Real estate investment trusts (REITs)—typically publicly traded companies that finance or own real estate—are valued for the income they provide. That’s because by law REITs must pass along at least 90% of their taxable income to shareholders as dividends.
Critics believe REITs are poor investments during periods of increasing interest rates, when rising yields from fixed income investments make REITs—which are generally much riskier than bonds—less attractive. They may have a point: REITs generated their lowest returns in a decade in 2018, a year in which the Federal Reserve raised rates four times.
That said, we believe short-term underperformance is rarely sufficient reason to jump ship, whatever the investment. And despite paltry returns in 2018, REITs actually outperformed several other asset classes, including U.S. stocks.
The case for REITs
Here are four reasons why REITs might deserve a place in your portfolio:
- Diversification: REITs rarely perform in lockstep with other stocks or bonds. In recent years, the divergence was partly the result of low interest rates, which caused yield-hungry investors to drive REIT prices higher. Additionally, REITs tend to follow the real estate cycle, which typically lasts a decade or more,1 whereas bonds and stocks are influenced by business cycles that typically last an average of roughly six years.2 Finally, REITs are an efficient way for individual investors to participate in commercial real estate, and it’s that ownership of the underlying real estate investments that makes REITs valuable from a diversification perspective.
- Income: In 2018, U.S. REITs yielded 4.7%, outpacing most other income-generating investments (see “REIT current yields,” below). Keep in mind, however, that distributions from REITs are taxable, unlike some fixed income investments. In addition, they typically aren’t treated as qualified dividends and will generally be taxed at higher ordinary income tax rates.
REIT current yields
In 2018, REITs yielded more than most other income-generating investments.
Note: Current yield is the annual investment income (dividend or interest income), divided by the price.
Source: Charles Schwab Investment Advisory. Asset classes are represented by the following: Morningstar MLP (master limited partnership) fund category average current yield; Bloomberg Barclays U.S. High Yield Very Liquid Index (high-yield corporate bonds); S&P U.S. REIT Index (U.S. REITs); Bloomberg Barclays U.S. Credit Index (corporate bonds); MSCI EAFE Index (international stocks); Bloomberg Barclays U.S. 7–10 Year Treasury Bond Index (Treasuries); S&P 500® Index (U.S. stocks); and Bloomberg Barclays Global Aggregate ex-USD Total Return Index (global bonds). Data is as of 12/31/2018. Past performance is no guarantee of future results. Indexes are unmanaged; do not incur management fees, costs and expenses, and cannot be invested in directly.
- Inflation hedge: Real estate is a hard asset and has tended to fare well in the face of rising prices. In particular, U.S. REITs with commercial holdings frequently have agreements that allow them to raise rents in tandem with inflation. Our research suggests that over medium-term horizons (five years) REIT returns correlate much more closely with inflation than stock returns do.
- Long-term growth: Past performance is no guarantee of future returns, but U.S. REITs have outperformed U.S. stocks in seven of the past 10 years.3 More importantly, we estimate an expected return for U.S. REITs of 7.3% on an annualized basis over the next 10 years. While this is similar to our expectations for U.S. large-cap stocks (7.4%), we believe U.S. REITs make for a compelling long-run, strategic allocation within a portfolio given their favorable diversification and inflation-hedging aspects.
Investing in REITs
As with stocks, it can be difficult to consistently make successful choices when investing in individual REITs. Therefore, investors might be best served by an exchange-traded fund or a mutual fund that tracks a broad-based REIT index, such as the MSCI U.S. REIT Index or the S&P U.S. REIT Index.
Due to their higher volatility4 relative to U.S. large-cap stocks (22% vs. 14%), REITs should constitute no more than 5% of your portfolio, separate from any REITs that may be part of your other stock allocations (in other words, this suggested allocation would be over and above REITs’ negligible sector allocation of 3% within the S&P 500 index5). Even though this allocation appears small, it can still help capture a degree of diversification, growth potential and income that would be tough to replicate with any other asset class—without taking on undue risk.
1 Case, Brad, “Looking Carefully at the Current Real Estate Market Cycle.” Market Commentary blog, National Association of Real Estate Investment Trusts (NAREIT), 09/19/2017
3 Standard & Poor’s. U.S. REITs are represented by the S&P U.S. REIT Index and U.S. stocks are represented by the S&P 500 Index.
4 Volatility calculated using monthly returns from January 2002 to December 2018
5 S&P 500 Real Estate Sector GICS weights, as of 12/31/2018
What You Can Do Next
- Learn more about the real estate sector, investing in REITs and how REITs can be part of a diversified portfolio.
- Research REIT ETFs and mutual funds.
- Many of the diversified portfolios from Schwab Intelligent Portfolios® include exposure to REITs. Take the profile questionnaire and see your portfolio recommendation now.