Chapter 11
Real Estate Investment Trusts: Becoming a Virtual Landlord
IN THIS CHAPTER
Understanding what makes a REIT a REIT
Knowing how much to invest
Recognizing your home as a real estate holding
Focusing on the best REIT fund options
Why, land is the only thing in the world worth workin’ for, worth fightin’ for, worth dyin’ for, because it’s the only thing that lasts.
— SPOKEN BY THE CHARACTER GERALD O’HARA IN GONE WITH THE WIND
Scarlett’s father said those words long before the U.S. real estate crash at the onset of the 21st century. Unless you happen to have bought into real estate just prior to that crash, you’ve probably done quite well with any investments you’ve made in land.
The value of commercial real estate — just about anywhere in the nation — softened right along with the housing market. But again, unless you bought just prior to the decline that began its serious fall in 2006, any investment in commercial property — or residential, for that matter — has probably done well. In fact, if you happen to own some commercial property, perhaps through a real estate investment trust (REIT), you likely made out very well in recent years.
In a nutshell, real estate investment trusts, popularly known as REITs (rhymes with “beets”), are companies that hold portfolios of properties, such as shopping malls, office buildings, hotels, amusement parks, cellphone towers, or timberland. Or they may hold certain real estate–related assets, such as commercial mortgages. More than 160 REITs in the United States are publicly held, and their stocks trade on the open market just like most other stocks.
Via dozens of mutual funds, you can buy into a collection of REITs at one time. Through about 30 or so ETFs, you can similarly buy a bevy of REITs. And that may not be a bad idea. For the 42 years that ended in December 2020, the Dow Jones U.S. Select REIT Index enjoyed an average annual return of 11.4 percent. That isn’t quite the 12.0 percent that the S&P 500 has returned during the same time span, but it is still a healthy return by anyone’s measure. And more recently, REITs have clobbered the S&P 500, returning about 20 percent during the first half of 2021 versus less than 14 percent for the S&P 500.
At the same time, REITS over the years have displayed a significant degree of noncorrelation. That is to say, REITS sometimes go up when the general market goes down, and vice versa. The end result, if you have both REIT and non-REIT stocks, is a portfolio with smoother returns.
Some holders of REITs and REIT funds believe (and fervently hope) that the excellent performance and the portfolio-smoothing noncorrelation of REITS will continue. Others (a minority, to be sure) argue that the glory of REITs may already be gone with the wind. In this chapter, I provide you with several reasons (in addition to those offered by Scarlett’s dad) why REITs deserve an allocation in most portfolios.
Considering Five Distinguishing Characteristics of REITs
You may wonder why an entire chapter of this book is devoted to REIT ETFs. Why, you may ask, didn’t I merely include them in Chapter 10 with the other industry sector ETFs? Good question!
I have five reasons. Any one alone probably wouldn’t justify giving REITs a chapter of their very own. All five together do, however. The first three reasons explain why REITs deserve some special status in the world of investments. The last two reasons are perhaps less compelling than the first three, but I include them in the interest of completeness.
Limited correlation to the broad markets
An index of U.S. REITs (such as the Dow Jones U.S. Select REIT Index) has evidenced a correlation of about 0.60 with the S&P 500 over the past 20 years. That means the price of an S&P 500 index fund and the share price of a REIT index fund have tended to move in opposite directions roughly 40 percent of the time. The REIT index has practically no correlation to bonds.
Will REITs continue to work their magic? Their correlation with the broad market has been increasing; undoubtedly REITs are becoming somewhat the victims of their own success. As they have become more mainstream investments, they have come to act more like other equities. Years ago, practically no one held REITS in their portfolios. Nowadays, according to one poll, fully two-thirds of professional money managers are using them.
But as I write these words, and for the next few years, I believe you can expect continued positive returns and limited correlation — albeit on a lesser scale on both fronts. Therefore, REITs will still help to diversify a portfolio.
Unusually high dividends
REITs typically deliver annual dividend yields significantly higher than even the highest dividend-paying non-REIT stocks, and almost three times that of the average stock. (Many stocks, of course, pay no dividends.) At the time of this writing, the Schwab U.S. REIT ETF (SCHH) is offering a dividend yield of 2.86 percent versus the Schwab U.S. Mid-Cap ETF (SCHM), which offers a dividend yield of 1.05 percent. I use the mid-cap fund because it makes for the best apples-to-apples comparison — most REITs are mid-cap stocks.
So the cash usually keeps flowing regardless of whether a particular REIT’s share price rises or falls, just as long as the REIT is pulling in some money. That’s because REITs, which get special tax status, are required by law to pay out 90 percent of their income as dividends to shareholders. Cool, huh?
