Real Estate Investment Trusts (REITs)

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Until now, my posts have focused almost exclusively on stocks, bonds, and bank accounts.  This is only reasonable, as most Americans, apart from the value of their homes, keep the bulk of their assets in these financial instruments.  But there are other investment vehicles: options, futures, currencies, and foreign investments of all sorts.  Future posts will look into each; this one focuses on real estate investment trusts (REITs).

REITs, though seemingly exotic, are actually straightforward investment vehicles.  They very much resemble stock and bond mutual funds except that instead of buying stocks or bonds on the investor’s behalf, REITs buy commercial real estate. Before 1960, when Congress passed legislation enabling REITs, the only way to invest in real estate was to buy properties directly, which presented considerable risk because few investors had enough money to diversify their holdings adequately among different sorts of properties and geographic locations.  Now, through the many REITs trading on major stock exchanges, investors have a way to buy into commercial real estate in smaller amounts and with greater diversification.

But diversification remains a critical consideration.  Because most REITs specialize in specific regions of the country, investors often have to consider investing in several to insure geographic diversification.  In addition, many REITs specialize in one type of property, such as shopping centers, commercial buildings, self-storage units, healthcare facilities, office buildings, and the like.  Here, too, you should consider investing in several to assure thorough diversification. Some REITs take on a lot of risk, while others are more cautious.  Before choosing, consider your own objectives and your tolerance for risk.

In addition to offering a way to bring real estate into your portfolio, the other major attraction of REITs is that they pay higher dividends than most common stocks –– often two or three times as much.  This is the outgrowth of the law that excuses REITs from taxes as long as they pay out, in dividends to shareholders, 90 percent of their annual income.  Because this generates a lot of annual income, many investors –– retirees especially –– are attracted to REITs.  Within reason, putting them in your portfolio is probably a good idea.  But investors must take care lest their desire for income seduces them to distort the diversification of their overall portfolio with too large an exposure to real estate.

As with any mutual fund, research any REIT you plan to buy.  Examine the prospectus to see how it approaches investing, what kinds of properties it buys, and their geographic distribution.  And look at its historic returns to determine whether the performance is worth the fees.