- On one hand, REITs offer higher dividend yields, inflation protection, real estate diversification.
- On the other, REITs are highly leveraged and consequently have more downside when economic circumstances turn.
- Don’t get tempted by the higher dividend yields of the general REIT market now, security selection is the only option for profitable longer term REIT investments.
As we promised in our farmland article, today we are going to talk about Real Estate Investment Trusts (REITs). We are going to discuss what REITs are, what benefits they offer, what risks there are with them and what the current market perception for them is, whether overvalued or undervalued.
What are REITs?
REITs are trusts that allow individual investors to invest in large scale real estate projects. They were created in 1960 by Congress in order to enable any investor to invest in long term real estate investments. By buying shares in an REIT you can diversify your portfolio with real estate without having to worry about managing properties or about minimum investments. The trust usually owns and manages properties itself.
REITs operate in various real estate sectors, from office buildings, to shopping malls, apartments, hotels, resorts, self-storage facilities, warehouses, and mortgages or loans to farmland, which we discussed on Monday.
There are also various types of REITs. Some are publicly traded while others are registered but not traded, and thus have more liquidity constrains for investors.
Benefits and Risks of Investing in REITs
- Lack of Liquidity – As there are many REITs, some of them have really thin trading volumes and are very volatile, but those REITs usually carry a premium so if you can part with your money for a longer period of time and are willing to do proper due diligence, you might want to dig into small cap REITs for higher dividends.
- Diversification and Liquidity – Large REITs offer high liquidity real estate diversification that can’t be matched anywhere else. You can buy a part of large real estate projects just by sitting at your home desk, and sell it again whenever you want.
- Real Estate Diversification – In addition to asset diversification, with REITs you can also get real estate diversification. As real estate prices do not move in sync across the country, having one piece of real estate might expose you to the wrong market. By owning an REIT, or several of them, you can be exposed to the whole U.S. real estate market.
- High Dividend Yields – The current average dividend yield from the 220 REITs that pay a dividend yield is 5.31%. REITs are able to pay such large dividends because it is not unusual for them to have payout ratios that are much higher than their earnings as REITs usually payout their entire free cash flow. This is the benefit of depreciation for real estate investments.
- Increasing and Stable Income – As rents increase over time, you can expect higher dividends that remain stable as real estate investing is more stable than other assets classes.
- Tax Advantages – If REITs payout more than 90% of their taxable income, its profits are not taxed at a corporate level which is the second reason for higher REIT dividends. If a corporation makes $1 pretax it has to pay 35% corporate tax which leaves $0.65 available for dividends. An REIT can payout the whole dollar without paying corporate taxes. Further, when holding REITs in your IRA account you can avoid paying your own dividend taxes.
- Inflation Protection – Real estate is a great protection against inflation. As money becomes less valuable, all assets of a fixed amount increase in value. Plus, with higher inflation, rents also increase and protect your income.
As we can see, REITs have a lot of benefits, but, unfortunately, all of these benefits currently come at a high price.
As home prices have increased since the Great Recession, so have REIT prices.
Figure 1: S&P/ Case Shiller 20-city U.S. home price index. Source: FRED.
Figure 2: Vanguard’s REIT ETF performance. Source: Yahoo Finance.
As the figure above shows, REITs are much more volatile than home prices. This is due to their leverage as REITs usually borrow to the maximum in order to leverage their real estate operations. It also means that in case of a recession, REITs might be severely hit. In the Great Recession, the Vanguard REIT ETF fell from a high of $83.76 in January 2007 to a low of $23.89 in February 2009.
Investors have to carefully assess if the higher dividend yield and real estate diversification is enough of a benefit to counter for a larger decline if circumstances take a turn for the worst.
REIT ETFs have the largest weights in the largest REITs. As the current Vanguard REIT ETF (NYSE: VNQ) dividend yield is 3.35%, it only confirms the thesis that smaller REITs offer higher returns but also less liquidity and more risks as the average dividend yield for all REITs is 5.31%.
As REITs have been surging in the last 7 years and their yields have been declining, one might argue that REITs are nearing bubble territory. In such a situation the best thing to do is to look for quality in the sea of REITs rather than buy everything through an ETF. Because once the tide retreats, we’ll know who is swimming naked, as over leveraged and poor quality REITs are exposed.
As for the risk and reward, yes REITs offer higher dividend yields but, due to their leverage, their downside is also greater.
Keep an eye on REITs, maybe have some exposure to them and then increase your exposure as prices decline.