Reits: Diversify Your Portfolio Beyond Total Index Funds

Real estate investment trusts (REITs) are companies that own or finance income-producing real estate across a range of property sectors. They are an attractive investment option for those looking for dependable dividend income and the potential for substantial capital appreciation over time. REITs are also a good option for those who want to invest in real estate without actually buying and managing properties themselves.

REITs can be private companies or publicly traded. They can be purchased in a variety of ways, including through exchange-traded funds (ETFs), mutual funds, or by buying shares of publicly-traded REIT stocks.

There are several benefits to investing in REITs. Firstly, they have historically delivered competitive total returns, based on high and steady dividend income, with REITs being required to distribute at least 90% of their taxable income to shareholders. Secondly, they offer portfolio diversification, as they have a low correlation with other assets, which can help reduce overall portfolio risk and increase returns. Finally, REITs are highly liquid and traded on major stock exchanges, making them easily accessible to investors.

However, there are also some potential drawbacks to consider. REIT dividends are typically taxed at a higher rate than most dividends, and REITs are sensitive to interest rates, with prices tending to fall when rates rise. Additionally, there are property-specific risks associated with different types of REITs, such as hotel REITs performing poorly during economic downturns.

Ultimately, the decision to invest in REITs outside of total index funds depends on an individual's financial goals, risk tolerance, and investment horizon.

REITs vs. stocks and bonds

Real Estate Investment Trusts (REITs) are a key consideration when constructing an equity or fixed-income portfolio. They can provide added diversification, potentially higher total returns, and lower overall risk. Their ability to generate dividend income and capital appreciation makes them an excellent counterbalance to stocks, bonds, and cash.

REITs are companies that own, operate, or finance income-producing real estate across a range of property sectors. They are a type of equity, meaning they represent partial ownership in a company that makes its money by owning commercial real estate properties and collecting rents from tenants. REITs are perpetual investments with no maturity date, and they can theoretically continue to exist and grow their asset bases for decades.

REITs are required by law to pay out at least 90% of their taxable income as dividends, and they have historically been a reliable source of safe and growing income while delivering healthy total returns. They are highly liquid and can be bought and sold with the click of a button.

However, REITs are highly sensitive to changes in interest rates and can experience significant short-term stock price volatility. They are also highly dependent on external capital markets to fund their growth, and they are vulnerable to market sell-offs.

On the other hand, stocks and bonds are also viable investments. Stocks tend to generate higher total returns than REITs and bonds due to their higher risk profiles. Bonds are fixed-income investments that are issued by governments and companies, paying a set coupon (interest rate) usually every six months. They have a limited lifespan and mature at a fixed date. Bonds have a higher priority in the capital stack, giving them preferential treatment in terms of repayment if the issuer experiences financial distress.

In summary, REITs can be a good addition to a portfolio that already includes stocks and bonds. They provide diversification and can offer higher returns and income than bonds, but they are more volatile and sensitive to interest rates. Stocks tend to be the riskiest and offer the highest returns, while bonds are the safest but offer the lowest returns.

High-yield dividends

Real Estate Investment Trusts (REITs) are an attractive investment option for those seeking high-yield dividends. By law, REITs are required to distribute at least 90% of their taxable income to shareholders as dividends annually. This makes them a popular choice for investors seeking regular income.

REITs are companies that own, operate, or finance income-generating real estate properties. They are traded on major stock exchanges, and investors can purchase shares in REITs, similar to stocks.

• Steady and High Dividend Yields: The high dividend yields offered by REITs, often higher than the average stock on the S&P 500, make them a favourite among investors seeking regular and stable income.
• Liquidity: Publicly traded REITs offer better liquidity compared to owning physical real estate, as they can be bought and sold more easily and quickly.
• Lower Volatility: Due to their larger dividends, REITs tend to exhibit lower volatility than traditional stocks, providing a hedge against the ups and downs of other asset classes.
• High Returns: Historically, REITs have delivered higher returns compared to some equity indexes, making them an attractive option for portfolio diversification.

However, it is important to consider the potential drawbacks of investing in REITs:

• Tax Liability: REIT dividends are typically taxed at a higher rate than most dividends because they usually don't meet the IRS definition of "qualified dividends".
• Sensitivity to Interest Rates: REIT prices tend to be sensitive to changes in interest rates. When interest rates rise, REIT prices often fall as investment capital flows into bonds.
• Property-Specific Risks: Different types of REITs, such as hotel REITs, can perform poorly during economic downturns.

Overall, investing in REITs can provide access to high-yield dividends and is a viable option for those seeking regular income and portfolio diversification. However, it is important to carefully consider the potential risks and conduct thorough research before investing.

Portfolio diversification

Real Estate Investment Trusts (REITs) can be an excellent way to diversify your portfolio. They are a key consideration when constructing any equity or fixed-income portfolio.

REITs own and/or manage income-producing commercial real estate, whether it's the properties themselves or the mortgages on those properties. They are traded on major stock exchanges and are highly liquid.