Still, REITs, like other stocks, can also be expected to see growth (and sometimes shrinkage) in share prices. Historically, about one-third of the total return of REIT stocks has come from capital appreciation.
You may have noted that I compared the dividend yield of REITs to the dividend yield of non-REIT mid-cap stocks, and that I did not compare the dividend yield of REITs to the interest on bonds (nor would I ever!). REITs and non-REIT stocks are similar in that they both represent equity, and as such, you can reasonably expect high long-term return with lots of volatility. Bonds are not similar in any way. With bonds, you can expect lower long-term return but with much less volatility.
I’ll talk much more about bonds in Part 3. For now, suffice it to say that bonds are a different animal and should not be measured against any kind of equity investment. Do not sell your bonds to buy REITs because the yield on REITs is higher. I emphasize this because now with bond yields so pathetically low, I’ve been seeing articles, some in respectable publications, that ballyhoo REITs as a substitute for bonds. This is like suggesting that people bored with their docile housecat can trade it in for a mountain lion. Bad move.
Different taxation of dividends
Because REITs are blessed in that they don’t have to pay income taxes, their dividends are usually fully taxable to shareholders as ordinary income. In other words, whatever dividends you get will be taxed at year-end according to your income tax bracket. Few, if any, REIT dividends will be considered “qualified dividends” by the IRS, and so you will not pay the special 15 percent dividend tax rate that most people pay on their stock dividends. For that reason, your accountant will undoubtedly urge you to handle your REITs a bit carefully. I also urge you to do so. REITs, unless you are in a very low tax bracket, should be kept in tax-advantaged accounts, such as your IRA.
Special status among financial pros
The vast majority of wealth advisors — whether they primarily use style investing, sector investing, or astrology charts and tea leaves — recognize REITs as a separate asset class and tend to include them in most people’s portfolios. Is that distinction logical and just? Yes, but…I’ve asked myself this question: If REITs deserve that distinction of honor, what about some other industry sectors, such as energy? After all, energy has lately shown less correlation to the S&P 500 than have REITs. Doesn’t energy deserve its own slice of the portfolio pie?
Well, one possible reason why REITS, and not energy stocks, are seen as a separate asset class (in addition to the reasons I explain in the previous sections) may be that the REIT marketers are savvier than the marketers of energy stocks. That’s possibly the case. But I believe there is more to it than that.
Connection to tangible property
Some people argue that REITs are different than other stocks because they represent tangible property. Well, yeah, REITs do represent shopping malls filled with useless junk and condos filled with single people desperately looking for dates, and hospitals charging $10 for a Kleenex, and I suppose that makes them different from, say, stock in Anheuser-Busch or Procter & Gamble. But the reality is that REITs are stocks. And to a great degree, they behave like stocks. If REITs are different than other stocks, unusually high dividends and lack of market correlation are the likely distinctions — not their tangibility. After all, aren’t beer and toothpaste “tangible”?
Calculating a Proper REIT Allocation
You don’t really need REITs for the income they provide. Some people have this notion that withdrawing dividends from savings is somehow okay but withdrawing principal is not. Don’t make that mistake. The reality is that if you withdraw $100 from your $1,000 account, it doesn’t matter whether it came from cash dividends or the sale of stock. You’re left with $900 either way.
If you need cash, you can always create your own “artificial dividend” by selling any security you like (preferably one that has appreciated). Not that I have anything against dividends — they’re fine — but they shouldn’t be your primary reason for purchasing REITs. (Much more on dividends, their pros and cons, in the next chapter.)
Your primary motivations for buying REITs should be diversification and potential growth. In the past, the diversification afforded by REITs has been significant, as has the growth. In this section, I help you consider how much of your portfolio you may want to allot to REITs.
Judging from the past
If you could go back 20 years in a time machine, I’d have you put, heck, everything in Apple. But REITs would not have been a bad option, either. Looking forward, of course, the picture’s a bit less clear. However, I think you can presume, regardless of future performance, that REITs will continue to move in somewhat different cycles than other stocks.
I think you can also presume fairly safely that REITs will continue to produce healthy gains, over the long run. As with all stocks, anything can happen in the short run. Anything.
Putting all the factors together, I suggest that most investors devote perhaps 15 to 22 percent of the equity side of their portfolios to REITs. If your portfolio is “60/40” (60 percent stocks and 40 percent bonds), that would translate to a REIT position of 9 to 13 percent of your entire portfolio.
