After writing about PeerStreet, the benefits of hard money lending and exposure to the real estate market, a couple of people have asked how REITs fit into an asset allocation and whether it’s worth getting involved in smaller real estate deals when you can use index funds to invest in REITS.
For those that don’t know, a REIT is a Real Estate Investment Trust. In some ways, they are comparable to a mutual fund since they allow both small and large investors to pool resources for the purpose of acquiring ownership interest. Most REITs own and operate large commercial properties like apartment complexes, hospital, office buildings, warehouses, etc. You can invest in individual REITs traded on the public stock markets or you could invest in a REIT index fund from a company like Vanguard if you wanted exposure to the entire public REIT market.
If you’re not interested in being a landlord and can’t afford to purchase a $100,000,000 commercial building in NYC, REITs offer you the opportunity to own a slice of this market and the resulting appreciation and revenue from operation.
For dividend investors, REITs are often attractive because they are required by law to pay out at least 90% of their income each year (after expenses). That means a portion of those rent checks find a way back to your pocket each month.
Three main kinds of REITs
There are four main type of REITs in the United States:
1. Equity REITs. Equity REITs are the type discussed above. Investors pool their resources and acquire property throughout the United States and world. Revenue typically comes from leasing space to tenants. Rent is then distributed to the owners of the REITs as a dividend to shareholders. Sometimes an Equity REIT will sell a property and pass on the capital appreciation to its investors. Equity REITs are probably the most common type of REIT you will find in the market.
2. Mortgage/Debt REITs. If you’re not interested in being involved in the equity stack, mortgage/debt REITs loan money for mortgages to real estate owners or purchase existing mortgages or mortgage-backed securities in the open market. As you can imagine, these REITs were particularly hammered during the financial crises since they heavily invested in collatarelized debt objects (CDOs) composed of mortgage backed securities. That doesn’t mean they are toxic assets but mortgage/debt REITs are only as good as the quality of the underlying mortgage (just as Equity REITs are only as good as the underling properties). Mortgage REITs generate income based on the spread between the interest paid by the mortgage borrowers and the cost of funds for the REIT. This makes them sensitive to interest rate changes.
3. Hybrid REITs. Some REITs try to pick and choose between the equity and debt markets to find the right balance.
Public vs private REITs
In addition to the type of REITs discussed above, REITs come in two flavors: public or private.
Public REITs trade on the public stock markets where investors can buy their securities directly. If an investor wants to focus in on a particular market or type of property, you can invest in a single REIT in the same way that you could pick an individual stock.
One example would be something like the the American Tower Corporation (AMT) which is described as a real estate investment trust that owns, operates and develops multi-tenant communication real estate (i.e. cell phone towers).
If you’re not interested in picking individual stocks (like me), you might consider something like the Vanguard REIT Index Fund which has $64 billion spread out across the entire REIT market.
Private REITs aren’t available on the public stock market. An example would be the Fundrise eREIT. Fundrise is one of the many real estate crowdfunding platforms. It’s taken the approach of focusing on the REIT market, rather than sourcing individual deals. As such, they’ve put together a professional managed portfolio of commercial real estate assets that are available to accredited investors on the platform.
The argument for private REITs over public REITs (as told to me by the Fundrise rep) is that private REITs have significantly lower fees, less liquidity since they aren’t publicly traded and a corresponding lower correlation to the broader public market.
It’s impossible for me to tell for sure if private REITs have lower fees but REITs in general seem opaque when it comes to fees. There are many opportunities for fees to be layered throughout real estate transactions (broker fees, management fees, property maintenance fees, origination fees, finder fees, etc.) and so it’s natural to assume that the farther away you are from the underlying real estate transaction the more fees you’ll end up paying.
For that reason, public REITs as a whole don’t have the best performance record. Rather than generating large returns, they seem to be considered a steady and predictable income stream.
REIT correlation to the stock market
Another supposed benefit to REITs is that they should generally not be correlated with the broader stock market. Since REITs are composed of real estate assets throughout the company, they should track the broader real estate market as prices move up and down. Further, since equity REITs generate income via rent, they shouldn’t see as much volatility even if tough markets because rent has to be paid regardless of the market turmoil.
