending a 20% deduction to pass-through income. This effectively lowers the 37% top rate on public REIT dividends to 29.6%.

The frequently high proportion of profit paid to shareholders as dividends makes REITs comparable to dividend stocks such as energy, utility or telecommunications companies because mature industries are more likely to return high dividends rather than retain earnings to grow their businesses. Investors looking for passive income streams usually hold these stocks, which pay qualified dividends that are taxed at lower capital gains rates.

Con: Higher taxes than stocks that pay qualified dividends. Investors often pay more tax on passive income from public REITs than from dividend stocks because the American Taxpayer Relief Act of 2012 capped taxes on qualified dividends at a low 20%; the rest is taxed as ordinary income or at different rates because distributions can be ordinary income, capital gains or return of capital. Despite this, investors still come out ahead in many cases (see below).

Pro: Higher total returns. Despite typically higher tax rates to the investor, public REITs can be a better deal because REIT income goes directly to shareholders who pay lower tax rates rather than taxes being paid to the government at the corporate level, such as by utilities or telecom, which must be paid first, reducing what’s left to pay shareholders. This can help REIT stocks outperform dividend-yielding equities over an extended period. 2

To demonstrate the after-tax advantage, take a dividend stock like Verizon, with a 4.25% dividend yield on August 19, 2019, as tracked by Dividend.com. A 20% tax would trim a $425 dividend on a $10,000 investment to $340. Meanwhile, a $10,000 investment in the diversified Brookfield Property REIT draws a 6.82% dividend yield as of August 19, 2019. Even at a 29.6% tax rate, the REIT dividend returns a higher dividend: a $682 dividend from a $10,000 stake brings an effective $480 return. This example makes it clear that investors should evaluate total returns.

Con: More taxes. At the end of the day, REIT investors can pay more in taxes, but it is possible to still earn more money.

Pro: Greater price stability. A great positive is the intrinsic value of the property, which can provide capital appreciation along with income. REITs hold tangible assets that retain a fairly constant net asset value. While short selling or other daily trading pressures can push REIT share prices below their net asset value, market momentum can work the other way too, lifting share prices beyond the value of the underlying assets. But overall, the real estate’s intrinsic value tends to keep price swings in a narrower range and over multiple years the higher yields make up for price volatility. REITs draw a higher return for the same risk—or the same return at lower risk. As a result, REIT values typically correlate more closely with the real estate market than the stock market over the long term.3

Con: Finding recession-resistant REITs. While there are plenty of recession-resistant public REITs, finding them takes substantial due diligence. Public REITS have shown positive total returns 75% of the time in recession-bearing years, rising an average of 6.5% in all, notes Brad Thomas, editor of Forbes Real Estate Investor.

Pro: Portfolio Diversification. Investing in asset classes that have little or no correlation to each other provide diversification that can reduce portfolio volatility. Equity REITs can offer investors diversification that reduces portfolio volatility thanks to their relatively low correlation with stocks and bonds, notes Nareit. In fact, listed equity REITs are not highly correlated to any other aggregate asset classes, according to CEM Benchmarking. A correlation of 1.00 indicates perfect correlation; lower numbers indicate that asset classes are not perfectly correlated and don’t move exactly in tandem with each other. The correlation between REITs and the broader stock market has historically averaged about .55, notes U.S. News & World Report.

Con: Impact of specialization. Public REITs typically invest in multiple properties, limiting exposure to the risks of any single asset. Even so, REITs tend to specialize in certain types of properties—apartment buildings, hotels, offices, malls, storage facilities—or debt investments, such as mortgage REITs. These different property types may react adversely to different market conditions, especially in the case of mortgage REITs, which carry greater risk because of their use of leverage and their exposure to interest rates.

Pro: Hedge against inflation. Because equity REITs own physical assets, they may also offer a hedge against inflation that won’t erode like fixed income securities or need to be reduced when the market is volatile like equities. When inflation rises, commercial real estate rents have tended to increase and with them, the income investors receive from the REITs—providing retirement investors reliable income even in inflationary periods, notes Nareit.

Con: Interest rate risk. Rising interest rates make the cost of financing the properties in REITs more expensive. And high yields make public REITs more sensitive to interest rate movements. U.S. News & World Report points out that REITs are 47 percent correlated with interest rates, though they also mention that some people argue interest rate increases may actually be a good thing for office and residential REITs in particular because of the correlation with economic growth and increased demand.

In the long run, REITs can provide a powerful tool to manage cash flow and maintain passive income streams. Keeping pros and cons in mind, investors should purchase REITs that limit their risk based on the asset allocations in their portfolios. There’s a lot to consider, from the types of properties a REIT holds, the geographic location of those assets or the market conditions that can have an impact on yields to how a REIT is managed and its past track record. Not all REITs are created equal, and investors must perform due diligence to understand the risks and tax implications of their choices.

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  1. According to Bloomberg data for the period of 12/31/1978 through 12/31/2018, the S&P 500 had annualized total returns of 11.5% while the FTSE NAREIT All Equity REITs Index returned annualized returns of 12.1%. For further information and data, please visit the NAREIT website at https://www.reit.com/data-research/reit-indexes/annual-index-values-returns. During this time period the United States endured the 2008-2009 recession led by real estate collapse. Past specific performance is not indicative of future performance. Also indicate that the recession happened during this time frame.
  2. According to Bloomberg data for the period of 12/31/2008 through 12/31/2018, the S&P 500 had a 2.03% dividend yield while the FTSE NAREIT All Equity REITs Index had a 3.90% dividend yield.
  3. CEM Benchmarking report titled “Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States, 1998-2016” released in Nov 2018

The views expressed herein are those of Geoff Shaver and Origin Investments Advisor, LLC.  Such views are for general information only and are not meant as investment advice. No part of this article may be reproduced in any manner without the express written permission of Origin Investments Advisor, LLC. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This information does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person. Each investor should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this article and should understand that statements regarding future prospects may not be realized. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.