Achieving a diversified portfolio is accomplished by adding exposure to a variety of assets whose prices tend to move disparately under changing external forces like economic cycles or geopolitical shocks. But some classes like real estate are more difficult to own directly. For a typical investor looking to add some property exposure to a portfolio, buying and managing an apartment complex is a bit of a stretch.
Fortunately, REITs offer a scalable, cost-effective way to add this powerful asset class without buying a shopping mall. Real estate investment trusts comprise a special class of companies that pool physical real estate investments and issue securities that represent a fractional ownership share in the pool.
Classified as "pass through" securities under the tax code, REITs must funnel at least 90 percent of their income directly to shareholders. This imparts two advantages: the company pays no corporate income tax, and shareholders generally enjoy relatively high income yields compared with more conventionally structured dividend stocks.
Congress enacted legislation in 1960 that created REITs as a means of enhancing real estate investment opportunities for the general public. Recognizing the capital intensity and long-term nature inherent in large real estate ventures, Congress established a special class of ownership aimed at expanding the breadth of participation and spreading the risk of property investing. Most large real estate trusts in the U.S. are publicly traded on the major exchanges just like other stocks and are therefore quite accessible to most investors. Many smaller REITs are not publicly traded and hence unsuitable for all but the most sophisticated investors, owing to their inherent lack of liquidity and transparency.
REIT investments may be broadly classified into one of two categories. Equity REITs own and often operate physical properties like shopping malls, warehouses, hospitals and industrial buildings. These firms develop and lease properties and then act as the landlord. Mortgage REITs are involved in the financing of properties through ownership of mortgages or direct lending to real estate owners. These firms typically raise capital through equity issuance and borrowing to buy and manage a portfolio of loans, including single family mortgages and commercial loans.
As one might expect, dividend yields vary along with the expected risk of the particular sector and the specifics of each REIT. Mortgage REITs typically offer higher payouts, sometimes exceeding 10 percent annually, but carry significant risks associated with changes in interest rates. This risk is magnified through the use of leverage to juice the yields. Terrific when it is working, but losses and dividend cuts can cascade abruptly when the worm turns (or even sees its shadow).
Equity REITs encompass a multitude of characteristics and risks that investors can easily calibrate to fit their specific requirements. Some own properties that are subject to long-term leases (industrial buildings or hospitals, for example). Projected cash flows for these firms tend to be stable and predictable, supporting more modest but less variable dividends. Others owning properties subject to greater uncertainty or shorter leases (like hotel buildings) offer higher yields but can quickly whack payouts when conditions weaken.
Some analysts have expressed concern that valuations are inflated after a long run for the sector. But the same can be said for virtually every income-producing asset class, as retirees continue to need income despite historically low yields on more conservative investments like bonds and CDs. And REIT valuations are certainly more moderate compared with recent historical values than the S&P 500 index as a whole.
As always, careful research is essential. But if you have no exposure to this asset class in your portfolio, it's not too late to look at REITs.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.