What if, like many people, you’re a homeowner whose home represents most of your net worth? You may want to play it a little light on the REITs, but don’t let the value of your home affect your portfolio decisions to any great degree. (See the sidebar, “Your residence, your portfolio.”)
Splitting the baby: Domestic and international REIT funds
International REITs are worth breaking out of your international stock holdings for all the same reasons that U.S. REITs are worth having tucked into a larger portfolio of U.S. stocks. The REIT allotment you give to your portfolio might be evenly split between U.S. and international REITs, in keeping with the 50/50 split between U.S. and non-U.S. stocks that I suggest for your overall portfolio.
As I discuss in Chapter 9, about 45 percent of the world’s stocks are non-U.S.; in my mind, it stands to reason that an optimally diversified portfolio will have good exposure to foreign stocks. If you follow my advice, you might (assuming you have a “60/40” portfolio) have two REIT funds, and each might be given a 3 to 5 percent allocation in your portfolio. Alternatively, you might have just one global REIT fund making up 6 to 10 percent of your portfolio, which will give you both your U.S. and foreign-REIT exposure in one shot. You’ll find specific funds to meet these roles in just a few paragraphs.
Oh, for you mathletes who think I’ve just made a mistake: Yes, yes, I know that I just said 6 to 10 percent of your (60/40) ETF portfolio might be made up of REIT funds, while several paragraphs earlier, I suggested that as much as 9 to 13 percent of your portfolio might be devoted to REITs. The reason for the discrepancy: You’re also going to get some REIT exposure, above and beyond what you get from your REIT funds, in your broad stock-market ETFs. If, for example, you were to buy an S&P 500 index fund, about 3 percent of that fund would be made up of stock from REITs.
Picking REIT ETFs for Your Portfolio
If you want REITs in your portfolio, you won’t get a whole lot of them unless you purchase a REIT fund. Despite the fact that there are roughly 160 of them, publicly traded REITs simply don’t make up that large a segment of the economy.
So if you want the diversification power of this special asset class, you need to go out of your way to get it. But thanks to ETFs, doing so shouldn’t be much of a hassle, and you get many of ETFs’ other benefits in the bargain, including rock-bottom expenses.
The tax efficiency of ETFs can help limit the amount you’re taxed on any capital gains you enjoy on your REIT fund, but it can’t do anything to diminish the taxes you’ll owe on the (nonqualified) dividends. For that reason, all REIT funds — ETFs or otherwise — are best kept in tax-advantaged retirement accounts, such as your Traditional IRA, Roth IRA, or 401k plan.
Although about 50 REIT ETFs are currently available to U.S. investors, a handful really stand out for their low costs and reasonable indexes. In fact, making the selection shouldn’t be all that hard.
If you want to see nearly the whole buffet of REIT ETFs available, visit www.reit.com; click Investing in REITS, then List of REIT Funds, and finally Exchange-Traded Funds. You’ll notice that some are leveraged (such as the ProShares Ultra Real Estate ETF [URE]), and I’d rather you stay away from the leveraged ETFs for reasons I discuss in Chapter 18. Others are focused on slivers of the REIT market (such as the Janus Henderson Long-Term Care ETF [OLD], which invests primarily in REITs that own and run senior living facilities). I’d rather you steer clear of those, too. (You can slice and dice a portfolio to death, but why do so?) Of what’s left, several are quite good. Here, I outline the best of the best.
U.S. domestic REIT ETFs
The three funds I recommend are strikingly similar, and any one would fit the bill nicely when it comes to investing in the U.S. REIT market.
Schwab U.S. REIT ETF (SCHH)
Indexed to: Dow Jones Equity ALL REIT Capped Index
Expense ratio: 0.07 percent
Number of holdings: 140
Top five holdings: American Tower Corporation, Prologis, Inc., Crown Castle International Corp., Equinix, Inc., Digital Realty Trust, Inc.
Russell’s review: The word “Capped” as it appears in the name of the index means that the indexers limit the representation of any one security in the index. In the case of this Dow Jones Index, no one REIT corporation can be given more than 10 percent representation in the fund. That kind of capping is a good thing in terms of diversification and controlling risk. It can, however, temper performance as the fund is limited in how much it can invest in one super-fast-growing REIT that suddenly dominates the market.