REITs have a low correlation with other assets, which can help reduce overall portfolio risk and increase returns. They are also a good counterbalance to stocks, bonds, and cash.

However, it is important to note that REITs are sensitive to interest rates and can become highly correlated with the broader market during crashes.

When considering investing in REITs, it is recommended to keep them to 5-10% of your portfolio. This can provide a good balance of diversification and risk management.

• High-yield dividends: REITs are required to pay out 90% of their taxable income to shareholders, resulting in high dividend yields.
• Long-term capital appreciation: REITs have the potential for moderate, long-term capital appreciation.
• Liquidity: Shares of publicly listed REITs are readily traded on major stock exchanges.
• Transparency: Listed REITs are monitored by independent directors, analysts, and auditors, providing investors with performance oversight and financial condition insights.

In conclusion, investing in REITs can be a strategic decision to diversify your portfolio, but it is important to consider the potential risks and ensure that REITs align with your investment goals and risk tolerance.

REITs and taxes

REITs, or real estate investment trusts, are companies that own or finance income-producing real estate across a range of property sectors. They are a popular way for investors to own income-generating real estate without having to buy or manage property.

REITs are required to distribute at least 90% of their taxable income to shareholders each year, which makes them an attractive investment option. However, this also means that REIT dividends are often taxed as ordinary income at the investor's marginal tax rate, rather than the lower qualified dividend rate.

• Taxation at the Trust Level: REITs typically don't pay corporate income taxes because they pass the majority of their earnings on to investors as dividends. To qualify as a REIT, a trust must pay out at least 90% of its taxable income to shareholders.
• Taxation for Unitholders: The dividend payments REIT investors receive are usually treated as ordinary income and taxed at the investor's marginal tax rate. However, part of the dividend may be classified as a capital gain or a return of capital, which have different tax implications.
• Capital Gains: If a REIT sells property that it has held for at least a year, it may pass a capital gain or loss on to the investor. Capital gains are generally taxed at a lower rate than ordinary income.
• Return of Capital: In some cases, a portion of the dividend may be classified as a return of capital, which is not taxable in the year it is received. However, it lowers the investor's cost basis, which may result in higher capital gains taxes when the REIT shares are sold.
• Tax Advantages: Holding REITs in tax-advantaged accounts, such as IRAs or 401(k)s, can defer or eliminate taxes on distributions, making them more tax-efficient for investors.
• Tax Treatment of Different REIT Types: There are two main types of REITs: equity REITs and mortgage REITs. Equity REITs own and collect rent from properties, while mortgage REITs finance mortgages and collect payments. The tax treatment of REIT dividends depends on the type of income generated by the REIT.
• 1099-DIV Form: If you own shares in a REIT, you will receive IRS Form 1099-DIV each year, which breaks down the different types of dividends you received and how they should be reported on your tax return.
• Qualified Dividends: While REIT dividends are typically classified as ordinary income, a small portion may be considered "qualified dividends" if they meet certain criteria. These qualified dividends are taxed at the lower capital gains rates.
• Tax Withholding for Non-U.S. Residents: Non-U.S. residents receiving REIT income may be subject to a 30% withholding tax. However, a reduced rate or exemption may apply if there is a tax treaty between the U.S. and the investor's country of residence.

When investing in REITs, it is important to consider the potential tax implications and consult with a financial advisor or tax professional to understand how REIT dividends will impact your individual tax obligations.

Interest rates and REITs

Rising interest rates have historically impacted the share prices of equity REITs. However, increases in interest rates are often driven by economic growth, which may support the growth of REIT earnings and dividends in the future. Research shows that REIT returns have generally been positive and have often outperformed the S&P 500 in periods of rising interest rates.

REIT Stock Performance and the Interest Rate Environment

REIT share prices, like the broader stock market, often react to changes in the outlook for interest rates, including both short-term and long-term rates. Over longer periods, there has generally been a positive association between periods of rising rates and REIT returns. This is because rising rates generally reflect an improvement in the underlying fundamentals. Market interest rates typically increase during periods when macroeconomic conditions are strengthening, which often drives positive REIT investment performance.

REITs and Rising Interest Rates

Rising interest rates can negatively impact REITs as it becomes more expensive for them to borrow money for acquisitions and development projects, and it can hurt the value of assets they already own. However, rising interest rates can also be driven by economic growth, which may support the growth of REIT earnings and dividends in the future.

REITs and Interest Rate Cuts

Rate cuts tend to bode well for publicly-traded REITs. When interest rates stabilise, it makes REIT valuations less volatile because it reduces the uncertainty in future cash flows, making it easier for investors to assess and value real estate assets.

REITs and Interest Rates Conclusion

While rising interest rates can negatively impact REITs, historical data shows that REITs have been resilient and have often outperformed broad equity indexes during periods of rising interest rates. On the other hand, rate cuts and stabilising interest rates can benefit REITs by making their valuations less volatile and easier for investors to assess.

Frequently asked questions