REITs pros and cons

We live in a low-yield world. Interest rates are much lower than in recent history and this has spurred a mad “search for yield” whereby investors look for anything, really anything, that offers yield above the measly low interest rates currently prevailing in this country. REITs have greatly benefited from this trend and when my hairstylist starts telling me that he invests in REITs it makes me wonder if that sector might be a little bit overheated (brings back memories of the late 1990s when a different hairdresser in a different city gave out Tech company recommendations). Here are some pros and cons of REITs.

Papa ERN’s Low Yield Rant:

If you think yields are low here in the U.S., some government bonds across the globe now yield negative interest rates. You have to pay Switzerland, Japan and a few other countries for the privilege to loan them money. I could even see that some people are willing to pay a little bit to stash cash safely over night. But paying Switzerland to store money for 10 years or more? Lending money to Unilever for 0.08%? No thank you! But enough of my rant, back to REITs!

Intro: what’s a REIT

  • Check out Wiki for the detailed intro
  • REITs are corporations that invest in real estate assets; residential, commercial real estate, even timberland. There are also REITs that invest in mortgages and mezzanine loans
  • REITs enjoy a tax-advantaged status; they can avoid corporate taxes but are required to pay out 90% of their taxable income as dividends
  • REIT dividends are not qualified, thus will be considered ordinary income on your tax return. Hence, most people like to hold REITs in tax deferred accounts (IRA, 401k, etc.)

Pros: Why investors like REITs

  • A steady dividend flow. The broad market yields maybe 2% (VTI, U.S. Total stock index fund), but REIT ETFs yield above 4% (as in VNQ, Vanguard REIT index ETF). Some individual REITs have yields in the high single digits, even double digits, not bad in this low-yield world
  • Mr. Money Mustache likes REITs because some of them have dividend yields that compare favorably with his former rental property yield. Why not get the same rental income with less of a hassle? No more late night calls from tenants about the toilet not flushing!
  • In the past, REITs offered a pretty good inflation hedge. To be sure, stocks in general hedge inflation over the long-term, but rental properties seem to rent out at prices that track inflation fairly well, and thus REITs enjoy the aura of a certifiable inflation hedge. Besides, in the CPI, the share of housing inflation is above 30% in the overall index, and even above 40% in the core CPI index (excluding volatile food and energy components), so just by construction CPI and housing inflation track each other well.
  • REITs had a very nice run since the equity market trough in early 2009, up almost 24% annualized, which is significantly higher than the overall market or the Vangaurd high dividend yield equity ETF, see table further below
  • REITs will continue to do well if the economy keeps chugging along, home prices don’t drop and interest rates stay low or at least don’t snap back up very rapidly

What is the source of the recent impressive REIT returns?

Let’s take a look at the returns in some of the popular ETFs:

  1. VTI: Vanguard US Total Stock ETF
  2. IEF: iShares 7-10 US Treasury ETF (why a bond ETF? Patience, that will become obvious below!)
  3. VNQ: Vanguard REIT ETF
  4. VYM: Vanguard high dividend yield ETF

Since 2/28/2009 they all had pretty impressive returns, especially the REIT ETF, while the high dividend yield ETF had roughly the same return as the overall total market ETF. The bond ETF, naturally, has lower average returns, but also much lower risk and a negative correlation with equities. While VNQ had a very impressive run since 2009, it also significantly higher volatility than the overall market or the high dividend ETF.

VNQ stats part1
ETF return stats 2/28/2009-5/31/2016

Let’s run a regression of the two high dividend ETFs to see what factor exposures to bonds and equities they had during the current bull market. This regression asks the question, what portfolio of VTI and IEF (potentially levered) would have best explained the observed performance (monthly returns in excess of cash) of VNQ and VYM? The factor exposures (betas), standard error of estimates and R² (measure of regression fit) are in the table below.

VNQ stats part2
ETF Factor Model regressions (monthly data 2/28/2009-5/31/2016)

It appears that the REIT ETF behaved like a highly levered portfolio of stocks (116% weight) and bonds (85% weight). That’s not bad by itself, given how well both bonds and stocks performed. But VNQ also had a negative intercept, which means that on average that replication of VNQ with VTI and IEF would have outperformed the actual ETF by 1.2% p.a. Moreover, the measure of fit is low, which means that the REITs ETF has a lot of additional volatility on top of this simple factor model.

