For decades, when investment advisors talked about “diversifying their portfolio to include real estate,” they usually meant adding. REITs into your stock portfolio.
Don’t get me wrong, real estate investment trusts (REITs) have their advantages. It is highly liquid and easy to buy or sell with the click of a button on your existing brokerage account. You can also invest at a cost of 1 share. So you are investing $15 instead of $50,000.
But do listed REITs offer true diversification from the overall stock market? Maybe not as much as you might think.
What are REITs?
A real estate investment trust is a company that invests in real estate or provides loans backed by real estate. In fact, to qualify REIT based on IRS codethe company must derive at least 75% of its gross income from real estate in some way, and at least 75% of its assets must be real estate related.
As the names suggest, stock REITs own real estate directly, while mortgage REITs own debt backed by real estate. A hybrid REIT owns both.
REITs typically specialize in one area. niche real estate. For example, REITs only focus on: Self storage facilitymultifamily homes in gateway cities, or other 100 niche markets.
some real estate Crowdfunding company We offer private REITs that are sold directly to investors. However, most REITs are traded on public stock exchanges.
As such, it is subject to the same volatility and mood swings as the stock market as a whole. Prices could plummet in one day, even if the underlying real estate assets aren’t rising in value. But we are ahead.
REIT rules
As outlined above, to qualify as a REIT, a company must derive the overwhelming majority of its income from real estate.
A REIT must also pay out at least 90% of its taxable income in the form of dividends. In practice, this means that while they typically pay high dividend yields, their share price appreciation may be limited as profits cannot be reinvested into portfolio growth.
REITs have other rules, such as governance by a board of directors and a minimum of 100 shareholders after the first year, but I feel like I’m about to start yawning, so I don’t need to stick to that.
So why should a company jump all these hurdles to qualify as a REIT? Because they get special tax treatment. Money distributed to investors as dividends is not subject to corporate income tax. As a result, many REITs distribute 100% of their earnings to shareholders and pay no corporate tax at all.
REIT return
Indeed, real estate investment trusts have performed exceptionally well over the past half-century.
From 1972 to 2022, U.S. REITs The average annual return was 11.26%. that is, S&P500, with an average annual return of 11.98%. Both numbers include dividends and price growth, and both are just mathematical averages of annual earnings, not more accurate compound annual growth rates (CAGR).
So if public REIT returns aren’t, where is my interest?
Correlation between REITs and equities
The problem with REITs is that they offer little diversification from the stock market. They are too closely correlated.
a Morningstar research We found a 0.59 correlation between US REITs and the US stock market as a whole over nearly two decades. If middle school math needs a little explanation, a correlation of 1 means lockstep, while a correlation of 0 means no relevance at all.
Real estate stocks have a correlation of 0.59 with the large stock markets, similar to other sectors of the economy. For example, telecommunications stocks have a 0.62 correlation with the overall market. Consumer staples have a correlation of 0.57 and energy stocks have a correlation of 0.64. You can also think of REITs as another sector within your broader equity portfolio.
Take one look at this graph and tell me that the correlation is not clear.
Why does the correlation matter? Because it means that when the stock market crashes, so do REITs. Eggs, baskets, and more.
Consider the average US REIT return of -25.10% in 2022. Yes, I read the minus sign correctly. It lost more than a quarter of its value. on the other hand, Average U.S. Home Prices Rise 10.49% In 2022.
It’s quite a disconnect. This is exactly the point of diversifying across different asset classes. If one collapses, hopefully you’ll get high returns in another asset class. This is especially important for retirees who rely on investment returns to pay their bills.
In fact, this figure for residential real estate prices does not include the income side of property income. Prime rental properties often earn cash yields of 8% or more, and short-term rental yields can be even higher in the right markets. When comparing long-term and short-term rental income, mash visorAirbnb rentals can yield as high as 12%.
Alternatives to public REITs
If you want a low correlation between your equity and real estate investments, you’ll need to invest even further than listed REITs.
To get the benefits of real estate along with true diversification, consider the following options.
- Private REITs: You can invest in non-trading REITs through crowdfunding platforms such as Fundrise and Streitwise. Please do your own due diligence. However, at least it has little correlation with the stock market.
- Non-REIT funds: Not all real estate funds meet the legal definition of a REIT. For example, Groundfloor offers a fully liquid, uncorrelated real estate short-term loan fund called Stairs.
- Fractional Ownership in Lease: Platforms like Arrived and Ark7 let you buy fractional shares of single-family rental properties for $20-$100 per share. Collect rental income in the form of distributions and receive a portion of the profits when the property is sold.
- Real estate syndication: Syndicates offer fractional ownership of commercial real estate such as multifamily homes. trailer house park, self-storage facilities, etc. The downside is that it usually requires a high minimum investment of $50,000 to $100,000. However, some real estate investment clubs like mine help investors pool their money and invest with less capital.
- Direct Ownership: There is always the old-fashioned way of buying property on your own. But again, that often requires him $50,000 to he $100,000 in down payment, closing costs, repairs, cash reserves, etc. This makes it difficult to diversify the real estate portfolio.
Should You Invest in a REIT?
I’m not going to teach you how to invest. If you value liquidity above all else and want to start a few real estate investments with $100, buy some REIT stocks.
Personally, I would like to balance my real estate investments with my stock investments. Liquidity of holdings is not required. Stocks are already liquid.
I actually invest in Real estate as an alternative to bonds in my portfolio. They serve much the same function, such as diversification from equities, unearned income, and low risk of default.Real Estate Offers Better, Too protection against inflationAnd while it can go down 5-10% in value, it will never go down 100% (just like a bond goes down in value if the borrower defaults or declares bankruptcy).
Invest in the way that works best for you. I’ve found my happy place, balancing between a reluctant real estate syndicate and a diverse array of equity funds from around the world.
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Note by BiggerPockets: These are opinions written by the authors and do not necessarily represent the opinions of BiggerPockets.