REITs give you ownership in commercial buildings like these. (View from my Boston apartment in 2014.)
The takeaway: Real Estate Investment Trusts (REITs) let you own commercial real estate. You don’t have to be a real estate mogul to play with the big “boys.”
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Fifty-five years ago, my parents purchased their dream home for $63,000. Today that house sells for $800,000. That’s a return rate of 5% a year. During this same time-period, inflation has averaged 3.8% a year.
This is why it often pays to own some real estate. It’s an asset that keeps up with inflation. And Boomer, you know what inflation is.
Inflation is a stealth cancer that will crush your retirement dreams.
Should I buy more real estate?
Boomer, if you own an $800,000 home, it’s possible you don’t need any more real estate in your portfolio. Instead, it may be time to start focusing on stocks and bonds to diversify your portfolio.
But if you don’t own an $800,000 house, and the percentage of stocks and bonds in your portfolio vastly outnumbers the percentage in real estate, maybe some real estate isn’t a bad idea.
You can add real estate to your portfolio in two ways.
First, you can buy homes and rent them out. I’ve done it. I’ve told you about it. I lived to tell the tale, Boomer.
Second, you can buy Real Estate Investment Trusts.
What is a Real Estate Investment Trust (REIT)?
A REIT—rhymes with street—is like a mutual fund. Fund managers collect relatively small sums from individual investors. Using the money that they collect, they make large investments in real estate.
Boomer, if you’re going to make money in REITs, then you need to know how REITs make their money. There are three different types of REITs. They make their money in three different ways.
- Property (or Equity) REITs buy property. Such property typically includes shopping centers, hotels, apartments, warehouses, and office buildings. Property REITs make their money from
- 1) rents collected on these buildings and
- 2) selling these properties after they’ve increased in value.
- Mortgage REITs make loans. They make loans to buyers and developers of residential and commercial properties, like those bought by Property REITs. Mortgage REITs make their money from the interest generated on these loans.
- Hybrid REITs. These REITs are a combination of the above two. Hybrid REITs make their money using a combination of techniques used by the above two.
How do you make money from a REIT?
Shareholders—including you—receive 90% of all REIT income generated by:
- gross income from rents on the property the REIT owns;
- proceeds from the sale of its properties; and
- interest on the mortgage loans it makes.
The money that you receive from the REIT is called a dividend. In the world of investing, the 90% dividend REITs pay is considered sky high. Dividends paid in most every other economic sector are between 1% and 5%!
So what’s the REIT downside?
You pay higher taxes on REIT dividends compared to dividends in other economic sectors. REIT dividends are taxed as ordinary income. Whatever tax bracket you are in, you pay that same tax rate on your REIT dividend. It can be as high as 37%. In contrast, dividends in virtually all other economic sectors are taxed between 15% and 20%. (Check with your tax professional for the new 2018 tax laws.)
REIT dividends widely fluctuate compared to dividends in other economic sectors. When losses occur because Property REITs make unwise purchases and Mortgage REITs make unwise loans, these losses are passed along to you. The result will be that your dividend will shrink or be nonexistent.
In contrast, dividend paying firms in virtually all other economic sectors pay stable dividends. Stable dividends help them avoid massive shareholder sell-offs. Sell-offs reduce a firm’s value.
There is no buffer from REIT losses, as occurs with stock and bond mutual funds. A REIT is a basket of real estate properties in one, and only one, economic sector—real estate. In contrast, a stock mutual fund, like the S&P 500, is a basket of stocks in a variety of economic sectors. These include technology, health care, financial services, construction, utilities, etc. When one of these sectors temporarily tanks, the others may hold steady or go up, thereby smoothing out your investment returns.
In contrast, no such smoothing occurs in REITs. If the real estate sector as a whole tanks, the return on your REIT will tank as well. Consequently, your REIT dividend will shrink or be nonexistent.
Where can I buy REITs?
You can buy REITs from:
- Financial services firms like Vanguard or Fidelity, which operate real estate mutual funds that include REITs;
- A private REIT company;
- A public REIT company that sells shares on, for example, the New York Stock Exchange.
Boomer, I prefer the first option. Why? Because, as you know, I like the low cost and favorable returns that come with index funds, particularly index funds that include REITs. The Vanguard (VGSIX) and Fidelity funds (FRESX) each have a minimum investment of about $3,000.
If on the other hand you prefer to buy a private or publicly traded REIT, don’t forget to study the REIT’s annual report. Ensure that the REIT is solvent and diversified by location and property type.
As you weigh this decision, remember our mantra: trust no one.
Do your own due diligence.
No one cares more about your money than you.