Investment Choice: REIT

Why you want to invest in REIT? As historical performance shows, investing in real estate can improves diversification of your portfolio and give you better return and lower risk over the long term.

In my previous discussions on building portfolios with ETFs (the last segment can be found here), we have seen REIT (real estate investment trusts) as an ingredient in several of the model portfolios. In fact, if you check some recommended asset allocations (for example, this post on asset allocation at About.com), you will likely to find REIT in the mix. Real estate, itself as one of the major asset classes (including cash, bonds, stocks, currency, natural resources, and precious metals), increasingly plays a key role in building a well diversified portfolio. For myself, I have a small portion invested in Third Avenue Real Estate Value Fund (TAREX), which happens to be my third best mutual fund investment in terms of returns, thanks to the real estate boom in the early years of the decade (following chart shows the performances of DJ Equity REIT Total Return Index, DJ Industrial Average, and S&P 500 since 2001).

What is REIT

REIT, according to Wikipedia, is

a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. In return REITs are required to distribute 90% of their income, which may be taxable in the hands of the investors. The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks.

In other words, REIT is a real estate company that invests in residential and/or commercial real estate (office buildings and shopping malls). Since such investment activities are generally beyond the reach of individual investors, the company issues publicly traded stocks so retail investors can also invest in real estate by holding their stocks. There are mainly three kinds of REIT:

• Equity REITs: Equity REITs invest in and own properties.
• Mortgage REITs: Mortgage REITs deal in investment and ownership of property mortgages.
• Hybrid REITs: Hybrid REITs combine the investment strategies of equity REITs and mortgage REITs by investing in both properties and mortgages.

Why invest in REIT

What role does REIT play in a portfolio? The answer is two-fold: income and diversification.

From the definition, for a company to gain REIT status, it must pay at least 90% of its taxable income as dividends to its shareholders. Thus, when investing in REIT, investors not only can expect appreciation of their investment principles, but also hefty dividend distributions. In this sense, REITs are dividend-paying stocks that will provide a stream of income (thus, it makes sense to REIT in tax sheltered account such as IRA). Besides the income part, an Ibbotson Associates study on investor returns from 1972 to 2004 shows the decline in correlation between REIT and other asset classes. According to the study, adding REIT to a portfolio can reduce the risk and/or boost the return:

• T-bills 10%, Stocks 50%, Bonds 40%: Return 10.9%, Risk 10.6%
• T-bills 10%, Stocks 45%, Bonds 35%, REIT 10%: Return 11.2%, Risk 10.3%
• T-bills 10%, Stocks 40%, Bonds 3%, REIT 20%: Return 11.6%, Risk 10.1%

A 2004 article on Invstopedia, The Impact of Interest Rates on Real Estate Investment Trusts by David Harper, also shows the negative correlation between interest rates and REIT returns.

How to invest in REIT

Investors interested in REIT have several choices to participate: stocks, mutual funds, and exchange traded funds (ETFs).

Stocks

The following REIT stocks are members of S&P 500 index, among them Boston Properties (BXP), Equity Residential (EQR), Plum Creek Timber (PCL), and ProLogis (PLD) are available at ComputerShares for direct purchases.

• AIMCO (AIV)
• Archstone-Smith (ASN)
• AvalonBay Communities (AVB)
• Boston Properties (BXP)
• Developers Diversified Realty Corporation (DDR)
• Equity Residential (EQR)
• Host Hotels & Resorts (HST)
• Kimco Realty Corporation (KIM)
• Plum Creek Timber, Inc. (PCL)
• ProLogis (PLD)
• Public Storage, Inc. (PSA)
• Simon Property Group (SPG)
• Vornado Realty Trust (VNO)

Mutual funds

There are more than 100 REIT mutual funds (including different share classes), thus choosing which one to invest depends on many factors on the investor’s objective, risk tolerance, return expectation, etc. Most of REIT funds are actively managed, meaning they usually charge higher fees. If you can come up with the $3,000 initial investment, Vanguard REIT Index (VGSIX) will be better choice. With a rock-bottom 0.21% expense ratio and 5-year annualized return of 21.62%, the fund is hard to beat. The following are some REIT mutual funds:

• Alpine Realty Income and Growth Fund (AIGYX)
• American Century Real Estate Investments (REACX)
• CGM Realty (CGMRX)
• Columbia Real Estate Equity Z (CREEX)
• Fidelity Real Estate Investment (FRESX)
• Third Avenue Real Estate Fund (TAREX)
• T. Rowe Price Real Estate (TRREX)
• Vanguard REIT Index (VGSIX)

ETFs

In addition to those REIT ETFs mentioned in the model portfolio series, there are some other ETF choices out there. Be aware, however, that investing with ETFs involves additional costs as ETFs are traded like stocks.

• iShares Dow Jones US Real Estate (IYR)
• iShares Cohen & Steers Realty Majors (ICF)
• iShares Dow Jones US Home Construction (ITB)
• Vanguard REIT Index ETF (VNQ)
• SPDR DJ Wilshire Intl Real Estate (RWX)
• DJ Wilshire REIT ETF (RWR)
• UltraShort Real Estate ProShares (SRS)
• Ultra Real Estate ProShares (URE)

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