Why REITs Should Be in Your Portfolio
Some holders of Real Estate Investment Trusts (REITs) and REIT funds believe (and fervently hope) that such performance will continue. Others argue that the glory of REITs may already be gone with the wind. Here are several reasons why REITs deserve a permanent allocation in most portfolios.
Limited correlation to the broad markets
An index of U.S. REITs has evidenced a correlation of 0.4 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.
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 1.8 percent, versus 3.5 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?
Different taxation of dividends
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 or 20 percent dividend tax rate. For that reason, your accountant will undoubtedly urge you to handle your REITs a bit carefully.
Special status among financial pros
The vast majority of wealth advisors — whether they primarily use style investing, sector investing, or astrology charts and tea leaves — recognize REITs as a separate asset class and tend to include it in most people’s portfolios. Is that distinction logical and just? Yes, but . . . If REITs deserve that distinction of honor, what about some other industry sectors, such as utilities and energy? After all, both utilities and energy have lately shown less correlation to the S&P 500 than have REITs. Don’t they deserve their own slice of the portfolio pie?
But one possible reason REITs are seen as a separate asset class may be that the REIT marketers are savvier than the marketers of utility stocks (which, in addition to having low correlation to the broad market, also pay exceptionally high dividends).
Connection to tangible property
Some people argue that REITs are different than other stocks because they represent tangible property. Well, yeah, REITs do represent stores filled with useless junk and condos filled with single people desperately looking for dates, and that makes them different from, say, stock in Microsoft or Procter & Gamble. (Isn’t toothpaste tangible?) But the reality is that REITs are stocks. And to a great degree, they behave like stocks. If REITs are different than other stocks, dividends and lack of market correlation are the likely distinctions — not their tangibility.