The prevailing wisdom for any investment portfolio to safely navigate the stormy waters of the choppy market is to diversify. That may be through balancing your portfolio depending on age, risk tolerance or whatever parameter you desire. This can be facilitated by stock/bonds mix or domestic versus international exposure or looking at your portfolio in terms of the equity sectors it covers e.g. healthcare, technology, consumer goods, energy, real estate or financials to name but a few.
A Few Questions About REITs.
- What is a REIT, what forms can they take and how can I buy one?
- If I wish to invest in a REIT, where in my investment portfolio should it be placed – taxable or tax-advantaged accounts?
- Am I investing in a REIT because I think it is a useful way to diversify my portfolio?
- Why should I even bother with a REIT?
I will aim to answer these questions and much more below. Let’s get started.
What is a REIT and how can I buy one?
A REIT is a Real Estate Investment Trust. It is an investment in real estate through property and/or mortgages (this post will not focus on mortgage REITs or hybrid REITs) and trades on major exchanges just like a mutual fund. OK, full disclosure, the last sentence is not strictly true – see later under non-traded REITs. They will normally provide you with a liquid stake in real estate. The more common version is a publicly traded REIT. The real estate can be anything from apartment complexes, data centers, commercial warehouses, health care facilities, hotels or shopping malls. Bricks and mortar pieced together in an organized fashion to serve a function. Most of us are going to continue needing some form of family shelter, exotic hotels for vacation, access to an ever-increasing amount of information (big data) and places to be treated for ailments as we grow old. Thus investing in real estate funds is a no-brainer, right?
Table 1 below provides an example of funds from three common brokerage houses – Vanguard, Fidelity and T Rowe Price. Note for accuracy that TRREX is a real estate sector mutual fund that invests in REITs and publicly traded real estate companies. The year-to-date (YTD), 1-year and 3-year annualized returns are summarized. Data are courtesy of Morningstar analyses. For an interesting comparison, I have included annualized returns and expense fees of two popular index funds from Vanguard. I will come back to why I am referring to these funds later.
Table 1: Performance of Select REIT Index and Real Estate Sector Mutual Funds (yellow shading) over the Last 3 Years with Associated Expense Fees
Thus, like any mutual fund, and assuming you have available funds in a settlement account, you can buy your chosen REIT relatively painlessly with a few clicks and a few more of your hard-earned dollars. What is interesting about the three funds chosen is that they are not performing too badly over the last three years. The corresponding 10-year data (not shown) is not too shabby either. For VGSIX, FRXIX and TRREX (don’t you just love a fund that sounds like a dinosaur?), the 10-year annualized return is 6.9%, FRXIX not available (relatively new fund), and 6.5% respectively. That type of performance would help any portfolio over the long haul, I think you would agree. To put it into perspective, the 10-year annualized return for VTSAX is 7.2%. Are you still hanging in there and not bored to death by data tables?
What investment forms can a REIT take?
REITs can generally come in two major types – traded REIT that I have introduced already. And non-traded REITS. Some key differences between the two are summarized in Table 2 below. You should know that Mr. PIE likes his tables, especially ones that are laid with yummy food and good wine.
Table 2: Comparison of REIT Types
Some of the major differences are that investment in a non-traded REIT poses risks that are much different to a publicly traded REIT. Some of these risks are outlined as follows:
- Liquidity – non traded REITs lack liquidity. You can’t get access to your money, when you want to. Sometimes as long as 10 years after your initial investment. And if you do want access, the redemption penalties can be quite severe. That means you pay for the privilege to get at your own money. What the ****?
- High Fees – non traded REITs have high upfront costs, commissions. Can be as high as 5-15%. Gulp.
- Lack of share value transparency – market price is not available since non-traded REITs are not publicly traded. Often share price is determined on a yearly basis by a group of appraisers and may not be accurate or timely. You have to do your own leg-work to find this information and it is generally not in a digestible form that is appropriate for even the savvy investor.
It is very clear that the investor should be fully aware of the risks before committing to a non-traded REIT investment. The SEC kindly provides an excellent write-up for investors on the pros/cons and risks associated with non-traded REITs. You can also find the reports of a non-traded REIT through the EDGAR database (either a 10-K or a 10-Q form). FINRA has an equally informative article on their site that highlights the complexity and potential pitfalls of investing in non-traded REITs.
Case History on Non-Traded REITs: Mr. and Mrs. PIE own two non-traded REITs. This case history focuses on one REIT that invests in data centers and healthcare facilities. The prospectus was made available to us about 3.25 years ago by our former advisor and we elected to buy into it. The REIT is held in each of our Traditional IRAs. See section below on tax efficiency. It was very well researched by our advisor. The up-front commission fee was already baked into fees with our advisor which were actually not unreasonable. We are three years into the life of this REIT and since our original investment it has grown by 24.7%. If we wish to liquidate the funds today (and let’s assume the REIT was in a taxable account as opposed to an IRA which are subject to well established early withdrawal penalties) , we would be charged a redemption penalty of 2.5% of our original investment. If we wait another 12 months to the 4-year mark, there is zero penalty. Had we chosen to try to liquidate the REIT within 1 year of investment, we would not have been able to do this at all. This lack of liquidity is not for the faint-hearted or the investor who needs immediate access to their money for any number of reasons. Like houses that can be very difficult to sell in certain geographies and in difficult market situations, non-traded REITs can be just as illiquid.
So far, our REIT is performing reasonably well and we are comfortable with how it is being managed. The reports for investors tell a story of a well-structured portfolio of properties being led by an experienced management team with a good track record. It should be noted that our exposure to REITs is a relatively small percentage (~6%) of our overall portfolio. The decision we made three years to invest in REITs would not be the decision we make today, starting afresh. For the record, we are currently assessing the overall value of non-traded REITs in our portfolio.
