While real estate property ownership is not correlated to the U.S. equity markets as represented by the S&P 500 index, buying individual properties for ones investment portfolio offers significant challenges. However, investments in real estate-related securities, such as Real Estate Investment Trusts (REITs) offer significantly more flexibility. REITs are publicly-traded securities issued by companies that invest in investment grade institutional properties. REITs are pass-through entities for income tax purposes as long as they pay out a minimum of 90% of their profits to shareholders every year. The last four years of REIT performance have been spectacular especially in comparison to the rough years of 1998 and 1999. Their long- term outlook of their dividend stream causes them to look attractive. Before investing in REITs, one must understand the fundamentals and how they can be an integral part of a diversified portfolio.

REITs are total return investments, offering high dividends typically 5% to 6% in todays environment and the potential for moderate, long-term capital appreciation. REITs, due to the stable nature of the revenue source, are not high growth type investments. In a diversified portfolio REITs provide a pattern of return that is dissimilar with other investments in the portfolio while potentially providing a long-term total return equivalent to equities.

REIT Benefits:

Investing in REITs offer a number of benefits, especially REIT Mutual Funds (probably the best way to invest in them). Some of the benefits include:

  • REIT returns have performed better (11.57% as represented by The Wilshire REIT Index) than the S&P 500 since the beginning of 1994 thru September 30, 2003 (generally considered the modern era of REITs) with approximately 20% less risk (The Wilshire REIT has a 14.03 standard deviation over the last ten years versus 17.37 standard deviation for the S&P 500).
  • REITs have high dividends currently 5% to 6%. These are fully taxable and not subject to the special 15% tax rate, which was enacted in 2003. Occasionally, additional cash distributions are made that are non-taxable. These are called return of capital for income tax purposes, which actually reduce your cost basis leading to a larger capital gain when you sell. Capital gains are now taxed at a minimum income tax rate of 15.0%
  • REITs have relatively strong balance sheets due to moderate levels of debt (typically 50% of less of the asset levels).
  • REITs have experienced, professional real estate managers. The securities are also overseen by the SEC.
  • REITs have low relative correlation (a similar pattern of performance) to broad market indices such as the S&P 500, Nasdaq Composite and the Russell 2000 (typically REITs move similar to these asset classes approximately 30% of the time or less)

REIT Risks:

REITs are also subject to risks such as recession risk, property damage and security threats, pricing problems, liability lawsuits, bad management, overbuilding, etc. There are other unique risks specific to REITs:

  • In past years when discussions about changing the income taxation features of REITs have occurred, prices of these securities have sometimes dropped significantly.
  • REITs, on average, are not as reliant on debt as they were in the 1980s. The average debt load is now approximately 50%. However, some are heavily in debt. Also, variable rate debt can cause significant financial problems as interest rates rise.

Parting Thoughts:

REITs have many positive attributes and they will enhance any portfolio long-term performance in terms of reducing its volatility and will perhaps increase its returns. Despite the fact that these investments have appreciated so much over the past four years, due to their dividends, they should deliver a total return better than large U.S. equities as represented by the S&P 500 (which is still grossly overvalued) over the next three to five years.

Legend Financial Advisors, Inc.
5700 Corporate Drive, Suite 350
Pittsburgh, PA 15237-5829
Phone: (412) 635-9210
Fax: (412) 635-9213
Toll Free: (888) 236-5960
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