By Dr. James M. Dahle, WCI Founder
By Joe Dyton, WCI Contributor
Real estate investing has long been a popular solution for putting your dollars to work for you. While investing in real estate can be a good supplement to your retirement accounts and other investments, what happens if you don’t have the money to get started? Do you just have to save up until you have enough to buy your first investment property? You could take that route. Or you could explore real estate investment trusts, aka REITs.
A REIT allows you to be a real estate investor without putting out as much money as you would by purchasing a property outright, and it offers the opportunity for a good return on investment through dividends.
Keep reading to learn more about REITs, the pros and cons, the different types of REITs, and more.
What’s a REIT?
A REIT is a company that owns, operates, or finances income-generating real estate. When successful, REITs provide investors with various steady income streams, portfolio diversification, and long-term capital appreciation. REITs operate similarly to mutual funds, as they take money from various investors. This allows individuals to receive dividends from their real estate investments without having to finance or manage the property themselves.
Once upon a time, WCI wrote an article about private REITS. These are some of the favorite tools of salespeople masquerading as financial advisors (there's a reason they're called “brokers”). They would sell these investments with a promise of high income (8% yields were not uncommon). The value of these REITs was not marked to market. Although you knew you were getting that juicy 8% yield, you had no idea what the actual value of the investment was and, thus, you had no idea of what your total return was. These “investments” (scams would probably be a better description) had heavy front-loads (as high as 15%) and heavy ongoing fees. Primarily due to those fees—as well as similar abuses by management—the long-term returns were often terrible. It turned out a great deal of that juicy yield was really just returning principal to investors.
In contrast are the publicly traded REITS, which are marked to market thousands of times per day when the market is open. These “real estate flavored stocks” provide ready liquidity and transparency, and you can buy them without paying a load. You can also readily diversify at a very low cost by using a mutual fund such as the Vanguard REIT Index Fund.
That fund has a moderately high correlation (0.61 last I checked but it varies over time) with the overall stock market. Sometimes it zigs when the market zags, but sometimes it zags when the market zags. In fact, sometimes it zags really dramatically, like during the Global Financial Crisis when it lost 78% of its value from peak to trough. Since the purpose of diversifying into real estate is to get solid returns and low correlation with the other assets in the portfolio like stocks and bonds, that moderately high correlation turned off a lot of potential real estate investors.
In addition, REITs, by their very structure, are not particularly tax-efficient. By law, they are required to pay out 90% of their return every year to investors. Those distributions are generally fully taxable at your ordinary income tax rates. The investors don't get to benefit from depreciation and 1031 exchanges and the other benefits that direct real estate investors enjoy. High returns plus low tax efficiency meant that these assets really belonged only in the limited tax-protected investment space available to investors.
More information here:
How Do REITs Work?
Investors may buy shares in a REIT portfolio. A given portfolio could include hotels, commercial real estate properties, apartment buildings, healthcare facilities, offices, retail centers, and more. Typically, REITs operate in a specific part of the real estate industry (offices, healthcare, etc.). There are REITs that comprise various property types, however. Either way, a lot of REITs are publicly traded, and they can be bought and sold just like stocks and bonds.
REITs earn money through mortgages underlying real estate development or on rental incomes after the property is developed. The REIT takes its collected income and distributes it as dividends to investors. This is how REITs provide a potentially steady income source for their shareholders.
How to Invest in REITs
REITs can be purchased in a few different ways. Investors can buy shares of publicly traded REITs through their brokerage account, just as they would any other stock. Options include buying a diversified REIT or multiple REITs to have a well-rounded portfolio. Buying a REIT-focused mutual fund or Exchange Traded Fund (ETF) is another way to get involved. While more challenging, public, non-traded REITs can be acquired through financial advisors or real estate crowdfunding portals.
What Are the Different Types of REITs?
Having options is one of the benefits of investing in REITs. There are typically three primary REIT categories:
Publicly Traded REITs
These are found on major stock exchanges, and they can be easily purchased through a brokerage account, just like other stocks or bonds. The US Securities and Exchange Commission (SEC) regulates publicly traded REITs.
Public Non-Traded REITs
These REITs are also available to individual investors and are SEC-regulated, but they do not trade on stock exchanges. Instead, investors can purchase public non-traded REITs through a financial advisor or an online portal. Since they aren’t traded publicly, they are less liquid than their publicly traded counterparts but also not as vulnerable to market fluctuations.
Private Non-Traded REITs
This REIT classification is not available to the public, registered with the SEC, or traded on stock exchanges. Private REITs are primarily sold to high earners, high net worth individuals, or intuitional investors.
Additionally, REITs can be broken out in different subcategories. For example, equity REITs own and operate properties that generate revenue, such as apartment complexes and office buildings. Meanwhile, mortgage REITs offer financing for income-generating properties by acquiring mortgages and earning income from the interest on their investments. Hybrid REITs invest in a combination of the two real estate types.