Thus, VNQ has been a levered portfolio on steroids since 2009, plus a lot of volatility that’s not just uncompensated, but even slightly detracted from the performance. Suddenly the REIT performance looks a bit less impressive.

The high yield ETF (VYM) on the other hand had only relatively little bond exposure and also a less than 100% equity beta. The ETF also outperformed this simple replication as evidenced by the positive intercept.

Which brings us to the cons:

Cons: Why we should be suspicious of REITs right now

  • As we saw above: You get higher dividend yield with REITs but also higher risk (20.4% in VNQ versus 12.5% in VYM). You would need a really large appetite for dividend yield if you accept 60% higher risk in exchange for raising the dividend yield from 3.3% to 4.5%. And it’s not that the high dividend stocks inside VYM are less profitable, they merely reinvest more of their profits in their business for future growth. So the 1.2% lower dividend yield is not lost, it simply remains on the company balance sheet.
  • Because REITs have to pay out such a large share of earnings, there are limited opportunities to grow their business.
  • PE ratios and Price to book ratios are quite high. If you thought spending $200,000 on a rental property was bad, paying $200,000 for only $100,000 or rental property is even worse. For example, one of the largest publicly traded multi-family REITs (and one of the largest stocks in VNQ) is Avalon Bay (Ticker: AVB), with a current dividend yield of 3%, as of 5/31/2016. That seems awfully low to me! If they pay out 90% of profits their net rental yield is only 3.3%. The company has a market cap of $25b, but according to its balance sheet, assets are only $17b. Minus $10b in liabilities (loans) you get only $10b in net assets as of 12/31/2015. Sure, accounting rules mandate that REITs have to low-ball their assets and keep them at acquisition value instead of adjusting to market value (as pointed about by a commenter). But it’s still a catch-22: either the asset value is much higher but the rental yield is really low, or the rental yield is very competitive (8.25% yield when based on net book value of assets) but then the price of stock has been bid up to 2.5 times the fair value. Either way, it’s not a pretty picture. Of course, a high price-to-book ratio is nothing bad per se; lots of high-growth companies have those. But REITs have limited growth potential; see bullet point above!
  • Related to the bullet above, REIT yields are quite low, by historical standards. They were closer to 6% 10 years ago, now only a bit over 4%.
  • As we showed above, REITs have behaved more like a mix of highly levered stocks and bonds over the past few years. That by itself is not a bad thing, but it means if the era of low interest rates were to end (watch out for June Federal Reserve Meeting!), REITs could get hurt, just like nominal bonds would. Rapidly rising interest rates could be bad for REITs if all the yield chasers try to panic sell. Intriguingly, it could be an inflation shock with the resulting losses of interest-sensitive assets that can send REITs tumbling. Rising interest rates are poison for bonds, and if REITs keep behaving like they have before they could give back that excess return over VTI and VYM pretty fast. Sure, inflation would also lift the underlying asset book values within REITs, but recall that the price to book value is so high right now, prices could fall by a lot before even getting close the slightly increased book value. In other words, who cares if the book value of that REIT goes up, the price to book ratio can move much more rapidly!
  • Another economic slowdown and/or drop in real estate prices will be bad for REITs. In 2008/9 REITs dropped by even more than the overall index: the Vanguard ETY VNQ dropped by 75%, compared to a 57% drop in the S&P500 (total return, drop from peak to bottom).

Then what’s the alternative to REITs?

