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There are a number of reasons that individuals decide to invest in real estate.
Some advantages are attractive and stable income, credible return over time, portfolio diversification and hedging against inflation. These are all great reasons to own real estate as an investment.
Purchasing investment real estate outright also can be challenging.
Some of these challenges may include lack of liquidity (not being able to sell a property quickly), time constraints, the need to maintain a property, and maybe worst of all, difficult tenants.
An alternative to owning real estate outright is to invest in a collection of properties that are managed by a designated company. These groups of real estate assets may take the form of Real Estate Investment Trusts, or REITs.
REITs can be purchased directly through a private company. They can also be purchased through a public company that trades on a stock exchange. The private REITs often require an investor to be “accredited.” Accredited investors must either make more than $300,000 per year (jointly with their spouse) or be worth more than $1 million (less their residence).
Luckily for many of us as nonaccredited investors, there are publicly traded REITs that anyone can easily purchase in their brokerage account.
There are also mutual funds and Exchange Traded Funds of REITs that can be purchased in a brokerage account and are occasionally offered in retirement accounts such as 401(k)s.
Before we move on, we must distinguish between property REITs and mortgage REITs. Property REITs invest in physical property such as apartments, office buildings, medical buildings, storage units and utility leases, such as cell towers. Mortgage REITs invest in mortgages. Mortgage REITs will borrow up to 90 percent of their value in short term loans (lower rate) in order to buy longer-term mortgages (higher rate). Mortgage REITs tend to have higher dividend payouts, but they are also get crushed when credit markets tighten such as the 2008 crisis.
All REITs tend to be interest rate sensitive.
When rates are increasing, it often puts pressure on REITs and thus a reduction in their share value. Mortgage REITS are more likely to suffer from increasing rates. Property REITs can often raise their rents to help offset higher rates and inflation. From this point, we are only going to be discussing property REITs.
REITs are attractive because they provide a respectable income stream while holding tangible property. They provide a way to be involved in real estate without all the challenges of owning property outright. Should you put a large portion of your investable assets into REITs?
No. REITs can be a very good asset class to add to a portfolio. They should only be a piece of your asset pie. Because they are not highly correlated to stocks, they help reduce the risk of the portfolio and can increase risk adjusted returns.
Taxation of REIT dividends is another consideration. REIT dividends are taxed at your ordinary income level since most profit is passed through to the shareholders. Don’t confuse REIT dividend taxation with the taxation of dividends from non-pass through stocks. Typically, non-pass through stock dividends are often taxed at a lower rate. For this reason, REITs may be more beneficial if held in a qualified retirement account such as an IRA or 401K. The higher taxation of their dividends has little consequence in these qualified accounts since all tax implications are deferred until you take a distribution.
As a positive note for those holding REITs in a non-qualified account, the new tax law may provide a deduction of 20 percent income passed through to the shareholder.
Some of the more prominent, publicly traded REIT Exchange Traded Funds are VNQ, SCHH, ICF, USRT and XLRE. All of these funds hold different mixes of investment. VNQ, a Vanguard fund, is the largest of the group. However, it is so large that its size may be hindering its ability to function as a pure REIT play.
REITS are often an excellent asset class to add to a well balanced portfolio.
Their dividend stream is credible, but their tax consequences must be considered before investment.
HERMAN KRUG is an Independent Investment Advisor with Stourbridge Capital Partners, LLC, Honesdale. He can be contacted at firstname.lastname@example.org, 570-253-3842 or via the web at www.stourbridgecapital.com.