More information here:
The Case for Private Real Estate
Investing in REITs—Pros and Cons
REIT investing sounds like a great opportunity. Buy into an established fund and earn a steady income through dividends without having to manage or finance a property. No investment is without its downside, however, and it’s important to recognize the good and the bad before parting with your hard-earned money.
Here are the benefits and disadvantages of investing in REITs:
The Pros of REITs
- Affordability/Accessibility: REITs make it possible for people who don’t have vast amounts of money saved for a down payment to still invest in real estate.
- Passive income stream: REITs pay out regular dividends to their shareholders. Investors gain an opportunity to enjoy the benefits of real estate investing without having to do much of the typical upfront work and maintenance.
- Easier access to funds: REITs offer a certain level of flexibility when it comes to accessing cash vs. owning a property outright. Investors can simply sell their REIT shares if they want or need cash quickly. If an investor had to sell an actual investment property to get their hands on cash, the process would be more difficult and take much longer.
- Diversification: Buying REIT shares helps keep an investor’s portfolio more diverse. Doing so also helps offset the risks that can come from other investment assets. Plus, REITs not only allow investors to diversify their overall portfolio but also their real estate holdings. Putting money into individual investment properties does not allow for as much diversification or flexibility that REITs offer.
The Cons of REITs
- Taxes: REIT dividends are great to receive, but they come at a cost in the form of taxes. The payout is tied to investors’ standard income tax rate, and taxes must be paid on the dividend income annually—even if the funds are reinvested. This differs from selling a stock after holding it for more than a year because the investor can save with the long-term capital gains tax rate, which is less than a typical income tax rate.
- Limited control: REITs cost less to buy into than acquiring an individual property, but investors also give up any say in how a REIT invests funds and what happens with the properties.
- Exposure to interest rates: A REITs’ value is tied to the real estate market. When rates go up, property demand could decrease—as would property values, which could hurt investments in the REIT.
Rise of the Crowdfunders
Technology has provided a way for many more investors to get involved in syndicated real estate through “crowdfunded” websites such as Equity Multiple, Fundrise, Realty Mogul, Crowd Street, AcreTrader (all affiliate links), and plenty of others. They all have a different focus. Some invest on the equity side, others invest on the debt side, and still others do both.
However, most of these sites, like most of the syndicated deals available before the existence of these sites, required investors to be accredited. That is, you have to be rich enough (and theoretically also sophisticated enough) that the SEC doesn't have to babysit their investing activities. In general, this meant liquid investments of more than $1 million or an income of over $200,000 ($300,000 married).
The real estate crowdfunding space became very crowded very quickly, and firms tried all kinds of ways to distinguish themselves from their competitors. One of the obvious ways to do that is to go after the non-accredited investors. Since an income of $200,000 gets you into the top 2% or 3% and an investable net worth of over $1 million gets you into the top 10% or so, it was obvious that the group of non-accredited investors was far larger than the accredited investors. Even if their average investment was smaller, the total amount of money to manage was still substantial. As they dissected the regulations, the sites realized one way they could bring crowdfunded investments to the masses was to form the investments into what are really privately traded REITs but which are different from your grandma's broker's REIT.
Some crowdfunded sites offer low minimums ($1,000), no loads, lower ongoing fees, and quarterly liquidity.
Should You Invest in a REIT?
Like with most investment opportunities—it depends. If you’ve wanted to invest in real estate but don’t have tens of thousands of dollars for a down payment on an investment property, REIT investing could be a great alternative. The same is true if you’re interested in real estate investing but not interested in purchasing, financing, and managing a property. REIT investing could also be good if you’re just looking to diversify your portfolio.
On the other hand, you must consider how comfortable you are with yielding control of your investment. After you buy shares of a REIT, you don’t have any say in how the properties in the trust are handled or if and when they are sold. If you want more of a voice in the matter, you may be better served looking into investing in your own real estate properties.
But what about private REITs?
While these properties are more diversified than just buying a few syndicated properties directly from crowdfunded sites, they are dramatically less diversified than buying the Vanguard REIT Index Fund. The Vanguard fund holds about 160 companies. The largest of those 160 companies could own hundreds of its owns properties. With one purchase, you will own a piece of tens of thousands of properties. You also give up significant liquidity with these online private REITs. You can sell that Vanguard REIT Index Fund in seconds any day the market is open. It could take you a full year to liquidate your private REIT holding, and that's after the mandatory one-year holding period and possibly two more years where a 1%-2% fee is assessed to early liquidators (adding up to four years). The management fees of the Vanguard fund are also 1/10th as large as those in these private REITs. Given those downsides, why would anyone buy into these online private REITs?
The main reason is because these online private REITS aren't buying the same properties that the larger, publicly traded REITS are buying. You're not going to find a big mall. It'd be more like some strip malls, a restaurant, and some single-family homes. The investments come from the same place as their other crowdfunded offerings, which are far more Main Street than Wall Street. So, it is a diversification play into a different aspect of the real estate market with smaller properties.
