Listed real estate securities are well-acknowledged as a tool for diversification and inflation protection. But how many REITs should one hold, and what percentage of total asset allocation should one give to them? We share the answers with you in the article below.
About REITs
Real estate investment trusts (REITs) pool investor money and use it to buy, operate, and/or finance income-producing real estate.
In some ways, one can think of them just like a mutual fund.
Both collect money from several traders and use it to buy assets as per a defined investment strategy.
The key difference is that REITs focus only on real estate assets, while mutual funds can work in equities, commodities, and more.
Most of these trusts focus on specific segments of the property market.
For example, some might work in apartment complexes, and others in office buildings, malls, hotels, or telecommunication towers.
REITs are different from other real estate companies, which are more interested in buying and selling properties.
Instead, they make their money by operating the asset and leasing out space.
These trusts can either be publicly traded or privately held.
The former work like securities and can be bought or sold on the stock market.
The latter are traded over the counter through brokers.
Most investors buy REITs for strong and stable dividend incomes and their ability to act as an inflation hedge.
These firms must pass on 90% or more of their earnings to shareholders, and this is why their yields are often quite high.
Lastly, the real estate market does well when inflation goes up because property prices and rentals also increase along with it.
Hence, REITs tend to give higher returns during such times.
What Is a Good Payout Ratio for a REIT?
Anywhere between 35% to 60% is considered a good payout ratio.
Above 75% is unsafe, and anything in between is moderately risky.
Payout ratios are derived as dividends per share divided by funds from operation (FFO) (for mREITs, the denominator is EPS).
Excessively high payouts indicate that the trust might soon cut dividends.
Another reason could be falling stock prices, which could be causing the payout percentage to artificially increase.
Neither is a good sign and therefore, investors should be wary of such REITs.
Are REITs Necessary in a Portfolio?
REITs are often seen as essential components of well-diversified investment portfolios.
While there are several other asset classes, it is difficult to find one that can offer all the numerous benefits that these securities can offer.
Firstly, they bring in significant diversification because of their low correlation to equity markets.
To understand this, it is important to know that real estate investments have a distinct economic cycle relative to other sectors.
Their lease rentals do not change much with market scenarios, unlike prices of goods or services.
Therefore, their earnings are more secure, even during downturns.
Moreover, real asset values tend to appreciate when inflation is going up.
This is again because property leases are often linked to rising prices, and it’s why REIT returns go up automatically during such times.
Their potential inflation hedging attributes set them apart from most other types of financial instruments.
Another very important benefit they offer is steady and high-yield dividends.
It is regular, in-hand cash, which is very good to have during times when equity markets are struggling.
Lastly, commercial real estate is the third biggest asset class in the US investment market.
It is important for your holdings to have at least some representation of REITs in the portfolio.
This is why both institutional and retail investors accept REITs as a core asset class now.
More often than not, some allocation is always made to them.
Are They Good in a Retirement Portfolio?
Yes, REITs can be a good addition to a retirement portfolio.
They have many characteristics that align well with retiree preferences. Some of these are listed below:
- Steady dividend incomes
- Diversification benefits
- Inflation protection
- Moderate capital appreciation
One key factor that makes them very attractive is their low correlation to equity markets.
By adding these securities to their holding, folks can bring down the overall volatility of the portfolio, thus making it less risky.
Lastly, REITs get certain tax advantages from the IRS.
Any income they distribute to shareholders does not invite corporate taxes.
This is one of the reasons why their dividend yields are so high. The government encourages them to share the earnings forward.
Those building a retirement portfolio can amplify these tax advantages by placing the dividends in a Roth IRA account.
In this case, the dividends can be used after you retire without having to pay any further tax on them.
Should I Invest All My Money into REITs?
No, it is never good to put all your money in one basket, whether it is REITs or any other asset class.
However, it could be a good idea to have them as part of a well-diversified portfolio.
Real estate exposure offers several benefits, such as strong and steady dividend incomes and protection against inflation.
But all of this comes at specific risks.
For example, these stocks tend to fare poorly when rising interest rates are accompanied by a slowing economy.
This is because a slowdown impacts the ability to lease out holdings, while higher rates make it difficult to finance purchases.
For mREITs, there is a direct effect on net margin, which is the key source of their income.
Therefore, placing money only in real estate trusts can be a bad strategy in such situations.
It is usually better to hold a diversified portfolio of assets, including equities, fixed income, commodities, REITs, and others.
It helps to reduce overall risk and secure returns in most circumstances.
How Much REITs in Portfolio Make Sense?