For that reason, it’s a bit surprising when you compare the Vanguard REIT Index Fund (VGSIX) vs the Vanguard Total Stock Market (VTSAX). As you can see, they seem to move in tandem. There are a lot of theories as to why this is the case. Obviously, the 2007-2008 financial crises had a lot to do with the housing market but that doesn’t explain the near exact volatility of the broader stock market. One theory is that since public REITs are traded in the stock market, they behave more like securities in general than real estate, which means that in times financial crises public REITs face the same flight of capital as investors look to park their money in safer investments.
If you’re not benefiting from the lack of correlation in an asset class, I’m not sure it makes sense to accept the volatility when overall returns will still be tied to the performance of the broader real estate market.
Further thoughts on private REITs
When I think of unlisted or non-public REITs, I think of the real estate crowdfunding platforms that are trying to change the public REIT market. However, I’m also told that private REITs are a common tactic used by commissioned salespeople looking to sell you an investment. I’d be skeptical of any person that is trying to sell you on the concept of an unlisted REIT.
They may tell you that there are many benefits to investing in an unlisted REIT, such as a stable share price, income that won’t be taxable, a higher return and the possibility that the REIT will go “public” at some point.
Of course, a private company can arbitrarily keep its share price stable but that has nothing to do with the underlying value of the assets. It doesn’t make any sense to assume that a price is stable just because a company wishes it to be so.
Many times someone will try to tell you that investment returns aren’t taxable to you. That’s because it’s called a “return of capital” (i.e. the first dollars out are returning your capital back to yourself). You’ll get taxed on those earnings eventually. There’s no such thing as a free lunch. If I wanted to give some capital and then let them return it to me, I’d use my checking account.
As for waiting for something to go public, don’t fall victim to the greater fool theory. Sure, there may be a greater fool out there but that’s no way to make an investment.
Should you invest in REITs?
As mentioned when I wrote about PeerStreet, currently I have very few of my assets in real estate (although once I tried Personal Capital, I realized I had more assets in real estate than I thought thanks to their excellent asset allocation tool).
Since I live in NYC and rent, I can’t even count my personal home as part of my real estate holdings (although there’s plenty of differing opinions about whether your home should be considered a real estate investment). For that reason, I’m actively exploring making real estate investments. I’ve put $10,000 to work on the PeerStreet platform, but that’s hard-money lending and not an equity investment.
At this point, I’m more interested in making an equity investment directly into a property through a real estate crowdfunding platform as part of a small percentage of my overall asset allocation (definitely less than 10% and probably more like 5%).
I’m not comfortable with REITs mainly because I don’t understand how the fee structure works and I’m not sure that anyone can see through the entire investment to understand how much of the returns are “lost” to various expenses. Real estate has too many opportunities for money to be siphoned out of the system (brokers, maintenance, managers, etc.).
Of course I won’t completely avoid that if I invest in a specific real estate project. It should just be easier to identify the expenses related to the actual project. On the flip side, I’d obviously lose the diversity. If you invest in a college dorm in Houston, Texas and a hurricane comes along, you’ll be lucky to get a return of the equity. So there’s that to consider too. You’ll be the first to know if/when I decide to invest in a real estate project.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Empower keeping track of his money. He’s also maxing out tax-advantaged accounts like 529 Plans to minimize his taxable income.
Hi Biglaw!
A couple of thoughts:
1) “Return of capital” actually IS a little bit of a free lunch if you compare it with receiving those earnings as a dividend. The dividend would be taxed as ordinary income. However, the return of capital reduces your basis – no present taxation – and if you hold the investment more than a year then the reduction in basis is taxed as capital gain at sale. Thus – as compared to an annual dividend, you can postpone tax and lessen it – and also potentially plan to sell when you have other investments that are selling for a loss to counteract the cap gain.
2) After reading your post, one aspect that I am having difficulty understanding is how you made your “trust/value” determination between PeerStreet and REITs. You seem to trust PeerStreet – you invested with them – but as far as I can tell, the individual investments are not audited and there are a huge number of opportunities for them to impose additional invisible fees because you are on a captive platform. Conversely, REITs are audited and under considerable scrutiny – and the competition keeps the fees down. You do realize that in your example post when PeerStreet says it is charging 1%, it is really 1% of the note return – so your 8.5% note becomes 7.5% – which represents a “management fee” of 11.8% of your return. Very few REITs would charge as much.
