Should I add REITs to my portfolio?
Real estate investment trusts or REITs are an example of an alternative investment. An investment or asset that falls outside of the three traditional asset classes (cash, bonds and stocks) is considered an alternative investment and is often categorized by what real assets it holds, like real estate or natural resources, or by its investment strategy (examples include managed futures, hedge funds and private equity). One method of distinguishing between traditional and alternative investments is by their return characteristics. As a group, alternative investments have expected returns that are uncorrelated or only slightly correlated with the expected returns of the three traditional asset classes. An attractive dimension of this low correlation is that it indicates the potential to increase diversification within a portfolio of traditional assets. When two assets have low correlation, we expect that when the price of one asset goes up, the price of the other will go down. Low correlated assets provide the opportunity to get higher risk-adjusted returns in a portfolio.
REITs were first authorized by the Real Estate Investment Trust Act of 1960 which provided the means for small investors to directly participate in the returns generated by diversified portfolios of income producing real estate. REITs are governed by many regulations, the most relevant being that they distribute at least 90% of their taxable income (without regard to capital gains) to their shareholders each year. As a pass-through entity under the Internal Revenue Code, REIT earnings are not subject to tax so long as the entity restricts its operations to certain qualifying activities. This pass-through of earnings allows the investor to receive a rich dividend yield, higher than the yield of the S&P 500 Index and most fixed income asset classes. 75% of REIT owned assets must be real property, loans secured by real property, government securities or cash and 75% of REIT gross annual income must be derived from rents, interest from mortgages or other real estate investments.
REITs are diversified portfolios of income producing properties, which portfolios cover many real estate categories including industrial, office, apartment buildings, shopping centers and malls, hotels and health care. The understanding of the definition of what is real property continues to evolve to cover an ever-broader range of physical assets currently owned by companies who use those assets directly in their businesses. On August 31, 2016, the Internal Revenue Service and US Department of the Treasury issued Final Regulations, which together with previous rulings, sought to clarify the definition of real property relating to REITs. The growth in popularity of the REIT structure is seen in the many non-typical real estate companies that have formed or have converted from their previous corporate structure into a REIT. A REIT is classified as non-typical if the assets it holds have different and unique characteristics when compared to the owners of REITs holding more traditional real property. The rise of non-typical REIT formations and conversions has introduced a wide variety of new asset types into the REIT universe including timber, farmland, cell towers, advertising billboards, prisons, data centers and infrastructure assets of all types in the telecom, energy and storage sectors. One highly publicized conversion took place in 2010 when pulp and paper company Weyerhaeuser, then the world’s largest private sector timberland owner, converted into a REIT.