Accredited investors may turn up their noses at these online private REITs, but they are also eligible to invest directly with syndicators or through funds due to their ability to cough up the minimum investments of $50,000-$200,000. Non-accredited investors can't come up with those sums, and they are specifically excluded from those investments. It makes you wonder if Robert Kiyosaki was right when he said the wealthy get to invest in different investments than everyone else.
Critics say that only inexperienced or desperate real estate developers would go to a crowdfunded syndicator for funding, and thus their investments, whether in a REIT form or not, are inferior to those available to a more established syndicator. I suspect there is some truth to that, although both companies screen out the vast majority of projects they are brought.
All of these options can be attractive to busy high-income professionals who are not interested in purchasing, owning, managing, and selling properties themselves. For non-accredited investors, the online private REITs are your only option to invest in these smaller properties that don't make it into the REITs traded on the stock market and found in the Vanguard REIT Index Fund. For accredited investors, there are some who will be willing to pay the 0.85%-1% management fee for the increased convenience, increased diversification, and decreased tax hassle compared to buying individual syndicated properties either directly or through the crowdfunded sites. Other accredited investors who either want to avoid the additional layer of fees, prefer to select their properties themselves, or simply prefer the benefits of a private fund structure will want to avoid online private REITs. Either way, they've come a long way from the private REITs that were used to swindle your grandma.
In a 2021 post about Dr. Jim Dahle's real estate investments, we talked about what he's doing with the 20% of his portfolio that he dedicates to real estate, but for now, you should know that he doesn't have any money invested in online private REITs. However, he has invested directly into properties both with Fundrise and RealtyMogul and enjoyed positive returns.
Overall, REIT investing offers the chance to create a relatively hands-off revenue stream, but it isn’t without its risks. Be sure to look at the benefits and drawbacks closely before you dive into this venture.
WCI’s No Hype Real Estate Investing is the best real estate course on the planet and the best way to get started in this exciting (and profitable) asset class. Taught by Dr. Jim Dahle and more than a dozen other experts, this course is packed with more than 27 hours of content, and it gives potential investors the foundation they need to learn about all the different methods of real estate investing. If you’re interested in real estate investing, you can’t afford to miss the No Hype Real Estate Investing course!
What do you think? Do you invest in REITs? How? Why or why not? Do you expect to see more online, private REITs come onto the market? Comment below!
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I think both Realty Mogul and FundRise REITS are decent options for the non-accredited investor. More for diversification and access to smaller value-add properties than anything else. With Title IV Reg A+ gaining steam, I think we will see a lot more of these REIT offerings coming on line. These REITS are new and untested so I would proceed with caution.
For the accredited investor, there are better options. I favor a mix of private RE funds and single properties from really high-quality sponsors that have been through at least one market cycle.
Agree completely
REITs are incredibly complex investment instruments. Scott Kennedy at Seeking Alpha does a great job of analyzing them and breaking down that complexity for anyone brave enough to look under the hood. Best used in a diversified portfolio.
Interesting post. I still struggle to connect the dots on why crowdfunded RE is a good idea. Normal REITs are bad because of high correlation with stocks and high taxable income, but at least they are diversified. Normal Private REITs are bad for the for mostly the same reasons, their high fees, and because they don’t mark to market. The only thing crowdfunded RE solves relative to a private REIT is the lower upfront fee but at the expense of less diversification. Sure it won’t show much correlation to stocks, but that’s because it isn’t marked to market. These new platforms also suffer from idiosyncratic platform risk. What will happen to your investments if the platform fails and goes out of business?
According to FundRise (so take this with a hefty grain of salt), they have fewer ‘layers’ of ownership between the underlying properties and the investor than with something like the Vanguard REIT indexed fund. Consequently, they claim that the overall fees of their REITs are significantly lower.
Ummmm….count the layers. Seems about the same to me. I mean, you can almost ignore the Vanguard layer, it’s something like 12 basis points. At that point you’re left with the REITs themselves. And it’s not like that Vanguard layer doesn’t provide real benefits for those 12 basis points- liquidity, diversification, convenience, a household name etc. I mean, maybe someday the Fundrise eREIT becomes publicly traded and the Vanguard fund will own it!
My REIT exposure is Fidelity Real Estate Investment Trust Premium – I bought the minimum $10,000 and it has promptly lost 11% YTD…so I have $8900.
My other real estate “bet” is Ashford Hospitality Trust preferred shares (yield 8.39%) Another $10,000. And Arbor Realty preferred shares )yield 8.18%), another $10,000. These two have lost under 1%.
I bought these last two chasing yield with lower risk than floating rate loan funds or more bonds (in the current environment of increasing intersest rates).
Only my actively managed bond fund (Thompson Bond) has avoided bond losses recently.
I have no investments outside retirement accounts so tax issues are not in the mix.
So far, my diversification into REIT have not been very productive except with preferred shares. I think my FSRVX (REIT index fund) has the worst recent performance in my portfolio.
