Real Estate Investment Trusts (REITs) can sound a lot like owning a home or rental property. Owning REIT stock gives you a small sliver of ownership in real estate ventures. It leads a lot of people to ask us a seemingly logical question. Do REITs have a place in retirement portfolios for investors who already have real assets, like homes and rental properties? Scratch the surface and the differences between a REIT and real property are big enough to make them different parts of your portfolio.
To be fair, the question makes intuitive sense because both have:
1) Potential to pay income over time
A rental property in the right circumstances could bring in regular income payments. One important legal requirement for REITs is to pay out 90% of their taxable income to shareholders every year.
2) Diversification from other asset classes
Since REITs are closely related to real property, both tend to have a low correlation with stocks and bonds. This means they can provide additional stability to your overall financial picture.
Anyone who has shopped for a home for longer than a year has seen how much home prices in just one area can change. The only difference between a property’s value and the REIT’s price is that the REIT price is published hourly while a property’s price is estimated a couple times a year by a neighbor’s sale or appraised by a professional.
On the other hand, the differences between REITs and real property make them very different kinds of assets to your portfolio:
Publicly traded REITs can be sold in a few minutes. Sell some or all, depending on the needs, it’s as easy as a clicking a button. The ease alone makes REITs a great tool for your portfolio. Liquid assets like REITs benefit from practices like tax loss harvesting to regular rebalancing.
On the other hand, unless just a bathroom can be sold off to buy stocks when they are “on sale”, a home can’t help here. Be aware: This is the difference between property and publicly traded REITs. Private and non-traded REITs are very different. If your REIT isn’t listed on a stock exchange, it could have large exit penalties and almost non-existent liquidity.
2) Diversification within real assets
For most investors, even large real estate portfolios, include less than 10 properties. Each of those properties could be very different but most real estate portfolios focus on private dwellings. They're probably in a handful of the same cities and almost always all in the same country.
Diversified REITs, on the other hand, can include residential properties, university housing, commercial space, retail space, warehouses, even farmland. Including foreign diversified REITs also reduces exposure to the swings of the US real estate markets. This creates a level of diversification many real estate portfolios can’t easily match.
3) Transaction Costs
A real property can take weeks or months to sell. How do you quantify the cost of the time, effort, and stress it takes to sell a house? Typically, an agent also charges a percentage of the sale price as a “trading” commission.
Transaction costs for REITs can be dramatically lower. Many REITs can be traded commission free or for around $10 at most custodians. If you’re buying more than $170 worth, the REIT is an absolute steal compared to the real property.
4) Maintenance & Repair Costs
All real estate ownership comes with some of these costs but REITs are likely to have a few advantages.
- Better economies of scale
- Ability to negotiate with property managers
- Few if any time spent on maintenance, including dealing with a property manager or contractor
Also, because the REIT is better diversified, the risk of a large mistake or unforeseen cost is mitigated by a wide range of properties in the REIT. With more properties, some may have below average repair and maintenance costs.
5) Debt and Transaction Size
Very few people buy real estate with a lump sum cash payment. A mortgage not only decreases the expected return from a real property but also increases the risk. Most people wouldn’t think about using 6 figures of margin in an investments account and for good reason: The costs can be difficult to overcome. However, REITs can be purchased in very small quantities, reducing the need to take a loan or mortgage to gain real estate exposure.
There are great reasons to own investment properties. You can enjoy the regular monthly income from a renter or the wealth in owning a functional, tangible asset. In the worst case, you can actually live there (ok, that’s a great reason.) But, owning multiple homes does not provide the same liquidity and asset diversification that REITs can bring to your portfolio. They aren’t the same and shouldn’t be treated that way in your investment portfolio.
Disclaimer: The views expressed are for informational purposes only and are not intended to serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities by FutureAdvisor. All expressions of opinion are subject to change without notice in reaction to shifting market, economic, or political conditions. The investment strategies mentioned are not personalized to your financial circumstances or investment objectives, and differences in account size, the timing of transactions and market conditions prevailing at the time of investment may lead to different results. Clients may lose money. Past performance is not indicative of future results. Investments in securities involve the risk of loss. Any tax strategies discussed should not be interpreted as tax advice and do not represent in any manner that the tax consequences detailed will be obtained. Clients should consult with their personal tax advisors regarding the tax consequences of investing. FutureAdvisor does not provide personalized financial planning to investors, such as estate, tax, or retirement planning.