Real estate investment trusts (REITs) have been overshadowed by the U.S. stock market until this year, and for good reason. Looking back, the S&P 500 is up 14.64% over the past three years, versus a 7.09% growth in Morningstar's REIT category.
So far this year though, REITs are off to a sizzling start -- the Vanguard Real Estate Index (NASDAQMUTFUND:VGSLX) is up 12.25% as of March 1. While that sounds like a lot, it may be just the beginning. Here are three reasons to look at adding REITs to your portfolio in 2019, and which ones to consider.
1. Valuations are attractive
Things have been quiet on the REIT front for the past few years. The category posted modest single-digit returns in 2016 and 2017, and were down last year about as much as U.S. stocks. Given their humdrum returns, there hasn't been a compelling reason to buy REITs. This is largely due to the rising-interest rate environment. Investors traditionally look to REITs for their attractive yield, which is usually around 5%, but with interest rates rising on checking accounts and safer bonds, yield-hungry investors have opted for less risky strategies. This is to be expected, as REITs traditionally underperform in rising-interest rate environments.
With their modest returns and hazy outlook in a rising-interest rate environment, REITs entered 2019 with attractive valuations. REITs started the year trading far below their historical averages, at a 19% discount to net asset value (NAV) versus their long-term average of 4.3% (NAV reflects the market value of the real estate property, such as the value of the underlying building or hospital within the REIT), according to American Century Investments analyst Mike Rhode. That's a pretty steep discount, which can mean REITs are undervalued, and there may be more upside to come.
Although REITs haven't fared so well in the recent rising-interest rate environment, the opposite may be true for stable-rate environments. REITs stand to benefit from the Federal Reserve backing away from its tight monetary policy by holding interest rates steady, as opposed to raising them more. "This would create a major tailwind for the (REIT) asset class," said Rhode. One reason is that investors may have less incentive to buy Certificates of Deposit (CDs) and fixed-income assets if interest rates level off, creating an opportunity for REITs to attract some of those yield-seeking investors.
REITs also have a history of performing well during the late cycle of an economy. "Late cycle" means the tail end of a growing economy, when it has not quite become a recession yet. Cohen and Steers, an investment manager, found U.S. REITs have outperformed the S&P 500 by more than 7% annually in late-cycle periods since 1991. Moreover, according to Cohen and Steers, U.S. REITs have offered "meaningful downside protection in recessions." That's good news for those investors who are skittish about the economy. Though we may not be in a recession now, it does feel like we are in the late stage of economic growth, and if Cohen and Steers is right, now is a good time to start to buy REITs, which will help recession-proof your portfolio.
3. High yields help
REITs pay a healthy dividend -- they have to by law. The law requires REITs to distribute 90% of their taxable income to shareholders annually in the form of a dividend. This high dividend is a major contributor to a REIT's total return, and it's a significant reason why REITs perform well in a stock market environment that's producing lower returns.
U.S. stocks have had a great run over the past decade and continuing into this year, but their valuations are stretched, and returns may be more modest going forward since they've already reached such astronomical highs. If that's the case, a REIT's high dividend is also attractive in an otherwise low-return environment. All else being held equal, I get back more money sooner; A bird in hand is worth more than two in the bush.
The right year for REITs
For these reasons, REITs are set to shine this year. As for the recent run-up in the valuations of REITs, they may not be the screaming bargains they were a year ago, but the valuations overall are not as rich as those you'll find in the U.S. stock market. REITs returned less leading up to this year, plus Rhode's analysis of REITs beginning the year with a 19% discount can mean there's still some meat on this bone. Couple that with a stable-interest rate environment favoring REITs, a history of performing well in a late-cycle economy, and a higher dividend yield than the S&P 500 index, and you'll understand why 2019 has aligned all the elements for a great year for REITs.
There are many ways to invest in REITs and much more to consider if you are buying for the first time. There are equity REITs, mortgage REITs, actively managed REIT mutual funds, passive indexes, and exchange-traded funds (ETFs). Plus there are REITs that specialize in office buildings, hospitals, hotels, and multifamily dwellings.
Most financial advisors suggest allocating 1% to 5% of your assets into REITs as part of a diversified portfolio, so start looking to find which REITs are right for you.