According to PersonalCapital.com, I should/could have about 10% “alternatives” . WCI had about 7.5% in REIT at some point on a prior post that detailed their allocation, but this may have changed.
I had more of the FSRVX, but sold off a $60,000 chunk after the tax plan passed. I bought some “O” realty income Corp (Ticker O) and it has also done very poorly (-12%). I currently stink at picking any real estate oriented funds…
I have always been a little skeptical about PC 10% alternatives recommendation.
If you were concerned about rising interest rates affecting bonds, REITs were not the correct answer, they are very sensitive, especially lately, to interest rates. As most yield producing assets like blue chips, utilities, reits have become a reach for yield situation and trade based on a market set premium to the risk free rate about the last 5 years or so as its gotten to be fairly crowded.
As rates have risen these sectors have been predictably slaughtered. If we are indeed in a true rising rate environment rather than a technical one (due to Fed balance sheet, etc…) than all of these things that investors have taken as gospel or fact, especially the yield plays will be turned on their head. All the sudden no one will want 10% reits in their portfolio anymore.
^^^^^^^ this. REITS peaked June 2016; the same time TNX ( 10 year treasury yld. troughed).
……………the same time TNX troughed.
I think “slaughtered” is a little dramatic. REITs are down 11% YTD after making 5% in 2017 and 8.5% in 2016. Now in 2008 they felt a little “slaughtered” when they lost 78% peak to trough. But an 11% drop? That’s expected behavior with this asset class/sector fund. That happens all the time. In 2011 they lost 15% in a single quarter. In 2015 they lost over 10% in a single quarter. That’s just what they do. If that’s too volatile for you, stay out of them.
I wouldn’t put too much into short-term performance.
I also would be careful not to confuse REITs with bonds. They’re not bonds.
Buying anything with an 8%+ yield is risky. You may not see the risk, but I assure you it is there.
Remember Personal Capital doesn’t have a crystal ball any more than the rest of us. Certainly 10% “alternatives” is within the range of reasonable. Our portfolio is 60/20/20.
REITS were functioning as bond proxies.
Anyone who did that made a terrible mistake.
AKA, everyone, or enough of a majority that its been the pricing mechanism for at least five years. Anyone else was just assuming past performance which was heavily influenced by decreasing rates would continue forever after they were fully financialized and placed into indexes. That usually takes some luster out of returns that have been boosted by illiquidity.
As for slaughtered, O the above referenced REIT that is a yield chasers dream, is down over 30% from that peak, so much for the dividend making it worth it in that case. And it was 100% foreseeable. I told anyone who would listen (almost no one for the record) on Seeking Alpha articles at that time to sell the highly over valued O and switch into VNQ.
What wasnt to like, the dividend was higher, it was diversified, etc…etc…its only down 20% from that peak. Still a beating, but it still has the diversification benefits which are important. I used to own O, but sold at the time for VNQ, which when rates got super low I sold that too. Will look to reits once all the yield chasers go bust and they are great deals maybe.
Is that time now? Have the yield chasers migrated to 3% treasuries and sold out of VNQ?
Sadly dont know of course. At those times the risk/reward was more obvious. Everything know feels like a middle ground that could go either way. Do we really have inflation or do we just have technical pressure from the fed balance sheet reduction and a bunch of short bond speculators (record highs)?
While I think there may be some mild inflation, I think the bond action is a lot to do with speculators and the change of positioning from the fed. If we really see 3 to 4 hikes this year, rates may be higher.
I will probably rotate substantially into bonds at the time in that case and then ride it out until equities get shaky.
If you put any context into social sentiment, they are still drooling over themselves to buy O hand over fist and touting how lucky they are, so I think its a while before capitulation.
No one has really traded/invested in a slow rising rates environment for 50 years, so will be interesting.
And they may not have that chance in the next 50 years either. Interest rates may hang out right where they are now for a long time, and as we’ve seen, could even fall more.
Basic question here, are there additional advantages to an REIT index like Vanguard has other than asset class diversification? Tax deductions, tax loss harvesting, etc? Also, it sounds like if investing in this I should preferentially use a Roth account rather than 401k, is that true or would there be a good reason to use the 401k? Thanks!
No deduction. You could tax loss harvest like any other investment, but not in a tax protected account like a Roth IRA or 401(k).
No particular reason to put it in Roth vs 401(k). This post may help you understand that:
https://www.whitecoatinvestor.com/my-two-asset-location-pet-peeves/
That makes sense regarding account types, though counter-intuitive at first.
To follow-up on the benefits of an REIT, there would not be for instance the opportunity to claim a deduction for mortgage payment on the properties included in the REIT?
Essentially if using this I would simply be adding diversification to my portfolio, but not gaining some other benefit over investing in mutual funds?
Thanks again!
No. That’s all included in the returns of the companies. Interest paid by the company is deductible to the company. It’s not a pass-thru deduction.
