What is a REIT?
Diversifying a Portfolio with Real Estate
Real estate as a wealth generator is hardly a new idea. People owned property long before the advent of stock exchanges and other capital markets. In more recent times, large corporations and institutions have held commercial real estate in their portfolios.
But individual investors have not traditionally had ready access to a professionally managed, diversified real estate portfolio. This has changed in the last few decades with the development and growth of real estate investment trusts, or REITs. Now individuals can add a real estate component to their portfolio to improve overall diversification.
What is a REIT?
A REIT is a company that owns, operates, and/or finances real estate property. Most of this discussion will address equity REITs, which manage different types of income-producing properties, such as hotels, office buildings, industrial facilities, apartments, and shopping centers. As commercial landlords, equity REITs typically generate dividend income from the rent paid by tenants. Many REITs in the US are traded on the public stock exchanges.
Publicly traded REITs offer investors several potential benefits:
- Real estate exposure. While publicly traded REITs account for only a small portion of the real estate investment universe and the equity market, academic evidence suggests that REITs have similar returns to the overall real estate market
- Low correlations with financial assets. Over longer periods of time, historical correlations of REITs and stocks have been generally low. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)
- Diversification. A REIT holds a portfolio of properties, which may specialize by property type and industry, or be broadly diversified according to industry and region. With the more recent advent of real estate securities overseas, investors can further diversify their exposure among foreign developed markets.
- Higher yield, regular income, capital appreciation. Since REITs have to pay out a large fraction of earnings as dividends, they tend to offer higher-dividend income than equities, and this may benefit certain income-oriented investors. Total return of the shares is tied to income and change in market value.
- Distinct asset class. While REITs are considered equity vehicles and can have significant exposure to the size and value risk factors, they are generally considered to be a separate asset class, due to their low long-term correlations with stocks.
- Liquidity and transparency. Publicly traded REITs can be bought or sold whenever the stock market is open for business. The availability of market-determined share prices can reveal information about the market’s assessment of the company’s prospects, including the ability of the firm’s management team.
- Tax treatment. REITs operate as “pass-through” corporations in which most income goes directly to shareholders. They typically pay little or no taxes on corporate income.
Investing in REITS
A REIT mutual fund that manages a portfolio of REITs typically offers more diversification than owning a single REIT. Most REIT funds are either actively managed or indexed. An active fund manager seeks to pick securities that appear undervalued—an approach that often results in over-concentration in a single category, which may raise risks and potential costs, including transaction costs and management fees. On the other hand, an index fund tries to replicate a benchmark, such as the FTSE NAREIT Equity REIT Index or the Dow Jones US Select REIT Index. Although index funds may have lower fees, securities held in the portfolios may experience buying and selling pressure when indexes are reconstituted.
Our preferred approach is a structured strategy. Rather than trying to replicate an index, a manager may choose securities based on risk-return characteristics, diversification benefit, and favorable price negotiation. By keeping costs low and trading efficiently, a structured REIT strategy seeks to generate improved returns over time. Advantages of this approach include broader, more systematic exposure to the REIT universe at a lower cost.