Exchange Traded Funds: Five Distinguishing Characteristics of REITs - dummies

Exchange Traded Funds: Five Distinguishing Characteristics of REITs

By Russell Wild

There are three reasons that REIT ETFs are an investment class of their own. These reasons explain why REITs deserve some special status in the world of investments.

REITs offer limited correlation to the broad markets

An index of U.S. REITs (similar to the Dow Jones U.S. Select REIT Index) has evidenced a correlation of 0.38 with the S&P 500 over the past 20 years. That means the price of an S&P 500 index fund and the share price of a REIT index fund have tended to move in the same direction considerably less than half the time. The REIT index has practically no correlation to bonds.

Holding 20 percent REITs in your portfolio over the past 20 years — regardless of whether your portfolio was made up of mostly stocks or bonds — would have both raised your returns and lowered your volatility. It’s the Efficient Frontier in action.

Will REITs continue to work their magic? Their correlation with the broad market has been increasing; undoubtedly REITs are becoming somewhat the victims of their own success. As they have become more mainstream investments, they have come to act more like other equities. Years ago, practically no one held REITS in their portfolios. Nowadays, according to one recent poll, fully two-thirds of professional money managers are using them.

For the next few years, it is likely that we can expect continued positive returns and limited correlation — albeit on a lesser scale on both fronts. Therefore, REITs will still help to diversify a portfolio.

REIT ETFs provide unusually high dividends

REITs typically deliver annual dividend yields significantly higher than even the highest dividend-paying non-REIT stocks, and twice that of the average stock. (Many stocks, of course, pay no dividends.) At the time of this writing, the Vanguard Total Stock Market Index ETF (VTI) is producing a yield of 1.7 percent, versus 3.1 percent for the Vanguard REIT Index ETF (VNQ).

So the cash usually keeps flowing regardless of whether a particular REIT’s share price rises or falls, just as long as the REIT is pulling in some money. That’s because REITs, which get special tax status, are required by law to pay out 90 percent of their income as dividends to shareholders. Cool, huh?

Still, REITs, like other stocks, can be expected also to see growth in share prices. Since 1972, about one-third of the total return of REIT stocks has come from capital appreciation.

Different taxation of dividends for REIT ETFs

Because REITs are blessed in that they don’t have to pay income taxes, their dividends are usually fully taxable to shareholders as ordinary income. In other words, whatever dividends you get will be taxed at year-end according to your income tax bracket. Few, if any, REIT dividends you receive will qualify for the special 15 percent dividend tax rate.