Many Americans dream of owning their own home. But with a questionable housing market and a stalled economy, that dream has been put on hold for many. One way to still invest in the American Dream without a large sum of money is to consider real estate investment trusts (REITs). In this post, we examine REITs and provide tips from leading experts.
REITs are corporations that invest in real estate - typically office buildings, hotels, apartments and shopping malls - or mortgage loans. They are traded on a stock exchange, making it easily accessible for many investors. To avoid paying corporate taxes, REITs must distribute 90% of their income to shareholders, making them an option to consider for those investors seeking income.
One of the benefits of REITs is that they help achieve diversification and tend to reduce risk since they have little correlation with the S&P 500. Joe Light, writing for the Wall Street Journal, points out that the MSCI U.S. REIT Index returned 8.7% in 2011. That's more than four times the return of the Standard & Poor's 500 index during the same time. One example of last year's strong performance in this asset class is VNQ, a passive Vanguard ETF, that seeks to track the MSCI REIT index by investing at least 98% of its assets in stocks issued by real estate investment trusts. Over the last year it has returned over 13%. Light also writes that during the last decade, REITs enjoyed average yearly returns of more than 10.4%.
Like any investment, there is no guarantee that a strong past performance will continue in the future. However, the significant outperformance of REITs compared to the stock market last year is another example of how diversification can reduce overall portfolio volatility.
REITs have historically been steady investment types. Writing for the American Association of Individual Investors, Brad Case says that publicly traded REITs displayed higher levels of volatility during the credit crisis that ran from October of 2008 through March of 2009. But, as Case says, most asset classes suffered from the same volatility. And REIT volatility levels dropped to normal levels quickly after that crisis ended.
Amy Fontinelle, writing for Forbes, says that while REITs may be a small investment category, they can play a significant role in balancing investors' portfolios.
Fontinelle quotes a certified financial planner who says that REITs provide investors with a non-correlated asset, an income stream from their distributions, and the possibility of capital appreciation. The planner said that most asset-allocation models suggest that investors place 1% to 7% of their investing dollars in REITs, depending on their investment goals. Some model portfolios have REITs even as high as 20%. Whatever the exact percentage REITs may occupy within your portfolio, it is clear amongst most investment experts today that REITs should form part of your overall portfolio. Investors should remember that because of the income producing nature of REITs, they would be well served to hold REIT investments in a tax advantaged account.
There are several different types of REITs and you may prefer to invest in some types over others. Industrial REITs, for instance, acquire, own, and manage such properties as warehouses, distribution centers, manufacturing centers and business parks.
Residential REITs, on the other hand, are typically made up of multi-family properties, explains Forbes. A strong multi-family REIT will feature buildings that boast high rents and low vacancy rates. According to the Forbes story, multi-family REITs are often solid investment choices when the single-family housing market is struggling. Multi-family tends to perform better during these times as falling home values and rising foreclosures encourage more people to rent instead of buy.
When considering a REIT, it's good practice to research the history of the trust behind the REIT to determine how successful the trust has been and what kind of a reputation it has, the Forbes story recommends. In short, you should definitely check out the track record of the manager before investing.
The Forbes story also points out the importance of looking at a REIT's funds from operations to make sure that the REIT can cover its dividend payout. The funds from operations measurement is an especially important one as it tabulates the cash flow from a REIT's operations. Historically, REITs that boast a strong cash flow usually feature a better return on investment.
Because the different types of REITs are affected by different economic activity, diversity is important when it comes to investing in REITs. Financial planners recommend that investors place their money in several types of REITs or in a single REIT that consists of a variety of property or loan types. Investors can also achieve diversification by investing in a mutual fund or ETF REIT that tracks a broad number of REITs. The Vanguard REIT ETF (VNQ), for example, is designed to track the performance of the MSCI US REIT Index, which is composed of stocks of publicly traded REITs.
As Simon Constable writes for the Wall Street Journal, we'll all know that real estate is improving when we see both rising prices and home sales at the same time. For this to happen, the national unemployment rate will have to continue to fall.
This hasn't happened yet. But Constable, quoting Barry Ritholtz, the chief executive officer of a New York-based research and asset-management company, said that once it does, investors can get exposure to that growth through REITs.
Tell Us: Would you consider investing in REITs as an alternative to the American dream of owning a home?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.