Most financial advisors suggest holding between 5% to 15% of invested capital as REITs in a portfolio.
An analysis by market research firm Chatham Partners pegs the right allocation percentage as 4% to 13%.
Another one by Morningstar puts it between 5% to 18%.
In sheer numbers, holding about five REIT stocks, each focused on a different real estate sector, is usually a good idea.
Folks can also achieve the right mix by taking up real estate-focused ETFs or mutual funds instead.
Is It OK To Not Have Any REITs in Your Portfolio?
It is a good idea to have at least a few of these securities in your portfolio most of the time because of their numerous advantages.
They can outpace stock market returns over the long term (as we show later in the article).
Due to this reason, they are fast becoming a dominant investment-related trend, and traders may not want to miss out on them.
How To Decide The Right Allocation To REITs?
Firstly, beyond a point, simply adding more REITs might not give significant diversification benefits.
Therefore putting higher than 15% of your holdings in them might not give you an advantage from this perspective.
Another aspect to consider is how actively the portfolio is managed and how well-diversified it already is.
For example, if the trader actively manages the portfolio, it is possible to quickly add or replace REITs to optimize performance.
Otherwise, not having too many of them might be a better idea.
Again, just like any other asset class, real estate is not risk-free. There are many factors that could impact the performance of these shares.
For example, a REIT focused only on apartment buildings may perform poorly if economic activity slows down and demand for housing falls.
Hence over-exposure to these securities is not advisable.
Ultimately how much asset allocation a trader decides depends on their individual capacity to absorb risk.
If they are looking at very high capital appreciation, perhaps choosing a lower REIT allocation than other stocks may work better.
For those who want steady dividends, adding a little extra of these trusts could be beneficial.
How Long Should You Hold REITs?
There is no specific holding period required for REITs.
However, it is best to see them as a long-term investment.
This is especially true for non-traded real estate securities.
The returns for these trusts are not easily accessible until either the firm liquidates or lists itself on the stock market.
In many cases, that could take up to ten years or more.
Even for exchange-traded REITs, holding on longer allows investors to ride out market fluctuations and get better returns.
Are They a Good Investment?
Real estate trusts could be a good place to put money in if inflation is high or during periods of a stock market downturn.
Even when interest rates are rising, they are not known to perform poorly (on average) unless the broader economy is also failing.
Their strong and steady dividends can be comforting, especially during periods of market turmoil.
Again, those thinking of investing in direct ownership of real estate assets may find REITs to be a better proposition.
This is because owning them is much simpler than buying a property. They can be bought and sold just like other types of stocks in the market.
They do not require any special effort apart from having a brokerage account. Property acquisitions often need a lot of location scouting, documentation, and market research.
It is also possible to get a diversified real estate portfolio with REITs by investing in ones that focus on different categories of property.
For example, they can give access to commercial real estate, which is otherwise out of the reach of retail investors.
These securities are also very liquid, which makes them easy to dispose of when needed.
Buying and operating actual property is a tough job, but selling it can often be even more difficult.
This is especially true if the economy is not doing well. You might not find any takers during a downturn.
Are There Any Downsides To REITs?
Yes, there are some downsides and risks that investors should be aware of.
For example, REITs do not usually offer much in terms of capital appreciation.
Since they are bound to distribute back 90% of their earnings, there is lesser scope to reinvest and grow their businesses.
Lastly, REIT shareholders have no choice in the type or other attributes of the properties being acquired.
It could be possible for a sharp investor to find a high-income generating piece of real estate and easily outshine REIT returns.
Have REITs Outperformed the S&P 500?
Yes, exchange-traded equity REITs have generally outperformed the S&P 500 over the long term.
Certain segments, such as residential REITs and self-storage, have done better in every period, be it three, five, ten, 15, or 20 years.
One situation where these securities really shine is in periods when inflation rears its ugly head.
For example, investment returns from real estate trusts did better than the S&P 500 by 3.6 percentage points during high inflation and by 2.4 points when it was moderate.
Final Thoughts
Most experts recommend keeping REITs between 5% to 15% of overall holdings.
However, the right number often depends on the risk profile and management style of the investor.
Those who trade actively can hold more of these stocks in their holdings, while passive investors should limit their exposure to them.
Moreover, folks also must understand that any diversification benefits tend to run out beyond a point.
Therefore adding more of these securities than necessary to a portfolio may not make sense.
Having said that, real estate investment trusts offer many benefits, such as inflation protection and high dividends. They are also very well suited for retirement savings portfolios.
Therefore, not having REITs in a portfolio might not be a good idea.
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