  • If you are looking for a pure inflation hedge, keep in mind that equities in general are already an investment into the productive capacity of the economy and are thus real assets, i.e., an inflation hedge. Equities may suffer in the short-term from fears the central bank might step on the breaks too hard, but eventually firms will have the pricing power to raise prices and profits in line with inflation.
  • If you want a strong correlation with CPI prices, think energy equities, though they have their own issues ever since commodity prices started going south. Moreover, they are included already in your index fund already, so why load up on them even more?
  • If you want high dividend yield then think high dividend stocks (duh!) such as the Vanguard High Dividend stock ETF (VYM). They seem to have less nominal bond exposure (risk), but almost the same yield as REITs.
  • If you seek exposure to the U.S. housing market, why not Home Depot (HD) or Lowe’s (LOW), who also benefit from a rising U.S. housing market. Or home builders? Again, they will already be in your index fund, so why double down on the risk?
  • Real Estate Crowd-Funding (e.g. fundrise.com, peerstreet.com, or patchofland.com). One caveat here is that many of these investments are not exactly real estate investments, but rather high-risk, high-yield loans with real estate as collateral. That’s a very incomplete substitute to a true real estate investment, where you get rental income and participation in home price appreciation.
  • Direct real estate investment. Unfortunately, that also has all the disadvantages of being a landlord: an illiquid investment, hassle with tenants, risk of lawsuits, etc. But if one can get a 4% yield on rentals after all costs, fees, maintenance, repairs and taxes, it would be a very attractive passive income source to sustain a high withdrawal rate plus inflation adjustment, plus low correlation with the equity portfolio.
  • Private Equity funds that invest in Real Estate. This would be an option for people who want ownership of real estate, but keep it as a passive investment. The disadvantage is that these funds operate in a very unregulated world and that such investments are highly illiquid.

30 thoughts on “REITs pros and cons”

  1. Excellent dissection, ERN. I don’t know if it’s the Diet Dew or the dire warning that’s making me a little jittery after reading this. Well, “dire” is a strong word, but the picture doesn’t look super rosy.

    I have 10% of my portfolio in Vanguard’s REIT index fund. Do you own REITs or other investment real estate?

    Reply

    1. Thanks PoF! If a medical doctor compliments my “dissecting” skills (pun intended?) that’s a great way to start the day today!
      We currently have no REITs at all. I have been eyeing the high dividend yield equity ETFs for a while. Dividend yield is nice, but I also like the lower risk profile.

      We own our primary residence in a very high cost city, so we got a pretty good chunk of our net worth tied up in real estate already through that. We will sell that place and move to a cheaper town once we retire.
      We also started to dip our toes into the water with other real estate investments. The private equity route. We have so far invested in three funds for a total of around 10% of our net worth. Very illiquid investments (shares of an LLC, non-traded) with a 7-10 year horizon. So we would like to stagger/ladder the investments over a few years and eventually have 25-30% in PE Real Estate when we retire.
      Once we got a bit more of history, I will make a blog-post about our experience so far.

      Reply

  3. Good post but this line: “It appears that the REIT ETF behaved like a highly levered portfolio of stocks (116% weight) and bonds (85% weight).” cannot be justified with R-squared of just 53%. More than implying volatility, the poor correlation fit indicates that REITs are a good diversifier to both VTI and Bonds. Very often, REITs zig when other asset classes zag so they serve a useful purpose in a portfolio in moderation.

    Reply

    1. I didn’t intend to justify the “leverage” story with the low R^2. Leverage is implied by the sum of the two factor betas being so high (>200%).
      The relevance of the R^2 being so low is that if you indeed want to take this factor exposure (and there are reasons for doing so) you could have gotten that exposure for only half the variance in asset returns, or about 15% annual standard deviation, instead of 20%+ in the REITs. That additional noise (without any additional return) is not what would be called diversification in modern portfolio theory. It’s mostly idiosyncratic risk that you’d try to avoid. Think of this in terms of the Sharpe Ratio: you add risk without adding return (actually you slightly diminish returns, due to negative intercept), which is never a good idea. It’s actually the opposite of diversification.

      Reply

  4. I have always been interested in the concept of REITs but just never pulled the trigger because I prefer to own the real estate but I do think that for the non real estate investor, these make a great addition and can provide diversification in your portfolio. Great write up!

    Reply

    1. Hi, thanks for stopping by. We also prefer the direct route in real estate investing, but due to time constraints we have so far outsourced that and invested in Private Equity funds that specialize in real estate.

      Reply

  5. We are in a couple of non traded REITs. 4 year duration of each with one of them in final year. The redemption penalties are worth highlighting for those considering non traded REITs.

