The Risks of Real Estate Investment Trusts

Real estate investment trusts (REITs) are equities often used by those who want to boost the yield of their portfolio. These investment products offer an easy way to own a share in income-producing real estate property. REITs can have high returns, but like most assets with high returns, they carry more risk than lower yield alternatives like Treasury bonds.

Here are some factors to consider to help you figure out if the potential profits of REITs merit the risks taken.

What Is a REIT?

REITs are firms whose sole purpose is to own and operate real estate properties. Some invest in commercial property such as parking lots or office buildings. Others invest in residential property like apartment buildings or houses. By law, REITs must pass on 90% of their profits in the form of dividends. Most distribute them to their investors quarterly, making them a good interest-earning vehicle for retirees who want a steady stream of income.

Unlike public corporations, REITs often distribute 100% of their taxable income in the form of dividends, which means they do not pay corporate income taxes. After management deductions, profits are distributed pre-tax to investors. REITs have outperformed corporate bonds over the long run, making them more tempting for an investor who can handle the risks.

Risks of REITs

REITs are traded on the stock market, which means they have increased risks similar to equity investments. Real estate prices rise and fall in response to outside stimuli, underlying fundamentals, and a variety of other market forces. REITs, in turn, will reflect any weakness and mirror the effects on prices.

Although REITs’ long-term returns can be large, there have been periods in which they have not. When the real estate bubble burst between early 2007 and early 2009, for example, the price of shares in the iShares Dow Jones U.S. Real Estate ETF (IYR) dropped some 77% from a high of $91.42 to a low of $20.98.

REITs can also produce negative total returns during times when interest rates are high or rising. When rates are low, many people move out of safer assets like Treasuries to find income in other market areas, such as real estate.

Returns of REITs

Measured by the MSCI US REIT Index, the five-year gross return of U.S. REITs was 7.76% in February 2022, and the 10-year return was 9.6%. In 2021, annual performance was 43.06%, one of the best calendar-year total returns ever. It was -7.57% in 2020, one of only two negative-performance years since 2008. The return of 9.6% is comparable to the historical average annual return of the S&P 500 Index (roughly 10%).

Whether the returns are higher or lower than others for a given period, these are simply a snapshot of returns. They do not show that REITs are a better investment; they only show that returns are different and that you can use them in various strategies.

How to Invest in REITs

You're able to invest in REITs in several ways. There are mutual funds, closed-end funds, and exchange-traded funds (ETFs) to choose from. Popular exchange-traded funds that focus on REITs are: 

• iShares U.S. Real Estate (IYR)
• Vanguard Real Estate (VNQ)
• SPDR Dow Jones REIT (RWR)
• iShares Cohen & Steers REIT (ICF)

You can also open a brokerage account and buy into individual REITs directly. Some of the larger individual REITs are:

• Simon Property Group (SPG)
• Public Storage (PSA)
• Equity Residential (EQR)
• Healthpeak Properties (PEAK)
• Ventas (VTR) 

There are also a growing number of ways to access overseas REIT markets. These investments are typically riskier than U.S.-based REITs, but they may deliver higher yields—and since they're overseas, they provide diversification for a profile heavy in domestic real estate. One example of such an ETF is Vanguard's Global ex-U.S. Real Estate Index Fund ETF (VNQI).

REITs in Portfolio Construction

REITs tend to have a lower-than-average correlation with other areas of the market. While they are affected by broader market trends, you can expect their performance to deviate somewhat from the major stock indices and bonds to some degree. This performance can make them a potent hedge vehicle, though perhaps not as much as bonds or commodities.

You can use REITs to reduce the overall volatility of your portfolio while simultaneously increasing its yield. Another advantage of REITs is that unlike bonds bought at issue, REITs have the potential for longer-term capital appreciation.

They may also do better than some other investments during periods of inflation because real estate prices generally rise with inflation. REIT dividends, unlike capital gains from equities held for at least one year, are fully taxable. It's always a good idea to talk over asset allocation decisions with a trusted financial adviser.

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