If I decide to invest in a REIT, where should it be optimally held within my portfolio?
Investors are advised to hold their REITs in a tax-advantaged account such as an IRA (Traditional or Roth). REITs are less effective than other high dividend-paying stocks in a taxable portfolio because dividends represent a large portion of the returns of the real estate asset class and REIT dividends are taxed at a significantly higher rate than other stock dividends. A detailed analysis can be found over at the Boglehead forum if you want to get into some very heavy tax efficiency chatter. Bottom line, for an investor who expects to have a lower tax bracket when they withdraw money, a traditional IRA is the best choice. If you expect to have a higher tax bracket, then the Roth IRA is the route to go since withdrawals are tax free after age 59.5. If you have access to a Health Savings Account (HSA), this tax-advantaged account is also a great place to hold your REIT. The growth, dividends and withdrawals are all tax free when used for valid medical expenses.
Am I investing in a REIT because I think it is a useful way to diversify my portfolio? Why should I even bother with a REIT?
Ok, here is where it gets tricky. Each and every investor has a fairly unique situation. The opinions here in no way reflect what YOUR portfolio needs to look like to deliver for YOUR needs. Whatever style of investing you pursue, it must also allow you to sleep well at night.
I am going to put forward a case for perhaps not even bothering with REITs. And the reasons are is that it simply boils down to whatever else you are likely to have in your portfolio. Let’s use two large and popular mutual funds as exemplars– VTSAX and VFIAX. VTSAX invests in the total US stock market which is composed of organizations that focus on healthcare, technologies, consumer goods, energy, financials and consumer services amongst many others in developed markets. And importantly, real estate.
Examples of some of the largest holdings in VTSAX are Apple, Berkshire Hathaway, General Electric and Amazon. The real estate weighting in VTSAX is 4%. Yep, you heard that right – 4%. Nearly $17 billion of the total net fund assets ($418 billion) are dedicated to the real estate sector, including REITs. If you are invested in VTSAX, you have healthy exposure to real estate already.
Similar arguments hold for VFIAX which invests in 500 of the US largest companies. In terms of equity sector diversification, VFIAX has real estate weighting of 2.46%. That translates to $5.6 billion of this fund’s total net assets dedicated to real estate. Again, this is healthy exposure.
These large organizations such as GE, Apple and Berkshire Hathaway are buying up tracts of land and putting up facilities to support the growth of their various businesses. Putting it simply, the growth (or fall) of mega businesses such as GE, Apple and Berkshire Hathaway contributes to the rise (or fall) of index funds like VTSAX and VFIAX. Not only are these companies buying land in the US, but internationally also. With funds like VTSAX and VFIAX, you have exposure to domestic and international real estate now. You have your diversification. Winner, winner, Parisian bistro coq au vin dinner.
The other piece of the puzzle is expenses. Although I quoted the Investor form of Vanguard REIT (VGSIX) in Table 1, the Vanguard REIT Admiral shares fund (VGSLX) has slightly lower expenses of 0.12%. Compared to VTSAX at 0.05%, that is still nearly two and a half times the expense cost. The T Rowe Price Real Estate Fund (Ticker = TRREX – the dinosaur fund) is appropriately named as the expenses are ominously large at 0.76%, fifteen times higher than VTSAX. In the context of a similar fund performance, high fees over the long haul will have a negative effect on your portfolio growth. In Figure 1 below, the 10-year performance of VTSAX relative to Vanguard and T Rowe Price REIT / real estate funds are displayed. The bold red line is VTSAX. The two lower lines are Vanguard and T Rowe Price REIT/real estate funds. Please draw your own conclusions from the data.
Figure 1: 10-Year Performance of VTSAX, VFIAX, VGSLX and TRREX Funds
Whatever fund(s) you have in your portfolio, just do a quick check on Morningstar under the Top Sectors section for your fund ticker. It will tell you in terms of a percentage how much your fund is weighted to real estate. If you have $100,000 invested in VTSAX, you have $4,000 (4%) exposure to real estate. If I were you, I would not bother with that $5,000 “diversification strategy” using money from your annual bonus into a REIT index fund such as VGSIX. Or at least carefully consider the overall real estate weighting in your portfolio before pulling the trigger on that investment. Just an opinion though.
There is a great summary on asset classes (including REITs performance) over the last 10 years by Ben Carlson over at A Wealth of Common Sense. His “Asset Allocation quilt” is a fascinating visual in itself and packed with good information. REITs bring solid but overall below par performance relative to equities (large/mid/small cap) and with equity-like volatility.
I think there are a few simple take-home messages regarding REITs.
- Solidly performing REIT index funds or real estate sector funds are available and easy to buy at the common brokerage houses.
- REITs come in essentially two main flavors. Publicly traded and non-traded. Take some time to understand the relative risk in each before you commit your money. Caveat emptor.
- REITs are tax-inefficient and are best placed in a tax-sheltered account.
- Before investing in a REIT, step back and consider the weighting towards real estate in funds that you currently own. You may be surprised how much exposure you have to real estate already.
- If you like simplicity, REITs add another level of complexity to the management of your portfolio.
In my opinion, REITs are not a bad place to invest. Data shows that they can provide solid annualized returns over decent time periods. Non-traded REITs can offer value, albeit with increased risk. But REITs are a bit like the drawer full of no longer used, washed out T-shirts – they can be workable in a number of situations but are generally an unnecessary clutter in many houses. If it makes sense to you, consider a shine up of your existing portfolio with a little spring cleaning.
What’s your take on REITs? Do you think they add significant value to your investment strategy?