That’s correct, just diversification.
I wonder what the proliferation of crowdfunded REITs, especially those funded by non-accredited investors, will do to commercial real estate prices. If these investment vehicles continue to gain popularity, they may drive up demand for commercial office buildings, strip malls, apartments, and similar investments, pushing prices higher (and eventually putting downward pressure on investment yields, by the way). In fact, I think we’re already seeing this with apartment complexes of, say, 100 units or more. Some might argue that commercial real estate is presently overvalued, but the prices we’re seeing today may be bargains compared to prices ten or fifteen years from now. Also, those interested in buying individual commercial properties might want to buy sooner rather than later, before well-funded institutions snap up the best opportunities. Remember after the Great Recession, when single-family homes were purchased by institutions by the thousands, leaving scrappy individual investors to fight for what was left? Same idea, but now for commercial real estate.
It could go either way. If most of the crowdfunded investments are renovations and flipping, prices could go up. If many of the investments are in new or vacant buildings, it could increase the supply side of real estate and drive prices down.
It is great to have such options. I haven’t jumped on the real estate crowdsourcing or private REIT bandwagon. It may have potential, I’m just not sure I’m capable of assessing the risks well.
I do see the benefit of owning real estate. Currently, I (or investment groups I work with) own a private residence, a rental home, townhomes, senior living facilities, public REIT, a medical office building, surgery center, and international public REIT. I have a friend who has a triple net lease on a Dollar General and owns a storage facility. There are a boatload of options in real estate.
I agree. I haven’t made this jump yet, and won’t until my debt is paid off.
It seems strange to go against some of the same rules we follow so well with index fund investing. When it comes to real estate we want diversification and low correlation. But in order to get that we have to ignore the high fees, which is precisely what we don’t do or suggest with index fund investing. Just seems strange to me.
Also, I think the reason that these REITs may have correlated during the last crash was because the housing market was literally one of the most predominant reasons for the crash. (Subprime mortgages, etc). So, in that sense they would have had to be correlated.
I think real estate is good for diversification. I own some VNQ. I guess I am still skeptical of these newer crowdsourced platforms. I felt that way about peer to peer lending too. I have looked into Dollar General too. My concern with this is the lease with DG is 20 years but if they do not renew it you are left owning a cinderblock building in a rural area with no prospects of another tenant.
I agree Hatton1,
That is why I didn’t invest in DG. They have had some financial difficulties and they could vacate some buildings. Some buildings could be “repurposed” but there is certainly risk since the income will drop for sure – perhaps to zero.
On the other hand, my friend has an income of 320K per year from this completely passive investment (triple A leases) (four 80K revenue streams). Some of us could even live on that amount. Ha.
Ha Ha
WCI, might you have a recommendation or two for accredited investors or opportunities with 10k+ minimums. I heard a few suggest AlphaFlow recently.
Or do you think of these non-accredited eREIT giants like Fundrise as the “index fund” version of crowdfundeders, and that ultimately they will win the day as they accumulate assets, lower fees, and that the advantage of having an “expert” pick properties for an accredited investor company is overrated? Will someone become the Vanguard of this space?
I discuss what we own on the real estate front from time to time. The last time is this one: https://www.whitecoatinvestor.com/how-we-invest-in-real-estate/ You can find some recommendations there and plenty of discussion of pluses and minuses. Bear in mind NONE of this is mandatory for financial success.
I do NOT see eREITs as the equivalent of index funds and doubt there will be a Vanguard in this space ever. I think the biggest argument against these eREITs is that the best syndicators probably don’t need to go to Fundrise to get funding, so when you go to Fundrise, maybe you’re not getting the best syndicators. I don’t own any of these eREITs.
Not a fan of private reits whether reg a+ or not. If someone is not accredited there are many options for them to choose from including publicly traded REITs as you said. The bottom line is for all these privately traded offers the embedded fees are simply too high .
Good post.
What do you think is a reasonable level of fees? Bear in mind you can’t compare the fees to the ER of TSM. It’s more like looking at the expenses of each individual company in TSM. Kind of apples and oranges.
Obviously, once the syndicator is sufficiently incentivized, every dollar in extra fees is a dollar out of your pocket, but I’m not sure I’ve figured out what reasonable is yet. Just try to keep them as low as possible.
I decdided to look at mogulreit 1 again. The offering memorandum is 233 pages and all the fees one is paying directly or indirectly are not all located in one place. For instance buried in the doc is 2-4%finders fee for every property they buy. This is in addition to the asset management fee of 1%, not 1% of capital but 1% of aum. Then there is organizational fees and commissions. I am confident there are other fees but i refuse to comb thru all 233 pages to find them.
As a rule of thumb i want to see 10% equity contribution by the sponsor, limited partners pay prorate hard costs for start up. Acquisition fee of 1% of asset value and AM fee of 1%of capital. Preferred return of 8-10% with 70-80% split with no catch up period.
