An Introduction
What follows is the second installment (an edited and abridged version of the original newsletter) in a series on alternative investments by Spencer Wright from his latest Forecasts & Trends E-letter. You can find the first in the series, Is Private Equity Investing For You?, here. Wright points out that ‘The sheer size of the real estate sector creates an incredible number of investment possibilities…and for our discussion today, we will focus on a real estate investment called a REIT – a Real Estate Investment Trust.”
What Are Real Estate Investment Trusts (REITs)?
REITs offer a low-cost way to invest in the real estate market without having to directly own and operate properties. REITs can be public or private investments. If we consider just the US REIT market, it is valued at approximately $253 billion.
The Benefits REITs
- The principal benefit of having REITs in a portfolio is diversification.
- Morningstar recently published a paper on the effect of REITs in a portfolio. The paper produced some interesting information.
- Consider this graphic that details the role of REITs in a mixed asset portfolio.
Nearly 75% of experts conclude that the presence of REITs in a portfolio is an effective diversification tool over the long term.
Real estate returns are unlike those of stocks in part because:
- Their returns are primarily generated from income.
- At least 90% of a REIT’s taxable income must be distributed to investors in terms of dividends.
- REITs tend to offer higher dividends.
- REITs tend to follow real estate cycles, which last on average almost twice as long as bond and stock market cycles.
- The property market is highly segmented, which allows investors to diversify by real estate trends.
…If you include a REIT allocation in your portfolio the next obvious question is, how much? Of course, that depends a great deal on your individual situation and risk tolerance. Here is a chart that illustrates allocations of 5%, 10% and 15% to REITs benchmarked against a standard 60/40 portfolio without REIT allocations.
- As you can see, REITs have been additive over the long haul, especially during periods of market stress when traditional equity and bond investment can struggle.
- As mentioned, REITs can pay higher dividends than traditional equities and bonds. Commercial REITs can serve as a potential hedge against inflation as they often have agreements that allow them to raise rents in line with inflation.
The Risks of REITs
- As with all investments, REITs carry risk. The specific type of risk will depend on the type of REIT but there are some general risks that apply to most.
- REITs are subject to interest rate risk. When interest rates rise, the cost of borrowing goes up. Since many REITs rely on debt to finance their properties, this can potentially impact their profitability and dividend payouts. It can also affect property value and occupancy demand.
- Geographic risk is also a concern. If a REIT is heavily exposed to a narrow geographic area or region, it could have a negative impact on performance if that region experiences trouble in its real estate market.
- Residential and commercial REITs are especially subject to occupancy risks. If occupancy drops below a certain level, the REIT may have trouble maintaining historical payouts. Lower rents and occupancy rates can have a very negative impact on REITs.
Public and Private REIT Investing
- REITs are available to investors in both public and private marketplaces. They are referred to as listed (Public) and non-listed (Private) REITs. Both public and private REITs can invest across a very wide range of real estate. Some have broad portfolios that cover the main real estate sub-sectors but some are very focused on only one or two sub-sectors. While focused REITs may offer higher returns and or payouts, the returns often come with more risk.
- Listed REITs are traded on exchanges and are fully liquid, which is generally advantageous to individual investors. However, listed REITs can be subject to general market risks. Price fluctuations in the broad markets brought on by macro events can also affect REIT pricing, even it those events are not related to the real estate sector.
- Non-listed REITs are generally insulated from such macro market shocks but almost always have limitations on “liquidity” – when you can redeem shares. The level of illiquidity can vary greatly between REITs, some as much as a year or more. Non-listed REITs can also “gate” or limit the amount of withdrawals. As with any private fund, ask for a liquidity schedule when considering an investment.
Final Thoughts
REITs are a useful portfolio tool for diversification. They can provide income and capital appreciation. There are many different types of REITs with a wide variety of investment focus. Of course, like all investments, REITs are not right for all investors. Consult a financial professional to determine if an investment in REITs is right for you.”
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