Updated Feb, 2020

What’s the deal with REITs?

reit

REITs or Real Estate Investment Trusts are publicly-listed companies that invest in real estate.

REITs for their high dividends

REITs are often invested in for their high yield by people thinking that because REITs are backed by physical property, there is little downside risk and that the yield from property provides stability and therefore REITs are a sort of “bond proxy” in the sense that they can provide income stability like that of a bond. You couldn’t be more wrong. Basing your investment around dividends is a deeply flawed idea.

Since REITs are traded on the stock market and invest more in commercial property, they tend to behave more like stocks than direct residential property. Consequently, the value of REITs goes up and down just as wildly as the broader stock market.

Also, REITs use a lot of leverage, so in a major economic crisis, they can be hit much more severely. During the GFC, the total stock market dropped 50%, but REITs dropped much more than that at 70% globally and even more for Australian REITs. Make no mistake about it — REITs are stocks and come with all the same risks as stocks.

People get tripped up with REITs because REITs are legally required to pay out at least 90% of their earnings as dividends. As a result, people see the higher dividend amount and think there is a higher total return. In reality, REITs are merely paying out a higher proportion of returns as dividends and suffer from the same problem as any other high dividend stocks.

REITs for diversification

Before the GFC, many considered REITs to be the ideal alternative asset class.

This is because the property cycle tends to move out of sync with the business cycle, providing a diversification effect. Yet, unlike direct property ownership, with REITs, you’re able to buy and sell shares on the stock market and diversify into thousands of assets from all around the world with a single purchase.

Unfortunately, due to the ability to buy and sell in real-time, unlike unlisted property, the price is determined up-to-the-minute by the market and tends to fall sharply alongside equities in major market downturns, and consequently, a good amount of the diversification benefit is lost by the fact that it is listed.

Also, as mentioned above, many REITs invest in commercial property, so they’re more exposed to the business cycle instead of the residential property cycle, again making them more highly correlated with stocks than with property. On top of this, since REITs tend to be highly leveraged, in a severe economic crisis, they’re hit very hard.

As you can imagine, many changed their minds on the idea of REITs after the GFC. In fact, unlike before the GFC, where it was commonly mentioned to invest some of your assets in REITs as a diversifying alternative, not only are they just not mentioned any more, but plenty of articles say they’re not useful.

An interesting one by Larry Swedroe found that risk factors can explain the returns of REITs – small, value, and credit factors – so you can get the same diversification benefit with a SCV (small cap value) fund and a corporate bond fund. By doing this, you avoid the idiosyncratic sector risk (single sector risk) of investing a large portion of your assets in a single sector (real estate).

Many have taken these articles by esteemed authors as a green light to remove their REIT allocation and claim it is improving their portfolio based on new information, but I wonder whether this is a subconscious bias making them feel like it’s ok to sell an asset class that the rest of the herd has decided is no good.

So, are REITs worthy of being discarded?

While REITs don’t offer the same degree of diversification benefit as unlisted property, they still provide some diversification benefit and having some REITs is most likely beneficial.

If you look from a US perspective, international (non-US) equities crash alongside US equities during global crashes. So, many US investors have decided that the diversification benefit has been lost with non-US shares. What they fail to realise is that there is still a diversification effect outside periods of sharp decline, which is where REITs may still be useful despite the masses turning away from them.

The reason I don’t bother with adding a REIT fund is that adding a fund that makes up less than about 10% of your equities just doesn’t have a meaningful impact on your portfolio’s performance and the index already contains REITs at about 4% in the global index and 8% in the Australian index, but if you wanted to, it seems perfectly reasonable to add it in (as a diversifier, not for their high dividends or as a bond proxy).

Another upside is that if we go back to what was mentioned earlier about research showing that the performance of REITs can be explained by risk factors and, in theory, could be more effectively invested using a SCV fund — since there are no SCV index funds on the ASX, this seems like another potential reason to include it. Although, you still have the option of using a separate small cap fund like VISM and a value fund like VVLU, but VVLU has not been popular, and there is a chance the fund may be wound up one day as a result, and the small caps fund includes small caps growth stocks which have historically dragged down the broader small cap asset class.

Another potential reason to add REITs, which has been mentioned by one of my favourite authors Rick Ferri, is that property is underrepresented in the stock market. In the US, commercial real estate alone makes up about 13% of the economy, but only 3% is represented in the US stock market. As a result, he uses REITs as a 10% slice in his famed ‘core-4’ (4-fund) portfolio on top of the 3-4% of REITs already in the index.

If you do decide to invest in REITs, the most commonly given advice these days is to keep it down to a max of about 10% of your equities due to being highly leveraged and therefore highly risky in times of economic crisis as we saw that during the GFC.

REITs and Tax

Because REITs are legally required to pay out at least 90% of their income and therefore such a high portion of returns being from dividends, not only can’t you delay paying tax until you’re retired and on a lower income, you also miss out on the 50% CGT discount. As a result, if you invest in REITs, you need to be wary of the tax consequences. Unless your marginal tax rate is low, the drag on returns outside super is so large that it may be better not to have additional REITs at all.

Even in super, there’s a cost. In fact potentially more so than outside super. In super, income is taxed at 15%, which is better than outside super. But in super, capital gains that have not been realised (for potentially decades) are not payable (it’s essentially wiped) once you meet a condition of release and convert your super to pension mode for drawing down. So you’re still swimming upstream with REITs in super compared to using total market index funds, which tend to have more of their returns as capital gains instead of income.
This compares to the US, where a 401k (the US retirement vehicle) is income-tax-free when putting money in (compared to our 15%), but those gains are never wiped and are payable when drawing down in retirement at the same rate as income. So, REITs don’t have as much of a disadvantage there like in Australian superannuation.
So, while I like the idea of bumping up REITs to maybe 10% of my equities (it’s about 3-4% in the global index and 8% in the Australian index), the significant tax cost makes it unappealing, at least until pension phase in super or with a very low tax bracket outside super.

Conclusion

Whether you should or should not invest in REITs, I don’t know, but hopefully you have more information to help you decide.

One more thing – if you do decide to invest in REITs, I’d strongly suggest a global REIT fund like DJRE to diversify and avoid idiosyncratic country risk (single country risk) of investing in Australian REITs (AREITs). AREITs were hit very hard during the GFC. I don’t mean hard as in the way stocks more generally were hit with a massive 50% drop. I mean, they were hit much more severely (click on “max” below the graph on that page).

What about unlisted real estate funds?

Unfortunately, they have their own problems.
They are generally illiquid and difficult to buy and sell.
They are not subject to any listing rules or ASICs ongoing market supervision.
They are hard to accurately price without the market pricing it, and their information is often intentionally hard to sift through, so you need to be an expert to know how to pick the sales and marketing info from what you’re really likely to get.

Investing in unlisted real estate funds incurs due diligence, high management expenses, high transaction costs, multi-year periods of locking up capital, and a lack of transparency on current asset values given lagged valuations.