3) Over the years, I have invested in and sold REIT indices and individual REITs. There are so many flavors of REIT depending on what they focus on. For example, for many years REITs that focused on public storage were hugely profitable, but it seems to have declined in growth rate. You can even invest in a REIT that only owns properties that are then leased back to the US govt – that’s pretty good tenant reliability!
4) You also might want to look into closed-end funds that are REITs.
https://www.reit.com/investing/investing-reits/list-reit-funds/closed-end-funds
5) One thing to think about is what part of your portfolio that you might use a REIT to fill. Here’s a chart that might be handy.
https://www.cefadvisors.com/Download/correlation.pdf
You will note that the correlation between US stocks and investment grade bonds is 79% while REITs are 85.2%. YES – “bonds” which are supposedly not correlated with “stocks” are
actually pretty correlated – at least US stocks and investment grade bonds – and the difference between the REIT correlation and investment grade bond correlation is not that huge.
A lot of times when people are designing a portfolio with a “stock” percentage and a “bond” percentage, they are really using those terms as substitutes for “investments that rise rapidly and produce capital gain” and “investments that pay current cash”. (One reason why just allocating 70% to “stocks” does not work is that there is a huge difference between a penny stock and a utility stock, but both are “stocks”). Within the category of investments that you might choose in the “cash now” portion, you might include a high-dividend stock like a utility stock (still some upside, taxes are bad). You might also consider some REITs (wide variance in performance based on underlying investments, but usually lesser taxation and in some cases the same or more cash, some upside potential depending on investments.). You might also consider a muni bond (good if your tax rate is high, no upside). You might consider an investment grade bond (good if rates are stable or declining, no upside, subject to being called, limited exposure to rising rates.) You might consider a junk bond (nice payments if interest rates are stable or declining, no upside, bigger exposure to rising rates, potential for loss of capital in rising rates.) You might also consider a royalty trust (payout varies with cost of underlying commodity). You might also consider a MLP – it’s like a utility stock for transporting and refining oil and gas rather (again, commodity price risk, but decent payouts). You can sometimes find beta-adjusted bargains in the non-bond portion of the “cash now” investments because people have been trained to only buy bonds – and consequently they overbuy bonds.
The bottom line is that you would not replace the “SP500” portion of your portfolio with REITs – but you might use REITs for some of the “bonds” portion of your portfolio, depending on market conditions and the specific aspects of the REIT.
Thanks MP for your insightful comments!
On return of capital, I don’t really see it as a free lunch. I see it as a return of your own lunch. But I do take your point on delaying taxes which I guess is a bit of a free lunch. More importantly, return of capital isn’t an increase in the underlying value of the investment and can be used to mislead people into thinking they’ve received a return. That’s my concern.
On PeerStreet, I agree that the 11.8% management fee in your example is pretty high. Although REITs are audited, I find it virtually impenetrable to understand the complex layers of fees. Audits never seem to produce such a simple answer as “you’re paying an 11.8% management fee”. Perhaps I haven’t looked deep enough but I see the dilemma precisely as you described. Either I pay a known and fixed 11.8% management fee or I pay an unknown fee. I’m hardwired to avoid investments I don’t understand.
Over your investments with REITs have you found them to be highly correlated with the stock market? My review of the charts seems to show they move in tandem. The fact that they correlate so heavily concerns me, particularly when I can invest in individual deals that should have significantly less correlation.
Hi Biglaw!
Good counter-points as always!
With regard to the REIT/Market correlation question, I find that there are so many different types of REITs and that they behave differently with regard to correlation. For example, you might have a REIT that focuses on homebuilders and the industry that supports them – that REIT is going to likely track US economic activity, which has a significant correlation to the market. Conversely, you might have a mortgage REIT, which is going to have interest rate exposure and act more like a bond and have a much less correlation with the market. So basically, your question of correlation really comes down to – what are the underlying investments of the REITs in which you are investing?
If you take the overall REIT index, it is heavy on equity REITs – so it is going to have a significant correlation with the SP500. Not a 100% correlation, but still significant. I don’t think of “REITs” as a category like “SP500” – they are just too disparate.
