Please ensure Javascript is enabled for purposes of website accessibility

The REIT Stuff

By Dan Caplinger – Updated Nov 15, 2016 at 12:02AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Putting real estate in your portfolio is gaining favor.

As you look through the latest news headlines, you may have noticed seeing more about REITs than usual. On one hand, they've been the target of large acquisitions, including the recent takeover of Equity Office Properties by the Blackstone Group, and Simon Property Group's (NYSE:SPG) buyout offer for Mills (NYSE:MLS). On the other hand, REITs focusing on lower-end mortgages, such as Novastar (NYSE:NFI), are facing a significant reversal of fortune after several years of outstanding performance.

Until recently, however, extremely few investors knew anything about REITs. Excluded from the traditional asset allocation mix of stocks, bonds, and cash, REITs represented an obscure sector where few investors felt comfortable putting their investment capital. After huge double-digit percentage gains over the past several years, however, understanding what REITs are and what role they might play in your portfolio is essential to making the best returns you can earn.

The nuts and bolts of REITs
REIT is an acronym for real estate investment trust. However, don't let the name fool you. Most REITs are organized not as trusts, but as corporations. As such, they have shares of stock just like any other corporation. These corporations tend to have the bulk of their assets either in rental properties or in mortgages. If they meet certain requirements, these corporations can elect to be treated as REITs.

Corporations often choose to become REITs for tax purposes. In general, corporations are subject to corporate income taxes at the entity level. When they pay dividends to shareholders, those dividends are also treated as income on each shareholder's individual income tax return. As a result, corporate investments tend to be subject to double taxation -- a common criticism of the tax laws, and one reason why some stock dividends are taxed at lower rates than other income.

If a corporation qualifies for REIT treatment, however, it is able to avoid being taxed at the corporate level. Instead, the REIT is treated as a pass-through entity, whereby shareholders pay the entire tax liability on their individual tax returns. With corporate tax rates as high as 38%, this can be a substantial incentive for companies that focus on real estate investments.

In order to qualify as a REIT, a company must have at least 75% of its investments in real estate, with 75% of its income coming from rental income or mortgage interest. Most importantly, REITs must pay out at least 90% of their taxable income each year in the form of dividends. This explains why many REITs have such high dividend yields in comparison to ordinary stocks; most corporations retain a larger fraction of their earnings.

REITs are everywhere
REITs have gained in popularity due to a number of factors. During the early part of the decade, when stocks were falling sharply, investors sought alternatives that offered diversification in order to stabilize their dropping portfolio values. Later, when interest rates fell to their lowest levels in 40 years, investors looking for current income had to look beyond traditional fixed-income securities like bonds and bank CDs to generate enough cash to pay for living expenses. When combined with rising real estate markets, the potential for explosive price growth became a reality. One index of REITs is up nearly 25% per year over the past five years.

As REITs have become a more established investment vehicle, financial institutions have offered investors new ways to invest in REITs. Exchange-traded funds like the Vanguard REIT ETF (AMEX:VNQ) and iShares Cohen & Steers (AMEX:ICF) track the performance of a basket of REITs. In addition, the scope of real estate holdings among REITs has expanded greatly in response to investor demand. A new exchange-traded fund, StreetTracks Dow Jones Wilshire International Real Estate (AMEX:RWX), gives investors global exposure to real estate holdings around the world.

Changing allocation models
In response to the emergence of REITs, some financial advisors have recommended changing portfolio allocations to include a percentage for REIT investments. Some allocation models include REITs as a component of the fixed income portion of the portfolio, reducing exposure to other interest-paying securities such as bonds, while other models treat REITs as a completely separate asset class. On the other hand, many advisors argue that most people already have a huge amount of exposure to real estate in the form of their equity in their primary residences, and so there's less need to make additional investments in real estate for diversification purposes.

With their long run of outperformance, it seems inevitable that REITs will eventually suffer a significant correction in price. However, many analysts have been calling for such a correction for the past several years, but prices have continued to climb. With the increasing interest in REITs as a target of mergers and acquisitions activity, it's definitely possible that REITs have further to go before they succumb to pressure among investors to take profits.

Chasing performance is a mistake that many investors make, and the outstanding returns of REITs give those investors another opportunity to repeat past errors. Though REITs may play a useful role in creating a well-balanced portfolio, investors shouldn't expect those 25% annual returns to continue forever. Cautious consideration about adding REIT exposure to your portfolio is the best strategy for now.

For related reading:

In your personal finances, dealing with real estate is important to your overall financial success. With handy tips from the Fool's personal-finance service, Motley Fool Green Light, you can save more and spend less on the things you need to make your house a home. See how comfortable Green Light can make your finances with our free 30-day trial.

Fool contributor Dan Caplinger will be spending more than enough on his new house, so he's not planning to buy back the REITs he sold in 2005 anytime soon. He doesn't own shares of any of the companies or ETFs mentioned in this article. The Fool's disclosure policy gives you shelter.

None

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Simon Property Group, Inc. Stock Quote
Simon Property Group, Inc.
SPG
$90.18 (-2.17%) $-2.00
Vanguard Specialized Funds - Vanguard Real Estate ETF Stock Quote
Vanguard Specialized Funds - Vanguard Real Estate ETF
VNQ
$83.44 (-1.33%) $-1.12
iShares Trust - iShares Cohen & Steers REIT ETF Stock Quote
iShares Trust - iShares Cohen & Steers REIT ETF
ICF
$56.20 (-1.16%) $0.66

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
329%
 
S&P 500 Returns
106%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/24/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.