This excellent article on REITs for your portfolio was originally published on Value Walk. We received permission to republish it here.
The current economic climate is challenging. Interest rates are rising, and we are seeing inflation continue to balloon. Investors are keeping a close eye on their portfolios and adjusting where needed.
Intuition tells us that with rising interest rates, real estate investments are increasingly risky and will result in lower and lower returns. But does this conclusion also apply to REITs?
Real Estate Investment Trusts (REITs) offer a different avenue for including properties in your investment planning.
It is counter-intuitive, but even though some REIT prices are struggling right now, this is not the time to step away from your investments.
Yes, there’s always the risk of a house price crash, but now may be the time to raise your bets, buy new ones, and build on existing strategic REIT investments.
What is a REIT?
A REIT provides the opportunity to indirectly put money into real estate via an entity that owns and operates income-generating properties (think residential rentals, hotels, commercial leases, etc.).
Although the property (and subsequent share) values may increase, the bulk of the income generated by REITs is in the form of dividend returns.
This is due to the corporate tax break REITs receive if they distribute a minimum of 90% of their income to shareholders.
REITs are often publicly traded, meaning there is high liquidity for those who have put money into them.
The Three Types of REITs
- Equity REITs: These REITs generate income through rents paid. They have a low rate sensitivity. A strong management firm is vital to the success of an equity REIT.
- Mortgage REITs: These REITs operate from a loaning model, providing a direct loan or mortgage to property owners or acquiring residential or commercial mortgage securities. They generate income via net-interest margins (cost to lend versus income from agreed-upon interest). They have a high rate sensitivity.
- Hybrid REITs: As the name suggests, these REITs combine the income models of both hybrid and mortgage REITs.
Why it Could be Time to Consider REITs:
1. REIT’s Historical Performance in Similar Conditions is Favorable
Standard and Poor (S&P) studied six periods of increased interest rates dating back to the 1970s to assess the impact of the increase on REIT and stock performance.
REITs were found to have increased in returns in four of the six periods. Furthermore, they beat the market in three of the six periods.
Another assessment done by REIT.com reviewed the 12-month return of REITs from 1992 to 2017. 87% of rising rate periods demonstrated positive returns.
It is, of course, essential to note that there were also negative correlations with increased interest rates at times.
Therefore, we must note the importance of assessing other factors beyond rates when choosing where and how to invest.
2. Dividend Payouts Mean Money in Your Pocket
Appealing to our retirement-age investors, in particular, the dividend payouts from REITs provide an income for folks looking to live off of their investments.
Equity REIT yields will depend on your investment choices, with hotels trending higher risk and long-term commercial leases as more reliable.
As mentioned previously, doing your due diligence in finding a quality REIT with a strong management firm is integral to the success and stability of REIT yield.
3. Involvement in Real Estate Without Owning a Property
Purchasing a property often requires agreeing to a sizable debt in your name. When buying shares of a REIT, you are only investing the cash you have at your disposal.
Choosing a REIT, particularly an equity REIT, over conventional real estate purchases means you won’t be subject to significant variations due to increased interest rates.
Furthermore, you are investing in a more diverse portfolio of real estate that may better withstand fluctuations in the market.
Residential prices may be rising, but the hotel industry is thriving due to the resumption of travel.
Note the variety of REIT properties and choose one that suits the current climate.
Finally, REITs often trade at discounted rates compared to private real estate. Due to these substantial discounts, REITs proactively account for any price decreases on the active market.
4. REITs Exist Beyond Your Local Market
REITs can expose you to international markets with different rates, diversifying your net worth across multiple income streams.
Even though local interest rates are rising, that may not be true for international markets. Countries like Singapore, Australia, and South Africa all allow REIT listings. Consider diversifying geographically to bolster your portfolio.
5. Other investors are Jumping Ship
Due to the increased interest rates, many investors are choosing to sell REIT shares in favor of lower-risk investments. Consequently, the lower demand results in higher yield for those who stick it out with their REITs.
It’s important to remember the intent behind rising rates – to balance out inflation, which will, in turn, mean more capital injected into the economy, more people entering the real estate market, more reliable renters, and a more stable base for REITs to thrive.
So, is Now the Time to Consider REITs for Your Portfolio?
As with every investment, you must do your research: find out which type of REIT will match your risk tolerance, review their debt profile and history, and the impact of rates on sub-sectors of the market.
Note the variation in yield, and diversity of properties, and consider international markets as well as alternatives to exclusively residential opportunities.
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Disclosure: The author is not a licensed or registered investment adviser or broker/dealer. They are not providing you with individual investment advice. Please consult with a licensed investment professional before you invest your money.
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