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It’s no surprise that commercial real estate was one of the major casualties of the recent economic recession. But, then, neither is their comeback in a recovery that has offered low interest rates and depressed real estate prices. In fact, real estate is so widely acknowledged as a distinct and important asset type that it will receive its own sector classification this year, separating it from the financial services sector. And equity REIT ETFs that offer baskets of various-sized REITs may present a liquid and low-cost way to invest in this newest 11th asset sector.
First of all, for those not familiar with this investment vehicle, REIT is the acronym for Real Estate Investment Trust, a real estate company that holds real assets (actual properties) and offers common shares to the public, similar to other stocks. REITs are unique, however, in that their sole business is the development and/or management of income-producing properties, and they are bound by regulation to distribute 90% of their taxable profits as dividends, thereby avoiding corporate income tax. (For the record, there is a small class of REITs that hold mortgages and mortgage derivatives and are essentially finance companies. This sub-industry will remain in the financial services classification. Today we are focused solely on equity REITs that hold hard assets.)
The year 2015 saw a fairly major sell-off of REITs due to fears of rising interest rates. Those fears, however, may be unfounded. Historically, in periods of rising interest rates, landlords have been able to increase occupancy and rents and, consequently, generate greater cash flow and dividends. In fact, currently REITs are trading at steep discount while paying much higher dividends than bonds and the stock market. [1]
If you haven’t already done so, now may be the time to add Real Estate ETFs to your portfolio.
Note, however, that there are many different approaches to this asset class among various ETFs, including company size, property specializations or domestic vs. global REITs. Investors need to do their homework to choose which approach best fits their portfolio.
Market capitalization is important to proper portfolio diversification because there are different levels of risk between large- and small-cap stocks. So investors should understand the size of the holdings in various REIT ETFs. ETFs that create baskets of large-cap REITs (those that have huge global asset bases and capital-raising expertise) have benefitted most in recent years. As investors have flocked to large REITs, distribution yields, which is the amount of cash flow received or paid out by a REIT, have fallen. Now, with an improving U.S. economy, our strengthening dollar and continuing turmoil overseas, such large cap companies may not be able to offer the same near-term growth as their nimbler, smaller cap cousins that are focused entirely on domestic assets.
There are other important differences among REIT ETFs also. The largest category is diversified funds, which hold many property types including office, residential and hotels and lodging. A few specialize in residential REITs that own properties in high-rent markets such as New York and Los Angeles. Still others focus on retail REITs. And, as mentioned above, you’ll find several global REIT ETFs that offer exposure to real estate assets in foreign countries.
Whatever your risk appetite or choice of real estate asset type, real estate’s potential to generate income and hedge against inflation may serve investors well in their investment portfolio. For many investors, owning REITs through Exchange Traded Funds may be the appropriate investment vehicle to help them achieve their financial goals.