Many of us like to think that the way to grow wealth is through investing in the stock market. Given the bull market we’ve experienced over the past several years it can be an understandable assumption on one level. It’s easy to sit back and think that the best and only way to grow wealth is through stocks. Yes, being in the stock market can play a major role building wealth that lasts a lifetime, but it’s only part of the picture.
Another great way to grow wealth is through investing in real estate. In fact, many would claim that adding real estate to an investment portfolio is a great way to bring much needed diversity that will help wealth growth efforts. This is especially the case if it’s part of a retirement strategy that is geared towards producing multiple streams of income.
However, there is one slight problem with investing in real estate – owning property can pose a high barrier of entry to some. You likely need some type of down payment and will have to deal with other realities like:
• Finding tenants
• Repairing and replacing items that need attention
• Dealing with vacancies
• Managing the day to day needs of the property
These all present added costs that can make the barrier to entry even higher for some. Yes, you can hire a Property Management company to care for many, if not most of those things, but that comes with a cost that detracts from your return.
If you find real estate too expensive to invest in physically but still want the benefits of passive income, you can invest in a Real Estate Investment Trust – or REIT for short.
What’s A REIT?
REITs were started in 1960 by President Eisenhower as a way to allow retail investors to invest in real estate. Whereas real estate investing had previously been reserved for those with wealth, the REIT was and is intended to give access to anyone.
A REIT acts very much like a stock as it trades on exchanges and has grown in popularity over the past few decades as more investors have come to know about them. There are also some mutual funds that invest in public real estate, but by and large REITs are the easiest way to invest; just as you can buy a share in the stock market, you can buy a share in the stock of a REIT, and it is traded throughout the day on a stock exchange.
There are three basic types of REITs as defined below:
• Equity REITs – these are Trusts that own properties. These properties can range from office buildings to shopping malls to warehouses and hotels. Basically, Equity REITs cover public and commercial real estate. The income from this particular brand comes largely from the rent received on such properties.
• Mortgage REITs – these are Trusts that invest in mortgages of public property. These can either lend out money for mortgages, or purchase existing mortgages and mortgage-backed securities. The income received on this type of REIT comes largely from the interest received on the mortgage payments.
• Hybrid REITs – these are just as the name indicates. Hybrid REITs invest in both property and mortgages as a way to give investors access to both.
Outside of the main aspect of access to real estate investments to retail investors, the other main aspect of investing in REITs that many look for is passive income production through the means of dividends. As will be touched on later, REITs are required by law to return 90 percent of their taxable income to investors each year in the form of a dividend.
Is A REIT Right For Me?
Given the background on REITs a question you may be wondering whether investing in a REIT is right for you. To answer that question, you’ll need to consider your personal situation.
With the requirement to pass on 90 percent of income as dividends this makes REITs a somewhat obvious consideration for those looking to create a dividend income stream as a part of a multiple income stream strategy. This can be good for someone wanting to generate some income during retirement in a low interest rate environment.
The other consideration to keep in mind is if real estate investing is something you want to pursue. Assuming that actual physical ownership presents either too high of a barrier of entry or you’d rather not deal with some of the other aspects then REITs offer a justifiable alternative. If you handle it wisely, and it fits your needs, then REITs can be a great part of an overall investment strategy geared towards wealth production and preservation.
The other thing to keep in mind with regards to REITs is their performance versus the S&P 500. As can be seen in the two graphs below, REITs tend to stay on par with the S&P, especially when taken out further in the range of ten years or more. In some cases the S&P does outperform REITs as a whole, but generally within a range of 2 percent.
That said, REITs have considerably underperformed the major indices in the short run over the past few years due to the sweeping bull market.
There will generally be more fluctuation found in the S&P and other indices and that has to be measured against the heavy dividend income production of REITs. As can be seen in the graph from Fidelity, dividends represent about two thirds of REIT total returns over time.
REITs and Your Taxes
The fact that REITs are required to return 90 percent of their income in the form of dividends can make for a surprise come tax season if you’re not prepared for it as it’ll generally account as ordinary income.
The other taxation issue to consider with REITs is that REITs are at the mercy of local lawmakers for property taxes. If a state or local government decides to raise property taxes then that’s going to impact REIT holders as it’ll decrease the amount in dividends they’ll receive. While tax planning is possible to help mitigate the first tax implication of REITs the second is going to be more difficult to manage.
This is not to say that REITs are all bad to hold from a tax perspective. It just has to be done wisely. One relatively simple way to help mitigate the tax impact is to hold REITs in a non-taxable account such as an IRA as opposed to a taxable brokerage account as that can help shelter much of the tax hit one might face from receiving dividends. (See: Practice Tax Location to Boost Investment Returns).
Risks Associated With REITs
As with any investment product, REITs are not without risk. The first, and one of the more obvious risks of investing in REITs is that it’s traded like a stock, which means it can lose value. While REITs have more upside than traditional fixed income products, the associated higher risk must be considered when looking at REITs as a pure dividend product. They will fluctuate in value as time goes on, just as a stock does, so that must be considered.
Other risks of REITs are as follows:
They must compete with other high yield investments. As interest rates rise and high-yield [investment opportunities arise] REITs must compete with those. More options may cause lower demand, which could lower REIT stock prices.
Property taxes: As mentioned previously, REITs are at the mercy of lawmakers. If a municipality decides to raise property taxes then that’ll negatively impact dividends.
Rising interest rate climate: The current rate climate has made REITs attractive, to a certain extent. But as interest rates rise, other sources of yield may start to look more attractive from a risk-return perspective, which may bring increased pressure to REIT prices..
Loss of property: Another risk REIT owners face is downturn from niche markets. Having a broad based approach is one way to help mitigate this risk.
Each of these situations presents a unique risk to REITs in that they can directly impact the dividend production investors are reliant on. This does not make REITs bad investments. It just requires you to consider the associated risks and know how they might impact you – just as if you were investing directly in physical real estate.
Balance is Key
As with any investing, balance is key. That is no different when considering REITs as an investment option. There are various things to consider from what your overall goal is to where you are at in life.
Yes, there are risks associated with investing in REITs but there are also some upsides that are somewhat unique in the investment world. If you’re wanting to create a passive stream of income through dividends or are wanting access to real estate investing without actual physical holding of it then REITs can be a good part of a well-balanced portfolio. Even if neither of those situations are the case for your particular situation they can still bring some much needed diversification in certain circumstances.
The key, as is with anything related to your wealth accumulation, is staying on top of your investments. There are various factors which can impact return that need to be watched over on a semi-regular basis, which is where Personal Capital can help you stay on track with your investing goals.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.
Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.