For over a decade, U.S. bond yields have been dropping, leading investors to try desperate strategies and dangerous investment vehicles. To create more income opportunities, investors have been purchasing poorly understood Closed-end funds, junk bonds, and annuities, to name a few. In our ongoing series, No Free Lunch, we are addressing a variety of security selections that have hidden fees and unintended consequences. In this article, we tackle traded real-estate (REITs) and real estate funds. REITs should only be purchased with an understanding of the true, and sometimes unexpected, risk of the underlying investments. Many envision their home when they buy REITs and thus forego a critical review of the risks.
The first difference between a REIT and a home is that you cannot live in the majority of the holdings that make up REIT investments. The largest holdings within U.S. REIT funds are referred to as specialized REITs, not apartments or other multifamily housing. Instead, that specialized subcomponent adds up to a third of a traditional REIT funds’ value. The more traditional investments that you might be familiar with such as nursing homes, retail, and office buildings, represent most of the value, but in smaller individual percentages of a typical real estate fund. Having specialized knowledge about the commercial real estate market will help in this case. If properly analyzed, this mishmash of tangible assets, in our industry called “diversification,” can be good for you since these sectors allow for more growth potential than traditional real estate. Real estate and growth do not traditionally go together, which leads to what does, safety.
Are REITs as safe as buying a home or bonds?
NO. These funds, along with utility stocks, are frequently used as alternatives to bonds, although they should not be considered bond-like. For the same reasons we previously criticized closed-end funds, REITs should not be mistaken for bonds because their risk level is higher than bonds. Likewise, over the last 3 to 5 years, their risk level has been similar to higher than traditional stocks like the S&P 500. REITs can be used selectively to shield investors during severe market drops. For example, during late 2018, many of these REIT funds were able to reduce losses during the December correction. In a nutshell, REITs can carry much greater risk or may shield investors from losses depending on market conditions, which differentiates them significantly from bonds.
Does the yield compensate for the uneven higher risk?
The yield is the primary reason investors buy REITs and REIT funds. REITs are stocks that pay 50 percent higher (currently) interest than traditional stocks. There is one significant reason why this is the case. In the U.S., REITs are legally required to pay out 90% of their taxable income. If traditional stocks, such as those in the S&P 500 were required to disburse 90% of their taxable earnings, their dividend payout out would more than double as well. Like any other investment, you must be aware of high yields. When their dividend payouts are high, REITs, just like stocks, can signal a change when yields are too-good-to-true. This can mean that they are about to reduce their dividends, that they have decided to pay out more of their earnings and forsake future growth, or that a unique adverse issue is about to drop its price. Any of these three issues may cause a loss.
Since REITs are closer to stocks, do you measure their risk closer to stocks, bonds, or a real estate investment?
We have determined that a REIT pays higher interest than stocks due to its unique structure, but at times has a risk level closer to stocks. Thus, how do you measure its appropriateness for investment? Here’s another curveball. Because of the unique way that it pays out in the U.S., many traditional measures of measuring a stocks’ value, such as PE ratios and growth rates, are not only wrong but very misleading. There is a good starting point called, trading price to its Funds From Operations, known as FFO. It is the preferred method of analyzing these firms due to their high payout ratios and growth through the purchase of properties. The good news is that with some instructions from websites such as Investopedia, it isn’t too difficult to calculate. The bad news is that you will need to delve into documents such as 10-Qs and 10-Ks and get comfortable with looking through the financial statements of companies.
In none of this analysis above, did we mention non-publicly traded Real Estate investments, sometimes referred to as NSAs, or non-standard assets? These are technically private equity, thus forcing an entirely new method of analysis. More importantly, any broker trying to sell you NSAs should provide you a track record for successfully managing these types of investments. Keep in mind these are investments that are in the SEC’s crosshairs due to inappropriately large fees, shady accounting, and dishonest sales tactics. It’s better to stay away from NSAs unless you have a truly qualified professional who specializes in this type of investment vehicle.
The answer to the question at the beginning of this blog, “can real-estate funds add enough yield to justify inclusion in a portfolio,” is yes. While publicly-traded REITs don’t carry the massive costs associated with other products, there are many idiosyncrasies related to investing in REITs. They can also add some actual value during periods of market uncertainty, like a recession. Be sure to treat any investment product in your portfolio as merely playing the role of a pawn in your long-term goals. As we discussed above, REITs pay above-average yield by paying out more of their earnings and future growth potential than other firms. Remember that having a plan won’t guarantee a positive outcome, but it will reduce the probability of a negative outcome. Meet with your advisor regularly. He or she will best match your investments to your goals and objectives, and don’t invest solely in the highest yielding product – only this will ensure the long-term viability of your portfolio.
Disclosure: The examples provided in this blog are illustrative only and meant for educational purposes. Do your own due diligence or seek the advice of a trained professional before making any investment decisions. Data mentioned in hyper-links may change over time, keep in mind the date of this initial post and its subsequent re-posting. This blog does not suggest or recommend any mutual fund, ETFs, or other securities. The specific funds mentioned in this article are for educational comparisons only to demonstrate differences.