Updated January 2017 — "REIT," pronounced "reet," stands for Real Estate Investment Trust. REITs invest in and operate commercial real estate.
"In my opinion, REITs can play a key role in many investment portfolios," says John LaForge, Head of Global Real Asset Strategy with Wells Fargo Investment Institute, who specializes in REITs.
So what makes REITs interesting?
The Internal Revenue Service exempts REITs from paying corporate income tax; REITs must pass 90 percent of their operating income along to their shareholders in the form of dividends.
As of January 2017, there are 224 publically traded REITs, with 192 REITs trading publicly on the New York Stock Exchange with a market capitalization of $941 billion. Twenty-eight REITs are currently in the S&P 500.
REITs own and manage a variety of property types, including shopping centers, health care facilities, apartments, warehouses, office buildings, and hotels, among other properties. Most REITs specialize in one property type only, such as shopping malls, timberlands, data centers, or self-storage facilities.
There are several reasons REITs could have a place in your portfolio:
Portfolio diversification: While REITs share characteristics of both stocks and bonds, they do not always follow the price direction of stocks and bonds. In other words, REITs can add diversification to your portfolio.
Current income: On average, REITs pay a much higher dividend than most stocks and higher yield than most bonds because of the IRS' 90 percent rule. By contrast, equities with growth potential typically pay few to no dividends; bonds with healthy yields can be riskier and have limits to how much they can appreciate.
Liquidity: According to LaForge, "If you buy commercial real estate yourself in private transactions, it can be really hard to sell." "REITs are publicly traded and, therefore, are designed to be more liquid than selling individual commercial real estate properties."
Inflation hedging: "Real estate prices, and rents, generally move higher with inflation," LaForge says. "Our clients look for ways to combat inflation, and real estate provides a potential hedge."
REIT performance after the real estate crash
The 2009 financial crisis was "a day of reckoning" for REITs, LaForge says, with sharp declines in share prices. Some analysts feared the end of this asset class.
But most REITs raised capital, shored up their balance sheets and outperformed the broader markets, according to LaForge: "Looking at the period between January 1, 2010 through December 31, 2016, the FTSE NAREIT All Equity REITs Index has outperformed the S&P 500 in five out of the past seven years and has a cumulative outperformance of 1180 basis points versus the S&P 500."
In my opinion, REITs can play a key role in many investment portfolios." — John LaForge, Head of Global Real Asset Strategy, Wells Fargo Investment Institute
REITs in context: Real estate realities today
REITs are part of the "real assets" assets group in the Wells Fargo Investment Institute asset allocation model, along with commodities and private real estate. LaForge says, however, that it sometimes takes clients some convincing to get into the REIT space.
"It's important for clients not to confuse commercial real estate with residential real estate," he says. "Both commercial and residential prices plummeted during the crisis, but residential prices remain below historical peaks while commercial prices pushed to record highs in recent years."
One of the main issues with residential real estate was oversupply, LaForge says, with too much building leading up to the crisis. In commercial real estate, however, there was actually a lack of supply before the crisis hit "that softened the blow and enabled it to rebound much more quickly."
To determine whether REITs may offer potential tax benefits, it is important to understand how dividend distributions for REITs may be taxed (ordinary income, capital gains, return of capital). "As you consider your options, talk with your tax and investment professional about asset location and appropriate portfolio placement," recommends LaForge.