Real estate investment trusts (REITs)—typically publicly traded companies that finance or own real estate—are prized for the income they provide. That’s because by law REITs must pass along at least 90% of their 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 riskier—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. (Distributions from REITs are also taxable, unlike some fixed income investments.1)
That said, we believe short-term underperformance is rarely sufficient reason to jump ship, whatever the investment. And despite last year’s paltry returns, 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 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, whereas bond- and stock-market cycles typically last an average of roughly 5.75 years.2
- Income: In 2018, U.S. REITs yielded 4.68%, outpacing most other income-generating investments (see “REITs returns,” below).
- Inflation hedge: Real estate has tended to fare well in the face of rising prices. In particular, REITs with commercial holdings frequently have agreements that allow them to raise rents in tandem with inflation.
- 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 Globally, real estate investments outperformed equities by an average of more than a full percentage point per year from 1960 through 2015.4
Last year, REITs yielded more than most other income-generating investments.
Source: Schwab Center for Financial Research. Asset classes are represented by the following: Alerian MLP Index (master limited partnerships), 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). 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.
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.
And because REITs tend to be volatile, they should constitute no more than 5% of your portfolio. However, even that small allocation can 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.
1REIT dividends typically aren’t treated as qualified dividends and will generally be taxed at higher ordinary income tax rates.
3Standard & 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.
4Ronald Q. Doeswijk, Trevin Lam and Laurens Swinkels, “Historical Returns of the Market Portfolio,” ssrn.com, 01/2019.
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.