Fidelity MSCI Real Estate Index ETF (FREL)
Indexed to: MSCI USA IMI Real Estate 25/25 Index
Expense ratio: 0.09 percent
Number of holdings: 168
Top five holdings: American Tower Corporation, Prologis, Inc., Crown Castle International Corp., Equinix, Inc., Public Storage
Russell’s review: The designation “25/25” in the name of the index refers to the stipulation that no one REIT company can have more than a 25 percent share of the market cap of the fund, and no group of entities with weights above 5 percent can exceed 25 percent of the fund. In other words, this is a “capped” index, just like the index on which the Schwab REIT is built, although the Fidelity fund, and even more so the Vanguard fund I describe next, have looser rules where it comes to capping.
Vanguard REIT Index ETF (Vnq)
Indexed to: MSCI US Investable Market Real Estate 25/50 Index
Expense ratio: 0.12 percent
Number of holdings: 178
Top five holdings: American Tower Corporation, Prologis, Inc., Crown Castle International Corp., Equinix, Inc., Public Storage
Russell’s review: This is a broadly based ETF with a low expense ratio, even if slightly higher than Schwab’s and Fidelity’s. Be aware, however, that even with all the advantages of an ETF and the considerable tax-minimizing prowess of Vanguard, this ETF will represent something of a tax burden. For that reason, I recommend that you consider purchasing this ETF (as would be the case with Schwab’s or Fidelity’s REIT offerings) as a long-term investment and keeping it in a tax-advantaged retirement account.
International and Global REIT funds
If you follow my advice and split your REIT allocation between U.S. and international funds, the next three ETFs will definitely come in handy. The first two funds, Vanguard’s VNQI and Xtrackers HAUZ, invest only in markets outside the United States and pair quite nicely with any of the domestic REITs I discuss earlier. The next fund, REET, is divided between U.S. and non-U.S. REITs, so it provides one-stop shopping for REIT investments (although at a higher cost than you’d pay for the Vanguard and Xtrackers options).
Vanguard Global ex-U.S. Real Estate ETF (VNQI)
Indexed to: S&P Global ex-U.S. Property Index, which tracks the performance of REITs in both developed and emerging markets outside of the United States
Expense ratio: 0.12 percent
Number of holdings: 680
Top five holdings: Vonovia, SE, Mitsubishi Estate Co., Ltd., Goodman Group, Sun Hung Kai Properties, Ltd., Mitsui Fudosan Co., Ltd.
Top five countries: Japan, China, Hong Kong, Australia, Germany
Russell’s review: This ETF is an excellent way to tap into foreign REITs. Do take note that foreign REITs, like all foreign stocks, are going to be subject to currency flux as well as market volatility. In other words, expect a bit more of a roller-coaster ride with this and all foreign ETFs than you would expect of domestic ETFs. Given the high dividend yield, you are best off having foreign-REIT funds in a tax-advantaged account, if you have the room. But in a tax-advantaged account, you won’t be able to recover the foreign tax withholding via the foreign tax credit. So if you only have room for one fund in your IRA, make it the U.S. REIT fund.
Xtrackers International Real Estate ETF (HAUZ)
Indexed to: ISTOXX Developed and Emerging Markets ex USA PK VN Real Estate Index
Expense ratio: 0.10 percent
Number of holdings: 570
Top five holdings: Vonovia, SE, Goodman Group, Mitsui Fudosan Co., Ltd., Sun Hung Kai Properties, Ltd., Mitsubishi Estate Co., Ltd.
Top five countries: Japan, Hong Kong, Australia, Germany, Great Britain
Russell’s review: This has a somewhat similar mix to the Vanguard foreign-REIT fund, but it’s not identical. In fact, the five-year return of HAUZ far exceeds VNQI (8.3 percent versus 5.9 percent). However, the returns for the first three quarters of 2021 are very similar. The “PK” and “VN” in the index title mean Pakistan and Vietnam, two countries the index chooses to ignore. I’m not sure why, but given that these two countries make up a tiny, tiny percentage of the world REIT market, I don’t think it is worth lamenting.
iShares Global REIT ETF (REET)
Indexed to: FTSE EPRA/NAREIT Global REIT Index
Expense ratio: 0.14 percent
Number of holdings: 320
Top five holdings: Prologis Inc., Public Storage, Digital Realty Trust Inc., Simon Property Group Inc., Equinix Inc.
Top five countries: United States, Japan, United Kingdom, Australia, Canada
Russell’s review: If you have a smaller portfolio, or if you long for simplicity, go with this perfectly fine ETF. But in most cases, I suggest that you instead combine a domestic REIT ETF (such as VNQ or FREL) with an international REIT fund (such as HAUZ or VNQI). You’ll wind up with pretty much the same mix of REITs, but you’ll be spending less on management expenses. Also, if you only have so much room in your IRA, it’s best to have the U.S. REITs in there, and the foreign REITs in your taxable brokerage account.