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The Role REITs Play in Your Portfolio

A properly diversified portfolio should have assets that, like actors in a play, take on leading and supporting roles. Diversification makes for better theater and better investing. Would “Romeo and Juliet” be as memorable if it were only “Romeo”? Likely not. Would you be comfortable with the risk level and returns from an investment portfolio holding only large company stocks? You probably wouldn’t.

Investors can achieve broad diversification in their portfolios with index funds and exchange-traded funds (ETFs), as they typically hold the securities that make up an entire market benchmark. Additionally, their wide availability allows investors to diversify across different asset classes.

This includes real estate in the form of real estate investment trusts (REITs), which are companies that invest in various properties. Through REIT index funds and ETFs, you have access to properties ranging from apartment buildings to shopping centers to warehouses.

The market for real estate is big. According to the National Association of Real Estate Investment Trusts (NAREIT), 204 REITs listed by the Securities and Exchange Commission trade on one of the major stock exchanges as of January 31, 2014. Combined they have a market capitalization of $719 billion. Further, more than $1 trillion of U.S. real estate is owned by REITs.

Generally, there are two types of REITs: equity and mortgage. Equity REITs own and operate commercial real estate while mortgage REITs lend money to property owners. The vast majority of REITs are equity REITs, which is what we discuss here.

REITs provide long-term investors diversification and income

There are two primary roles REITs can play in a long-term investor’s portfolio. One is the role of a diversifier. REITs have shown a correlation to U.S. common stocks that has varied over time from high to low. Investors with long time horizons, such as those funding retirement, can benefit from their periods of low correlation.

In an analysis from NAREIT, large-cap stock and REIT total returns were only 56% correlated over a 20-year period from 1994 through 2013. In comparison, large-cap and small-cap stocks during the same period were 81% correlated. The diversification of REITs can also provide additional long-term returns without an increase to risk, according to the Washington, D.C.-based association. Over the same time period studied above, a 60% stock and 40% bond portfolio that allocated 10% to REITs would have a 0.2% higher annual return per year on average than one without REITs while risk stayed about the same.

Additionally, REITs can be an income source. Under U.S. Tax Code, in order for a company to be considered a REIT it must distribute 90% of its taxable income to shareholders. Therefore, REITs can complement dividend-paying stocks and bonds as sources of income in the portfolios of retirement investors.

What investors should avoid REITs 

The disadvantage of REITs is that the income they generate is taxed at the individual income tax rate. So, REITs may not be an optimal investment for investors in a high tax bracket.

Instead, investors in high tax brackets should consider avoiding REITs and holding municipal bonds in their portfolios. The income from municipal bonds is usually tax free.

For most investors, REITs are a great way to gain exposure to the real estate market. They can help diversify and act as an incomes source in your portfolio. As such, REITs just might play an important role in your portfolio.