I will take a bit less than the above, but i scrutinize the deal as much as possible…lack of sponsor capital is a huge red flag that usually stops my interest in its tracks. The other fees on my flexibility varies based on how good i think the sponsor and the deal are.
I appreciate you sharing your criteria for investing. It’s amazing how subjective it can be isn’t it?
I’m too cheap to deviate from the Vanguard REIT just for a bit more diversity.
Prime example of gender investing differences highlighted here. Men yearn to “own” land. Women investors are indifferent to it.
I never thought about it but you are probably right.
jz,
That’s an interesting observation. I never thought about it, but just looking at my own family, it is the men who want to keep buying more and more farmland. The women are saying enough already!
All of this is at the margin since for most of us, a REIT allocation may be ~5%-10% of our portfolios, but…
I have personally stayed away from publicly-traded REITs so far in my investment lifetime for the fact that I already include a healthy small-cap value tilt in my portfolio. REITs, historically speaking, have seen a lot of their high returns come from exposure to the size (mid-small) and value factors (Correlations go up when you compare REITs to a SCV fund versus a TSM fund: Monthly Correlations VGSIX/VTSMX 0.58 | VGSIX/VISVX 0.72).
You can, historically speaking, build a portfolio of SCV + Bonds to approximate REIT returns (A similar exercise can be completed against High-Yield Bonds). In addition, and this was surprising to me at the time, if you compare Small/Large Value to the NAREIT index in the 1970s, the value allocations held-up better in that inflationary period compared to the NAREIT index. In most years that had inflation peak above 5%, Small/Large Value held up better in comparison to the NAREIT index.
I still think Real Estate (And by extension, other real assets) are a decent place to find some level of diversification in relation to public equities and bonds, and I personally plan on investing in physical Real Estate later in life, but I do think that for those that already tilt towards small value in their portfolios, an explicit REIT ETF/Mutual-Fund allocation is a bit overkill.
REITS used to be mostly small cap value/mid cap value stocks, but the last time I looked at them, they were much more mid cap blend and even growthy. I just checked again:
http://portfolios.morningstar.com/fund/summary?t=VGSLX®ion=usa&culture=en_US
and they’ve moved a little back toward the value side, but I wouldn’t assume they’re static or “just a blend of SCV and bonds.” They have a different structure and invest in different assets. I think the argument for REITS as a separate asset class is quite strong. Not saying it’s mandatory to have that asset class in your portfolio, of course.
Yes, they do move around, but here is an example from VGSIX inception (Vanguard Real Estate Fund):
https://goo.gl/9ukh56
Returns of 100% REITs versus 76/24 SCV/Bonds are the same w/ SCV/Bonds having less volatility and a lower draw-down.
When you compare VGSIX on a correlation basis to VTSMX (TSM) v DFSVX (SCV), the correlations are higher to DFSVX at every time-frame: VTSMX Daily 0.68 / Monthly 0.56 / Annually 0.43 versus DFSVX Daily 0.74 / Monthly 0.65 / Annually 0.72.
A 0.72 annual correlation, which is where most people re-balance, is decent to be sure, especially between two riskier assets, but it’s not at some “earth shattering, you need to have this asset class” level.
As an example, if you combined the two portfolios REITS + SCV/Bonds, you do get a diversification bonus of about 0.21% over the period. But, if you assume that most people have a lower allocation to REITs & SCV AND you include trading costs (minimal but still there), that diversification benefit is very marginal in the long-run (Maybe 10bps?).
If you look at a factor regression analysis, you will see that since inception, VGSIX has had a significant amount of exposure to size, value, term and credit factors, i.e. SCV and Bonds.
Lastly, if you look at the one year that inflation surpassed 4%, 2007, you will see that the SCV fund beat the REIT fund. I mention this as most people use inflation-protection as a positive for REITs.
So again, I will reiterate that I think REITS are a decent place to find some level of diversification in “risk” assets, especially for those that have an easier time holding REITs (Real Estate) versus SCV (There is a behavioral effect in RE versus SCV in-favor of RE imo), but for those that have Size and Value exposure already, I think an explicit REIT allocation, in the long-run, is not necessary.
P.S. I know all of this analysis is based on backwards-looking data, and you are correct that REITs can move around the style box more than SCV (obviously) but my hunch is that over longer periods, REITs will continue to lean towards the small/mid value box based on their dynamics (A bit like how tech always seems to be more “growth” relative to other sectors).
Correlations and factor regression analysis are time-period dependent.
But sure, if you think there’s no real difference/diversification benefit, no sense in diversifying into REITs. I don’t believe that but I can see how a rational person could. I agree they are not a mandatory asset class in a portfolio. But then again, I don’t think SCV is either.
Of course. Everything we look at is time-period dependent (Bonds beating stocks over 40 year periods, Housing prices from 1950-2000, etc.). There are “strange” periods for every asset we could invest in.