REITs are included in total market indices at market weight, which for the U.S. market means roughly 3%. Public REITs perform more like private real estate, and their correlation to the broad stock market drops, over longer periods.
See:
Heitman, “Why REITSs? – Five Reasons to Invest in Real Estate Through Public Markets” at: http://www.heitman.com/news/why-reits-five-reasons-to-invest-in-real-estate-through-public-markets/.
Charles Schwab, “Capitalize on global economic growth with global real estate” at: http://www.schwab.com/system/file/P-7137236.
Historically, adding REITs to a stock portfolio comprised of broad market indices served to both reduce volatility and increase CAGR, when rebalanced regularly.
See:
Portfolio Visualizer efficient frontier plot of the U.S. stock market and U.S. REIT indices since 1994 (through end of August 2017): https://tinyurl.com/ybud5edp. The maximum volatility reduction was achieved with 20% REITs. The same held true with the total international stock market and foreign real estate indices since 2011 (the year of Vanguard’s foreign real estate index fund’s inception). See: https://tinyurl.com/y8sr9n6a.
Portfolio Visualizer efficient frontier plot of Vanguard’s U.S. REIT index fund (VGSIX) and Vanguard’s global real estate index fund (VGXRX) since 2011: https://tinyurl.com/ycxullrx. The maximum volatility reduction was achieved with about 50% U.S. and 50% foreign real estate securities.
U.S. REITs as an asset class are relatively expensive now, especially compared to foreign real estate securities. Per Morningstar data as of this morning, VGSIX and VGXRX, respectively, compare as follows:
Price / prospective earnings: 31.45 vs. 12.37
Price / cash flow: 14.30 vs. 7.66
Dividend yield: 4.28% vs. 3.72%
2017 YTD returns (through Friday’s close): 2.74% vs. 21.29%
I personally use Schwab’s Fundamental Global Real Estate Index (SFREX) which has current geographic allocations of 45% U.S. and 55% international. My target for REITs is 20% of my equity, which for me means about 14% of the total portfolio.
Thanks for the links Riley. I will check everything out. Here’s a visual for why it seems to me like REITs are highly correlated with the stock market. The comparison if between the Vanguard REIT Index Fund and the Vanguard Total Stock Market.
You’re welcome, and understood. The Heitman link discusses correlations between U.S. public REITs and the broader U.S. stock market. Notably, the correlation between the two decreases over longer periods. Heitman concludes, “Declining correlation as [mispricing] errors are corrected is a sign that underlying return drivers are fundamentally different–that is, REITs and non-REIT stocks represent different asset classes.” Heitman is not alone. See also the following resources showing the same:
1. Case, Brad, “The Role of REITs for Long-Term Investors,” AAII Journal, January 2012, at http://www.aaii.com/journal/article/the-role-of-reits-for-long-term-investors.touch (see section titled “REIT Correlations Widen Relative to Stocks” and Figure 3 therein)
2. Case, Brad, “REIT Correlations in 2017,” REIT.com, at https://www.reit.com/data-research/research/market-commentary/reit-correlations-2017.
3. Portfolio Visualizer’s correlation analysis between Vanguard [U.S.] REIT Index (VGSIX) and Vanguard’s Total [U.S.] Stock Market Index (VTSMX) here: https://tinyurl.com/ybp7rzup. The correlation between the two from 05/13/1996 through 09/29/2017 is 0.68. However, if you click on the “Rolling Correlations” tab, you can see how the correlation has changed over time, dropping close to or below zero between 1999 and 2001 and dropping rather steadily over the last seven or so years. Compare this to Portfolio Visualizer’s correlation analysis of Vanguard’s Total International Stock Index (VGTSX) and Global ex-U.S. Real Estate Index (VGXRX) here: https://tinyurl.com/yapv5j5g. These are much more correlated. This may be because some foreign countries don’t utilize the REIT tax structure, so the index VGXRX tracks also includes real estate securities, whereas the index VGSIX currently tracks is all REITs (at least until the current proxy vote is decided).
I’m not advocating REITs as a substitute for bonds in a portfolio. Rather, I’m simply pointing out the potential for meaningful diversification as part of the “equity” portion of a portfolio, especially for people like me that have no interest in worrying about one-off real estate deals or managing properties themselves.