Why Every Investor Should Own REITs

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Includes: SPY, VNQ
by: Charles Lewis Sizemore, CFA

If you don’t have REITs as a permanent asset class in your allocation, you should. And if you do own REITs, you should probably own more.

These are bold statements, but I’m here to back them up with facts. REITs are a fantastic asset class and are appropriate for every investor — from the youngest and most aggressive to those already decades into retirement.

REITs may not always be attractively priced, and there may be times when it makes sense to underweight them or to make a short-term tactical move to be out of them altogether. But these times are few and far between, and under normal conditions an allocation of 10%-20% in REITs is completely appropriate.

Today, we’re going to count the reasons why REITs belong in your portfolio.

#1 Diversification

Let’s start with one of the fundamental concepts of modern portfolio management: diversification. The alchemy of modern finance is that you can improve returns and reduce risk simply by holding the right mix of securities and rebalancing regularly.

But there is a difference between “diversification” and “de-worse-ification.” Loading up your portfolio with exotic asset classes only makes sense if you expect those asset classes to generate competitive returns over time. Otherwise, you’re simply diluting your portfolio with lousy assets that will drag down your long-term returns. Unfortunately, this is the case with bonds at today’s pitifully low yields.

As I’ll show in the next section, REIT returns are very competitive with those of mainstream stocks.

But importantly, for diversification to work its magic, returns are not enough. You also need those returns to be “non-perfectly correlated.” In other words, while you expect all of your asset classes to do well over time, you need some of them to zig while others zag.

Luckily, this is very much the case with REITs and mainstream stocks. Over the past six months, the correlation between the returns of the Vanguard REIT ETF (NYSEARCA:VNQ) and the S&P 500 SPDR (NYSEARCA:SPY) was only 0.51 (1.00 would suggest they move in lockstep). As we saw during the 2013 “taper tantrum,” REITs and mainstream equities can move in opposite directions for months at a time.

#2 Returns

Over time, REITs have generated total returns that were very competitive with mainstream stocks. Part of this is due to certain tax advantages that REITs enjoy (more on that later). But REIT returns say a lot about the attractiveness of real estate as an asset class.

The FTSE NAREIT Equity REITs Index, a broad index that covers most of the equity REIT universe, has delivered 5-, 10- and 15-year compound annual returns of 12.6%, 3.7% and 7.0%, respectively. This compares with total returns of 15.5%, 7.7% and 4.6%, respectively, for the S&P 500.

And remember, this period includes one of the worst real estate bear markets in U.S. history!

Real estate also has value as a long-term inflation hedge. Personally, I would take solid, income-producing real estate over other inflation hedges like gold coins, commodities or TIPs any day of the week.

#3 Income

Before they were embraced by the wider investing public, REITs were popular with retirees because of the income they throw off. Outside of leveraged — and risky — closed-end bond funds, REITs tend to be some of the highest-yielding securities on the market (see next section for the reason).

The FTSE NAREIT Equity REITs Index currently yields 3.6%. That’s about double the 10-year Treasury yield and more than 80% higher than the dividend yield on the S&P 500. And among individual REITs, it’s easy to assemble a solid portfolio with yields of 4%-6%.

As an asset class, REIT dividends also tend to be safer because rent payments are less volatile than corporate profits. Things have to really get bad for the rent check to bounce.

All the same, not all REIT dividend payers are created equal. For a good combination of current yield and dividend growth, try to focus your buying on REITs with yields above 4% and FFO payout ratios below 80%.

#4 Tax Efficiency

Once in a blue moon Congress actually gets something right. Congress created REITs as we know them today in 1960 as a way to allow ordinary investors to invest in real estate. But as a sweetener to encourage capital to flock to the new asset class, they made dividends non-taxable at the company level so long as the REIT pays out at least 90% of its taxable income as dividends.

This needs a little clarification. Dividends for regular corporations are subject to double taxation in that the earnings are taxed first at the corporate level, at rates as high as 35%, and then again at the individual investor level. REITs avoid that corporate level of taxation, which effectively means that they have an extra 35% available to share with stockholders.

As a general rule, investors pay a lower tax rate on regular “qualified” dividends; 15% to 20% depending on their tax brackets. REIT dividends are usually not considered “qualified,” so they are taxed at whatever your marginal tax rate happens to be. For this reason, I recommend you hold your REITs in an IRA or other tax-advantaged account if at all possible.

#5 REITs are VERY Democratic

Because REITs are required to constantly pay out their profits as dividends, they generally have to raise funds for new projects via new debt or equity offerings. This requires discipline that most companies simply do not have. It also effectively gives shareholders a “vote.” By constantly having to go to the markets for capital, management gives shareholders the chance to “approve” new projects by buying the new shares or bonds.

One of my biggest complaints about tech companies like Google (NASDAQ:GOOG) (NASDAQ:GOOGL) is that they are undisciplined with investor money. Because Google is flush with more cash than it knows what to do with, it tends to fritter a lot of it away with harebrained ideas that never get off the ground. Google was reportedly working on making a jetpack last year, not unlike the one used by James Bond in Thunderball. They also allegedly had plans to build a space elevator that would transport people from the Earth’s surface to a space station in orbit… and a teleportation device based on the transporters in Star Trek.

The science-fiction-loving geek in me thinks these projects are cool. But if Google had to go to the investing public to ask for funding for its James Bond gadgets and Star Trek toys, it would be laughed out of town. Don’t underestimate the importance of this aspect of REIT investing. The constant need to access the public markets creates discipline that you rarely see elsewhere.

This article first appeared on Sizemore Insights as Why Every Investor Should Own REITs

Disclaimer: This article is for informational purposes only and should not be considered specific investment advice or as a solicitation to buy or sell any securities. Sizemore Capital personnel and clients will often have an interest in the securities mentioned. There is risk in any investment in traded securities, and all Sizemore Capital investment strategies have the possibility of loss. Past performance is no guarantee of future results.