Additionally, I do agree that both REITs and SCV are NOT mandatory pieces of a portfolio. A 3-Fund or Lifestyle Fund portfolio are perfectly acceptable imo.
I just think you do not need both SCV and REITs. I think you can pick one and get similar diversification benefits to the rest of your portfolio…and that is something we will have to disagree on.
P.S. So it is not lost, I still enjoyed the post =)
Certainly every additional asset class adds less diversification benefit than the last. Beyond 10, you’re just playing with your money, and the benefits beyond 7 are pretty limited.
Funny enough, in our “non-fun”, “non-401k” account, i.e. our “ideal low-cost portfolio”, which is currently a joint-taxable account, we have 7 funds =)
Last one, and only because this came across my RSS feed today.
https://alphaarchitect.com/2018/02/23/are-factors-better-and-more-diversifying-than-asset-classes-for-the-most-part-we-dont-think-so/
Some interesting research on comparing the diversification benefits of asset classes versus factors in which the author’s conclusion are that they both provide similar diversification benefits & seem to have similar properties to each-other.
Which again makes sense to me as certain asset classes/sectors seem to behave in certain ways (RE as value, Tech as growth, Utility as low-vol, apparently Gold and Momentum…etc.).
Despite the results/benefits being similar, the author concludes that given the similarities AND the behavioral benefits of asset class diversification versus factor diversification (abstract and confusing), one should ignore factors and diversify by asset class.
So choose REITs or SCV…Probably don’t need both =)
I think the most important thing is to pick something reasonable and stick with it. A portfolio without SV or REITS is reasonable. A portfolio with either is reasonable. A portfolio with both is reasonable.
Agreed. Its close, but being able to stick to whatever allocation you have is more important than the allocation itself.
Regarding the tax efficiency of REITs, I think it’s worthwhile to point out that while they aren’t as tax efficient as stock index funds, they are far more efficient than taxable bonds.
Vanguard’s REIT Index fund (investor shares) returned 7.50% over the last 10 years. After applying the highest marginal rates, the after-tax return would have been 6.26%, assuming no sales. That’s a tax drag of 16.5% relative to the pre-tax return.
By comparison, Vanguard’s Total Stock Market index fund (VTSMX) returned 8.60% over the last 10 years, and this would have been reduced to 8.19% after the highest marginal rates were applied. That’s a tax-drag of 4.8%.
As another comparison, Vanguard’s Total Bond Market index fund (VBMFX) returned 3.84% over the last 10 years, and this would have been reduced to 2.60% after the highest marginal rates were applied. That’s a tax-drag of 32.2%.
So relative to a stock index fund with little turnover, REITs were certainly much less tax efficient over the last decade. But relative to a total bond market index fund, they were much more tax efficient over the same period.
While I don’t dispute your numbers, you also need to consider the higher expected rate of return of REITs when deciding whether to put them into a tax-protected (almost always the right answer) or a taxable account (assuming you don’t have any more tax-protected space.) Especially when you consider that there are tax exempt bond funds but not tax-exempt REIT funds! More info on this complex topic here:
https://www.whitecoatinvestor.com/my-two-asset-location-pet-peeves/
A few things to note and to clarify:
“REITs by their very structure are not particularly tax-efficient.”
As long as a REIT pays out more than 90% of net income, it pays NO corporate taxes, so there is no double taxation. The distributions are only taxed at the personal tax rate of the investor who received the dividend, so better for the low income tax payer. This is similar to owning an income property.
Also, starting in 2018, up to 20% of REIT dividends are deductible “above the line.” Meaning, they are deducted from income even if you do not itemize deductions. So, if your top personal tax rate is 37%, then you only pay 29.6% on the REIT dividends. If your marginal tax rate is 24%, you pay only 19.2% on reit divs. Note: I’m pretty sure that mutual funds and ETfs do not pass this dividend deduction to shareholders. Only owners of individual REITs get the deduction. Other pass-through companies can also deduct distributions, but with many more limitations.
“The investors don’t get to benefit from depreciation and 1031 exchanges and the other benefits that direct real estate investors enjoy.”
The reits that I follow, take advantage of 1031 asset exchanges frequently. REITS account for depreciation like any other company. It lowers their net income, which lowers the mandatory amount that they have to payout. Successful REITs often retain up to 1/3rd of their cash flow to grow equity and future cashflow.
Publicly-traded REITs publish their financial and business results 4x/yr—free to anyone with a computer. Most give exquisite detail about their portfolios, sometimes down to the individual properties.
REITs tend to have profits that track the economy. Stock prices can fluctuate for any number of reasons. And, bond rates do affect market prices. But, unless there is a specific real estate ressession, the actual business is as consistent as any other asset class.
95% of people won’t take the time or won’t learn how to research a REIT (or any investment for that matter). So I agree with most on this board to just index. But so many have a play-money fund. I don’t doubt that crowdsource investing can have some winners. But if you are going to actively manage manage some money, then publicly-traded REITs are advantageous in many ways—if you take the time to research what you buy.