    FWIW, REITs have a correlation to the S&P 500 of 0.7 over last ten years. Not correlated at all to bonds over same period.

    We also did a post on our view of REITs about a month ago.

    http://www.planinvestescape.com/reits-a-solid-foundation-or-filling-your-house-with-unnecessary-clutter/

    Reply

    1. Hi Mr. PIE, thanks for stopping by. Yes, I definitely remember your post and also leaving a comment there. Reading that comment again, it looks like that must have been our inspiration for putting this post together. Thanks!
      If you ever feel comfortable about writing more about that non-traded REIT, we’d like to hear more. We’re afraid that publicly traded REITs have been bid up too much in price to be attractive to buy now. Maybe your route through non-traded REITs or our route through Private Equity (even less liquidity, 7-10 years horizon!) is the best for people who don’t the hassle of being landlords.
      Cheers!

      Reply

  6. I like Mr. Money Moustache’s reason for investing in REIT. I myself own some share in CREIT and the dividend it has provided over the years has been nice. I also like it because you get exposure into real estate without the added hassble of dealing with the every day operational stuff.

    Reply
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  9. Part of the benefit of a REIT is that some of the distributions may be untaxed return of capital. If it is in a 401(k) or traditional IRA, that untaxed portion is actually taxed when withdrawn. The best place seems to be Roth IRA. More on this at https://seekingalpha.com/article/2943596-should-i-own-reits-in-a-retirement-account

    Also, if there are over $1000 in gains, you may be subject to unrelated business tax income (UBTI) even if it is . More on this at https://www.wsj.com/articles/SB10001424127887324412604578513393753709464

    Reply

    1. Most REITs and especially the large REIT ETFs don’t have that UBTI problem, though. It applies mostly to Master Limited Partnerships. The WSJ mentions it also applies to “some REITs” but I never heard what those REITs would be. I suspect they are private issue REITs. Publicly traded REITs should be safe. Or do you know any REITs where UBTI is an issue? Thanks!

      Reply

      1. I don’t know of any that are subject to UBTI, but I also don’t know how to tell if one would be subject to it. This is the primary reason for me steering clear of them. I guess it’s worth another look.

        Reply

  10. I think its important to note- there are a number of REIT’s in the s&p 500, including avalon bay. So if you own an equity index fund, chances are you already have substantial exposure to REIT’s

    Reply

      1. I hadn’t actually realized it was so small. I guess it is slightly bigger if you look at a broader based index: https://fundresearch.fidelity.com/mutual-funds/composition/315911693

        But my point was that nothing is missing from your portfolio if you don’t go out and buy an additional helping of them, as you are already market weighting reits. The question is not whether you should own some, but whether you should overweight.

        the fact that it such a small sector could explain why they trade as a substantial premium, with lots of people buying a broad based index and then also buying additional reits, they are overweighting and possibly not aware.

        Reply

  11. Very interesting (as always) one question here, what is your view on the fact that there still seems to be a hunt for yield from institutional investors globally? Also, many REITS have refinanced themselves at very low levels (well all companies and many at ridiculously low levels), both floating and fixed which should mean some buffer as well as inflation hedged rent increases (would expect all of them).

    Do you think we might be in an extended period of low rates for longer even if US has hiked but now seem to be a bit dovish again whilst Europe and Japan seems to be low for even longer = yields will stay suppressed and institutional investors will want to increase their exposure towards Alternative investments and in particular real estate.

    So to sum up, do you believe that low rates will stay for longer and that large (and small) investors hunt for yield might mean that the levels of REITs might actually remain high or possibly work as a buffer in deteriorating markets where rates remain low?

    Again, many thanks for sharing your knowledge and insights in such a depth!

    Jakob

    Reply

    1. Well, REITs haven’t fared as well as the S&P500 over the last few years.
      Of course, one could argue that now it’s time for converging again, especially since the rate hikes may soon come to a halt.
      But I think actual physical Real Estate (direct or through a private equity fund) is still the better route, both in terms of returns and tax treatment. 🙂

      Reply

  12. What are your thoughts on mREITs? The mainstream media touts them as excessively risky but I’ve yet to see the data on what specifically is so risky about them beyond their sensitivity to market interest rates / ability to manage spreads efficiently.

