The stock market’s roller coaster ride earlier this year suggests that 2018 is going to be bumpier than previous years. If volatility makes you nervous, it is important to maintain a diversified portfolio that will not plummet in value every time the Dow drops or interest rates tick up. One way to diversify your portfolio is with real estate.
This does not mean you need to go out and buy several apartment buildings or commercial properties and become a landlord. There is an easier, less risky way to gain real estate exposure through real estate investment trusts (REITs).
It is important to note that REITs do not provide a direct investment in real estate. Instead, a REIT is a special kind of corporation that buys, sells and rents real estate on behalf of its investors. To qualify as a REIT, at least 75% of the company’s income must come from real estate. Unlike normal corporations, REITs are not required to pay taxes at the corporate level. In exchange for this benefit, they must distribute 90% or more of their rental income to shareholders in the form of dividends.
These property companies can be either private or publicly traded. Public REITs are similar to other public equities in that they trade on stock exchanges.
Investors traditionally have turned to REITs to diversify their portfolios because they tend to perform differently from bonds and somewhat differently from the broad equity market, while generating long-term returns comparable to those of the latter. That said, the correlation between REITs and U.S. stocks has increased in recent years, which means that REITs may no longer provide quite the same diversification opportunities as in the past.
Many investors favor REITs for the securities’ relatively large income stream. Individuals approaching retirement may look to REITs’ dividends as a source of regular income, but bear in mind that there is no guarantee that REITs will distribute dividends. Liquidity is another important benefit, as REIT shares can be bought and sold on public markets. Additionally, REITs give you flexibility to achieve your target real estate exposure because you can own the exact amount that fits your investment strategy.
However, there are also drawbacks. For example, REIT dividends are taxed as ordinary income, which is subject to a higher rate than qualified stock dividends. One way to limit REITs’ tax impact is to hold them in an IRA, 401(k) plan or other tax-advantaged investment account.
Levels of diversification
You can invest in publicly-traded REITs by buying shares of individual real estate companies or a REIT-oriented mutual fund. The main difference between the two is the level of diversification. While individual REITs own multiple properties, some of these companies specialize in only one or two types of real estate. Industrial REITs, for example, generally focus on warehouses, while health care REITs might emphasize only medical facilities.
This is fine if you are looking for targeted exposure to one segment of the real estate universe. But, if broader diversification is your goal, you may be better served by an investment that owns many kinds of REITs and gives you broader exposure to the real estate asset class.
Weigh your options
A rising interest rate environment can put a damper on REITs because higher rates raise borrowing costs. They also can make safer income-oriented investments, such as money market accounts, seem more attractive by comparison. However, REITs have a relatively low performance correlation to equities. So, when the stock market plunges, REITs may not dip as much, which provides something of a hedge in an otherwise stock-heavy portfolio.
There is no guarantee that REITs will appreciate in value or pay dividends. Also, it is possible to lose money in such investments. Talk to your financial advisor about whether they can benefit your portfolio given your personal circumstances, long-term goals and risk tolerance.