Having read all this…I’m less enthused about REIT investing.
Beyond equities at present, the choices for getting above 4% seem constricted as bonds do poorly with rising rates and that plan is baked in for the next year…three more rate increases barring some calamity.
I have a 10% of my portfolio in cash at present. I am still working out where to put it.
Aren’t the fees considered too high for most investors?
What fee are you talking about specifically? I’ll copy and paste a comment I just made to a similar question on another real estate related post:
I think you have to be careful to compare apples to apples. For example, if the ER on an index fund is 0.04%, that’s the additional fee the manager/computer buying/selling the companies charges. But it doesn’t include the business expenses of the various companies. When you buy a company that owns a single asset such as an apartment building, it’s going to have expenses just like Apple does. And those are being included in that 3.5%. But you can’t compare that to an index fund ER because it isn’t the same thing. The business expenses of Apple are “invisible” to the index fund investor, but the management fee for the apartment building is not.
That doesn’t mean that expenses don’t matter. They always do and come directly out of the pocket of the owner/investor. But they’re not the same thing as a mutual fund ER.
Hello, thanks for the well-written post!
Does anyone have any thoughts on the tax efficiency of Fundrise-like investments? Should these should ideally be prioritized to tax-advantaged accounts (similar to conventional REITs)? Or, are there other tax considerations with this structure of investment that makes it more OK to look at keeping them in a taxable account.
Thank you!
First define a “fundrise-like investment,” then I’ll answer your question.
As a general rule, equity real estate is somewhat tax efficient. While income is taxed as ordinary income rather than the lower taxed qualified dividends or long term capital gains, you can often shelter some or all of that income for a number of years with deprecition.
As a general, debt real estate is terribly tax-inefficient. The entire return is paid out every year as ordinary income. Basically, it cannot become any less tax efficient.
The 199A deduction complicates things a bit in that it makes anything formed as a REIT (including Fundrise’s current model, which is different from what it was way back when I actually owned an investment I bought through Fundrise) qualifies for the 199A deduction, which basically gives you a 20% of income deduction, reducing your tax bite by 8% or so. It helps a little, but it hardly turns a debt real estate investment from a tax-inefficient investment to a tax efficient investment.
While simpler to keep an investment like the Fundrise REIT in a taxable account, it’s probably better in a self-directed IRA or 401(k) from a tax perspective, but that also depends on whether you have one, what else in your portfolio, what the relative sizes of your taxable to tax-protected accounts are etc.
Sure thing – what I meant by “fundrise-like investment” was an investment into one of Fundrise’s eREITs. I was not making a distinction between debt vs equity investments, as I was unaware of differences between their relative tax efficiencies. But based on your response, it sounds like it would be better to prioritize equity over debt if in a taxable account… (it seems like Fundrise offers some choice to investors in what kind of investment they can make).
I guess in my case – I would be comparing against the Vanguard Total Stock Market index fund, as this is what pretty much all of my money is in. I do not have a self-directed IRA or 401(k). Would you say that the tax efficiency of the Total Stock Index fund is still superior to an equity real estate investment through one of Fundrise’s eREITS?
Thank you!
Dramatically.
What do you think about buying REIT ETF’s versus individual REIT’s? This other article advocates for buying individual REIT’s, but I kinda like ETF’s more: creditcarrots.com/what-is-a-reit/
I prefer mutual funds/ETFs whenever possible. In the private real estate world, I prefer funds to syndications. A REIT in the private world is much more like a fund I suppose.
2 tax questions about REITs and I apologize if they are too simplistic. I am retired, and well below the age to tap my tax deferred accounts so I am living of dividends/cap gains. I want to add REITs to my portfolio for more passive income. I am not worried about them being taxed as ordinary income since I have zero other ordinary income, and it won’t be painful after the standard tax deduction. My questions:
1. Given that REIT dividends count toward “ordinary income” for tax purposes, do the dividends ALSO count as “earned income” toward SSI calculations when I try to draw SSI later in life? Meaning if I earn $20k/yr on REIT dividends, will that $20k going into my SSI calculator as “income” in these years where I am not working? I assume no, but wanted to verify.
2. Related, if REITs are taxed as ordinary income, can I offset any tax burden by contributing to an IRA via the ordinary income earned from REITs? I also assume no.
Assuming both answers are “no”, then it appears REITs are taxed as ordinary/earned income, but not really treated like ordinary/earned income otherwise, correct?
1. No.
2. No, you can only contribute from earned income.
Ordinary, but not earned. They’re passive income.
Good news though, the entire return of a REIT is not taxed. Not even the entire income of a REIT is taxed. Some is “return of capital”, which is basically the REIT passing through depreciation to you. But rents are taxed as ordinary income, so the REIT distributions that come from rent have to be too. But you don’t have to pay on share value appreciation (until you sell, and even then at LTCG rates). Nor do you pay on return of capital distributions. Just the ordinary dividends.