    Would these fall into the same bucket as preferred shares, high-yield products, etc. as mentioned in the yield shield posts?

    Similarly, would BDCs be lumped into that bucket too?

    Reply

    1. Do you mean mortgage REITs? With rates so lowI’d be afraid that they have very little upside potential and they’ll get hosed if rates were to go up again. Same risk as preferreds (or worse)!

      BDC (I presume business development companies) sound like an interesting niche. I was pitched a private equity investment in that space one. I didn’t get into it but it seems to be a good sector. Is there an ETF for this or were you thinking about specific companies? You probably know more about them than I, so please share! 🙂

      Reply

      1. Yes sir – mortgage REITs and business development companies.

        When I had a mortgage and was renting out my guest bed/bath I considered the mechanics of being a note holder vs a property holder and favored the idea of having virtually no overhead or maintenance expense. No free lunch of course – being a note holder incurs pre-payment / refinance risk – thwarting any upside from a lowering interest rate environment – and increased cost of capital risk in a rising rate environment as leverage is used to build/hold a portfolio of notes and achieve the dividends mortgage REITs offer. Hosed indeed! Just for fun, MORT and MRRL (2x long) are the primary ETNs for this space. I read somewhere the 2x incurs a bit of return of capital and thus NAV is decreasing – haven’t dug deeper.

        BDCS, and the 2x long cousin BDCL, are the main ETFs for the BDC space. Though, since the roster of publicly traded BDCs is quite small it’s ideal to pick a handful and skip the expensive 0.85% expense ratio. The bulk of the selection criteria involves identifying companies that minimize dilution when raising capital and utilize internal over external management. SeekingAlpha suggests MAIN, SUNS, GBSD, ARCC and HTGC are “higher quality.” MAIN and ARCC are on my short list but I have no positions in them or plans to open any in the near future.

        Since BDCs are in the same space as mREITs – lending and making a spread – I suspect the same risk profile applies. One key differentiator: BDCs may take an equity stake in companies to which they lend. This can create an upside and diversifier beyond making $ through loan spreads in the form of buyouts/exit strategies/IPOs/profit sharing/etc. of companies in the portfolio. These would be realized by shareholders via special dividends or a diversifier of regular dividend funds. Also, I believe the leverage used in the portfolios is generally lower than with mREITs, possibly in part because of this diversification.

        All said, I’m not sure if/how these instruments would fit in a portfolio or where they would shine. I suspect it’ll be a narrow use case, if any – they’re in some regards levered bonds. As with equity REITs, mortgage REIT and BDC dividends are taxed as ordinary income. While BDCs could serve as a passive way to allocate funds into private equity, the % of performance derived from private equity could be nominal relative to the performance derived from making spreads. Each BDC would have to be reviewed to identify income sources and weights.

        Any ideas how to exploit the nature of these instruments to do something interesting?

        Reply

        1. Seems too niche for me. I would not move any sizable share of my portfolio into either investment. And doing this with some play money it wouldn’t make a difference, so why bother?
          But if anyone has experience in this and wants to share their experience, please share here (maybe in a guest post?)

          Reply

  13. In your discussion above regarding price to book value for REITs, I would note that accounting standards require REITs to reflect the real estate they own at historical cost and additionally to record an allowance for depreciation. The result is that the book value of the real estate on the balance sheet will tend to be substantially below fair market value. As of today (Feb 2024) most REITs are trading at a substantial discount to NAV estimates, meaning REIT investors are paying less for an interest in real estate than they would be paying to buy real estate directly. This happens because private market transactions tend to be slower to respond to market forces than publicly traded REITs. I would also add that while it is true that REITs are required to distribute most of their taxable income, because of deductions for depreciation allowed for tax purposes, the average REIT actually distributes less than 70% of FFO. So they actually can effectively retain some of their cash flow for growth and expansion.

    Reply

    1. OK, understand now. I still find REITs a hard sell even after making that adjustment, though.

      But I will make a note in the post to reflect what you said about book values. Thanks for making me aware of this!

      Reply

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