By FPA member David Zuckerman, CFP®, CIMA®
Last Updated: May 16, 2011
What is a REIT?
REIT is the acronym for Real Estate Investment Trust, which is a real estate company that offers shares to the public. Some REITs have shares that trade on exchanges, and some offer shares privately. The difference between REITs and other stocks is that REITs are primarily in the business of managing income-producing property and receive favorable tax treatment because they are required to distribute at least 90 percent of taxable profit as dividends to shareholders. REITs may be the best way for you to get exposure to commercial real estate.
Why should you consider investing in commercial real estate?
If you own your home, you may already have sufficient exposure to residential real estate as an asset class. In addition, well-managed commercial real estate typically provides superior returns. Research has shown that the inflation adjusted, long-term rate of appreciation for single family residential real estate is only between one and two percent.1 Although this is not as much as many people would expect, a primary residence is a good investment because you are able to utilize this investment by living in it, which is not something you can do with a stock and bond portfolio. Also, a mortgage is a very good tool for “forced savings.” Once you own your own home, however, allocating additional capital to single family residential real estate may not be the best course of action. Commercial real estate, however, is a different asset class, and can include property types such as office buildings, industrial property, shopping malls, hotels, warehouses, and apartment complexes.
Why is a REIT a good way to invest in commercial real estate?
If you have the expertise and the capital, you can buy land and develop it yourself. Most people, however, do not have either the capital or the experience to develop a diversified commercial real estate portfolio on their own. REITs can be an efficient way to maximize economies of experience and gain diversified exposure to commercial real estate. That small apartment building may have caught your eye because it is conveniently located and may be very tangible, but it may not be the best way to diversify your real estate holdings.
Why buy one apartment building when you can own a piece of a portfolio that holds hundreds of high-quality buildings spread across the country? And just like other asset classes, you can reduce risk by diversifying your real estate holdings. REITs offer an effective way to invest alongside some of the most skilled and experienced real estate managers in the world. Skilled REIT managers provide exposure to segments of the real estate market, like premier office buildings, that the vast majority of individual investors could not otherwise access.
From 1975 to 2006, REITs generated an inflation adjusted return of 7.7 percent per year.2 Given the extent of the real estate downturn, future returns from REITs may not be as strong as in the past; but research suggests that REITs can provide both superior diversification and solid returns over long periods of time.3
What type of REIT should you invest in?
There are many different kinds of REITs. Some REITs only invest in healthcare properties, while others offer broadly diversified exposure to high-quality office properties. At the most basic level, REITs can be classified by how you acquire shares. If you buy shares in a REIT that is traded on a stock exchange, the REIT is publicly traded. Buying shares directly from a REIT itself means that you are purchasing shares in a non-traded REIT. Non-traded REITs are often promoted as low volatility investments because prices do not change everyday like publicly traded REITs. Buyers of non-traded REITs are, however, sacrificing liquidity for less volatility. Importantly, non-traded REITS can stop allowing investors to redeem their shares. A very bad scenario can develop if a non-traded REIT halts redemptions and begins cutting dividends, as you can be stuck in an investment with a falling yield that is tough to exit. For those with a long-term perspective, the liquidity of traded REITs may well be worth the volatility that comes with a major stock exchange listing.
Although you can select your own individual REIT investments, you can also buy shares in REIT mutual funds. And if you do not have the background, discipline, and experience to analyze risk/reward profiles for the hundreds of REITs and REIT funds that are available, you always have the option of consulting with a financial planner to determine which REIT is right for you.
1 Arends, Brett. “Is Your Home a Good Investment?” The Wall St. Journal 27 May 2009
2 Marston, Richard C. “Real Returns on Housing (with 75% Mortgage) and Other Assets Compared” 2009
3 Marston, Richard C. “Correlations between the NAREIT Index and Other Assets” 2009
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, Calif.