In my opinion, real estate investment trusts (REITs) are one of the most underappreciated asset classes out there.
They were created back in 1960 in response to demand for legislation that would allow regular everyday investors the ability to invest in large portfolios of the income-generating real estate.
President Eisenhower signed a law providing the legal framework for a real estate structure for investors akin to the mutual fund structure for investing in stocks.
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REITs have since spread around the world as an increasing number of jurisdictions create their own REIT legislation. In our part of the world, Australia has a large REIT market, with REITs available there since the 1970s.
Other relatively developed REIT markets include Japan (since 2001), Singapore (2002) and Hong Kong (2005).
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What is a REIT?
A REIT is a company that owns a portfolio of the income-generating real estate. The properties owned by REITs vary hugely – they can be commercial (i.e. offices), retail, residential or industrial, and can even include hotels, hospitals, and forestry.
REITs don’t even necessarily need to own real estate. Mortgage REITs (MREITs) own bundles of commercial and real estate mortgages, for example. In the case of MREITs, an investor is buying a portfolio of the mortgage debt or mortgage securities.
For the purposes of this article, however, I’m going to focus on REITs that own bricks and mortar real estate – also known as equity REITs.
There are dozens of reasons for you to own REITs… here are five to begin with:
By law, REITs have to pay out nearly all of their taxable income to shareholders in the form of dividends. Whilst the percentage of income that must be paid out varies depending on the specific REIT country jurisdiction, it’s usually at least 90 percent.
These REIT dividends are all backed by rents. The REIT owns (and often manages) portfolios of underlying real estate. It collects the rent and pays out nearly all of that income to you. And what’s more, it has to, by law.
In Asia-Pacific, there are REITs holding portfolios of quality properties paying 5 to 7 percent or more in dividends. This is attractive in a world of persistently low interest rates.
- Tax efficiency
As an investor in a regular listed stock, by the time you get that dividend cash into your brokerage account, it’s been heavily taxed.
Dividend income from regular listed companies is taxed twice. Firstly, it is taxed at the company earnings (or profits) level. In the U.S., for example, whilst the final effective corporate tax rate varies from company to company, the headline tax rate is 35 percent.
The second level of taxation is at the dividend itself, which, depending on your circumstances, can be up to 20 percent.
But REITs only get taxed at one level, depending on the REIT jurisdiction. Most of the time, this means that REIT income is tax exempt, so long as they pay a minimum of 90 percent of their profits to shareholders. In other markets, the dividends received by the investor are tax exempt, if the REIT has paid tax on its income.
Either way, this makes REITs much more efficient for us as investors… we only get taxed once.
- Be a landlord without the stress
Anyone who’s been following my writing for any length of time will know that I am a huge advocate for investment real estate ownership. But as someone who has owned investment real estate for decades, I know how much of a hassle it can be sometimes.
Deadbeat tenants who don’t pay the rent or cause damage, the costs of renovations and refurbishments between tenancies… the admin alone can be cumbersome.
But REITs allow you to be an owner, albeit a small one, of a portfolio of the rent-generating real estate without having to deal with any of the aggravations that can accompany being an individual landlord. None of the tenants from your REIT portfolio will be calling you at 4 am on a Sunday morning after a kitchen pipe has burst.
- And, you can own the best
As an individual, it’s unlikely any of us will ever be able to buy a prime downtown office building or a high-end retail mall in New York or Tokyo.
But REITs allow us access to some incredible real estate that we’d otherwise have no chance of ever owning ourselves.
- Predictability & low volatility
Rental income and property management costs are relatively predictable over the short to medium term. Lease terms are anywhere from two to 10 years in many commercial markets. That means as investors, our income outlook is stable – we don’t need to worry too much about earnings in the same way we do about our equities.
REITs also exhibit low beta. Beta measures how much a particular security moves around in relation to the broader market. It’s a measure of volatility in comparison to the market as a whole.
For example, a stock with a beta of 1.0 indicates that the price moves in line with the market, up and down. If the beta is more than 1.0 it implies the stock moves more than that market (in both directions). And, if the beta is less than 1.0 it means a stock moves with less volatility than the market.
REITs generally have a beta of less than 1.0. This means that whilst REIT prices won’t move up as quickly as the market does, when the market corrects, REIT prices should fall less than the market.
For comparison, utility stocks also typically exhibit a low beta.
If you think of a risk spectrum, with bonds at one end and equities at the other, REITs occupy the middle ground. Whilst a bond gives you a certainty of getting your money back, it lacks capital growth. REITs allow you the opportunity to enjoy capital growth and dividend growth because real estate’s value and rents tend to increase over time.
So if you’re looking for relatively high, predictable, stable income, backed by real assets, then REITs should be a part of your portfolio.
For an easy way to add REITs to your portfolio, you could look at an ETF. The largest is the Vanguard REIT ETF (Exchange; NYSE, Ticker; VNQ), which has US$34 billion under management and charges just 0.12 percent annually.
Article by Stansberry Churchouse