Real Estate Investment Trusts (REITs)

• Advantages
• How They Work

Liquidity: REITs offer the most liquid way to invest in real estate. REIT shares are traded daily on a national exchange, so, unlike actual real estate, they can be bought and sold at any time. All the companies we follow trade on the New York Stock Exchange (NYSE).

Portfolio Diversification: REITs have been shown to add diversification benefits to portfolios with stock and bond exposure. REIT returns have a low correlation to the returns of large stocks, small stocks and bonds. Adding REITs to a portfolio with exposure to stocks and bonds has improved returns and decreased risk. A study by Ibbotson Associates covering 1972 through 2000 shows investors with a portfolio of S&P 500 stocks, 20 year U.S. government bonds and 30-day T-bills could increase returns and reduce risk by adding 10% or 20% REITs to their portfolio (see Chart 6). Past performance is no guarantee of future performance. Diversification to manage risk is achieved by investing in different types of REITs, as well as selecting REITs that invest in different geographical areas.

View Chart 6: Effects of REIT's on a Stock and Bond Portfolio

Dividends: REITs are exempt from corporate income taxes, as long as they distribute at least 90% of their net taxable income as dividends to shareholders. Average yields typically range from 5% for shopping center REITs to 6.6% for office REITs.

Deferral of income taxes: No tax is payable on REITs until they are sold. At that point, profits are taxed as capital gains, not as ordinary income. Some REITs frequently distribute more than 100% of their net income. The amount over 100% is reported as a return of capital, which is not taxable to the investor.

Inflation hedge: As an investment in tangible hard assets, REITs can provide an inflation hedge.

REITs, some of which are also convertible securities, provide growth and income, and are ideal for investors who are looking to diversify their portfolio. REITs can enhance investment portfolios, whether they are held in taxed or tax-deferred accounts. However, because they do not qualify for the new 15% dividend rate, they are especially advantageous for tax-deferred accounts.